ELS Chapter 9: Graphing Exercise 1 Answers
Commercial Banks, the Federal Reserve, and the Creation of Money
1. If the Federal Reserve buys $10,000 in government bonds, what happens to the money supply, assuming the desired reserve-deposit ratio remains at 0.1?
  answer: The money supply increases by $100,000. Fed purchases of government bonds increase the amount of reserves in the banking system, leading to more loans and more deposits. Since deposits are part of the money supply, the money supply increases.
2. If the Federal Reserve buys $20,000 in government bonds, what happens to the money supply, assuming the desired reserve-deposit ratio remains at 0.1?
  answer: The money supply increases by $200,000. Fed purchases of government bonds increase the amount of reserves in the banking system, leading to more loans and more deposits. Since deposits are part of the money supply, the money supply increases.
3. If the Federal Reserve sells $15,000 in government bonds, what happens to the money supply, assuming the desired reserve-deposit ratio remains at 0.1?
  answer: The money supply decreases by $150,000. Fed sales of government bonds reduce the amount of reserves in the banking system, leading to fewer loans and fewer deposits. Since deposits are part of the money supply, the money supply falls.

4.

 If the Federal Reserve buys $10,000 in government bonds, but the banks' desired reserve-deposit ratio rises to 0.2, what happens to the money supply? How does the result differ if the desired reserve-deposit ratio remains at 0.1?
  answer: The money supply increases by $50,000 when the desired reserve-deposit ratio is 0.2. When the desired reserve-deposit ratio is 0.1, a $10,000 purchase of government bonds increases the money supply by $100,000. If banks hold a greater fraction of their deposits as reserves, fewer loans are made, leading to fewer new deposits and a smaller increase in the money supply.

5.

 If the Federal Reserve sells $20,000 in government bonds, but the banks' desired reserve-deposit ratio falls to 0.05, what happens to the money supply? How does the result differ if the desired reserve-deposit ratio remains at 0.1?
  answer: The money supply falls by $400,000 when the desired reserve-deposit ratio is 0.05. When the desired reserve-deposit ratio is 0.1, a $20,000 sale of government bonds reduces the money supply by $200,000. If banks hold a smaller fraction of their deposits as reserves, more loans are made, leading to more new deposits and a larger increase in the money supply.

6.

 When the Federal Reserve buys or sells government bonds, the money supply changes by a multiple of the initial change in reserves. Why does a Federal Reserve purchase or sale of government bonds lead to a larger change in the money supply?
  answer: Take the case of a Federal Reserve purchase of government bonds. If banks lend out their excess reserves, then the first bank in the money-creation process will lend out the entire increase in reserves. When these loans are spent, this will create an equal number of deposits, or money. However, this is not the end of the money-creation process. For every dollar of additional deposits that banks receive, banks hold only a fraction of a dollar in reserves, lending most of the remainder out. When these loans are spent, they create even more deposits (money), reserves, and lending. This loan-deposit process continues until there are no excess reserves to lend, but the ultimate effect is a multiple increase in deposits (money), relative to the initial increase in reserves generated by the Federal Reserve purchase of government bonds.