Eco 202
Test 2
Name_______________________________
30 March 2007
Please write answers in ink. You may use a pencil to draw your graphs.
Allocate your time efficiently. Good luck and don’t enjoy your spring break too much.
1. a. Draw a simple T-account for First Terrier Bank (FTB), which has $20,000 of deposits, a
required reserve ratio of 10 percent, and excess reserves of $800. Make sure you balance sheet
balances.
First Terrier Bank
Assets
Reserves
Liabilities
2,800 Checkable Deposits
Treasury Bills
4,200
Loans
13,000
Total Assets
20,000 Total Liabilities
20,000
20,000
b. Assume that all other banks hold only the required amount of reserves. If First Terrier
decides to reduce its reserves to only the required amount, by how much can it increase lending?
$800
c. As a result of this loan, what is the potential increase in the quantity of money?
∆D = 1/r * ∆R → ∆D = 10 * $800 = $8,000.
d. Now assume that the Fed purchases a $2,000 Treasury Bill from FTB? What happens to First
Terrier’s level of excess reserves?
It increases by $2,000, which means it can increase its lending by $2,000
e. How much can First Terrier lend after the Fed’s purchase? What is the potential increase in
the quantity of money as a result of the Fed’s purchase?
∆D = 1/r * ∆R → ∆D = 10 * $2,000 = $20,000.
2. During the early 1930s there were a number of bank failures in the United States. What did
this do to the money supply? The New York Federal Reserve Bank advocated open market
purchases. Would these purchases have reversed the change in the money supply and helped
banks? Explain.
Bank failures cause people to lose confidence in the banking system so that deposits fall and
banks have less to lend. Further, under these circumstances banks are probably more cautious
about lending. Both of these reactions would tend to decrease the money supply. Open market
purchases increase bank reserves and so would have at least made the decrease smaller. The
increase in reserves would also have provided banks with greater liquidity to meet the demands
of customers who wanted to make withdrawals. In short, while the actions of depositors and
banks lowered the money supply, the Fed could have increased it by buying bonds.
3. In the space below, please illustrate—using the market for reserves (federal funds)—the
effect on the federal funds interest rate of an open market sale of government bonds by the Fed.
Be sure to label correctly: the axes, the demand and supply schedules, the original interest rate
and level of reserves, and the new interest rate and level of reserves.
3. b. When would the Fed take this policy action? Explain.
The Fed will take such a policy action to raise the federal funds interest rate and drain reserves
from the banking system. This action will have the effect of dampening bank lending, and
raising the interest rates that businesses and consumers pay to borrow loanable funds. This will
slow spending growth, which, in turn, will check the upward pressure on prices. In short, the
Fed will take this action to keep inflation in check.
4. In recent years Venezuela and Russia have had much higher nominal interest rates than the
United States while Japan has had lower nominal interest rates. What would you predict is true
about money growth in these other countries? Why?
The Fisher effect says that increases in the inflation rate lead to one-to-one increases in nominal
interest rates. The quantity theory says that in the long run, inflation increases one-to-one with
money supply growth. It follows that differences in nominal interest rates may be due to
differences in money supply growth rates. It is reasonable to guess that much higher nominal
interest rates in Venezuela and Russia indicate higher money supply growth while lower interest
rates in Japan indicate lower money supply growth.
Eco 202
Test 2
Name_______________________________
30 March 2007
Please write answers in ink. You may use a pencil to draw your graphs.
Allocate your time efficiently. Good luck and don’t enjoy your spring break too much.
1. a. Draw a simple T-account for First Terrier Bank (FTB), which has $10,000 of deposits, a
required reserve ratio of 10 percent, and excess reserves of $300. Make sure you balance sheet
balances.
First Terrier Bank
Assets
Reserves
Liabilities
1,300 Checkable Deposits
Treasury Bills
2,700
Loans
6,000
Total Assets
10,000 Total Liabilities
10,000
10,000
b. Assume that all other banks hold only the required amount of reserves. If First Terrier
decides to reduce its reserves to only the required amount, by how much can it increase lending?
$300
c. As a result of this loan, what is the potential increase in the quantity of money?
∆D = 1/r * ∆R → ∆D = 10 * $300 = $3,000.
d. Now assume that the Fed purchases a $1,000 Treasury Bill from FTB? What happens to First
Terrier’s level of excess reserves?
It increases by $1,000, which means it can increase its lending by $1,000
e. How much can First Terrier lend after the Fed’s purchase? What is the potential increase in
the quantity of money as a result of the Fed’s purchase?
∆D = 1/r * ∆R → ∆D = 10 * $1,000 = $10,000.
2. Explain how each of the following changes the federal funds interest rate.
a. The Fed buys bonds
The supply of reserves will shift to the right, lowering the federal funds interest rate.
b. The Fed raises the discount rate
Banks will borrow less, causing the supply of reserves to fall (leftward shift) raising the federal
funds interest rate.
c. The Fed raises the reserve requirement
The demand for reserves will shift to the right, raising the federal funds interest rate.
d. In the space below, please illustrate—using the market for reserves (federal funds)—the
effect on the federal funds interest rate of an open market purchase of government bonds by the
Fed. Be sure to label correctly: the axes, the demand and supply schedules, the original interest
rate and level of reserves, and the new interest rate and level of reserves.
An open market purchase of government securities adds reserves to the banking system. The
increased quantity of reserves is shown as a rightward shift in the supply of reserves in the
market for federal funds. The increase in the available quantity of reserves means an excess
supply of reserves at the original federal funds interest rate. This excess supply will put
downward pressure on the federal funds rate, causing it to fall until the new equilibrium is
reached at i2.
3. During the early 1930s there were a number of bank failures in the United States. What did
this do to the money supply? The New York Federal Reserve Bank advocated open market
purchases. Would these purchases have reversed the change in the money supply and helped
banks? Explain.
Bank failures cause people to lose confidence in the banking system so that deposits fall and
banks have less to lend. Further, under these circumstances banks are probably more cautious
about lending. Both of these reactions would tend to decrease the money supply. Open market
purchases increase bank reserves and so would have at least made the decrease smaller. The
increase in reserves would also have provided banks with greater liquidity to meet the demands
of customers who wanted to make withdrawals. In short, while the actions of depositors and
banks lowered the money supply, the Fed could have increased it by buying bonds.
4. a. Suppose the Fed sells government bonds. Use a graph of the money market to show what
this does to the value of money and to the price level. Be sure to label correctly: the axes, the
demand and supply schedules, the original and new quantity of money, price levels, and value of
money.
4. b. When would the Fed take this policy action? Explain.
The Fed will take such a policy action to drain reserves from the banking system so as to reduce
the quantity of money (or slow its growth). A decline in the quantity of money raises the value
of money and lowers the price level.