ELS Chapter 12: Graphing Exercise 1 Answers
Banks, the Federal Reserve, and the Money Supply
1. Maintain the 1929 value (.075) for the reserve-to-deposit ratio, but increase the amount of currency held by the public by $1 billion and reduce bank reserves by $1 billion. This might be caused, for example, by a banking panic. What happens to the money supply after the increase in currency held by the public? Why has the value of the money supply changed by more than $1 billion?
  answer: The money supply drops by $12.33 billion (to $33.52 billion) as a result of the increase in currency holdings of $1 billion. Each dollar of reserves taken out "supports" $13.33 worth of deposits, so a reduction of $1 billion in reserves reduces deposits (and the money supply) by $13.33 billion (holding the R/D ratio constant). The withdrawn reserves are held as currency, increasing the money supply by $1 billion. The net effect of these two actions is a drop of $12.33 billion in the money supply (-$13.33 billion + $1 billion).
2. Restore the original values in the applet by clicking on the Reset button. Now, increase the level of currency held by the public to $4.85 billion, increase the level of bank reserves to $3.45 billion and increase the reserve-to-deposit ratio to .133 (these were the levels occurring in December, 1933). Why would reserves and the desired reserve-to-deposit ratio likely increase during a banking panic? What happens to the money supply after the increase in reserves and the increase in the desired reserve-to-deposit ratio? Why?
  answer: Banks would hold additional reserves against their deposits for at least two reasons: (1) They want to have enough currency on hand to meet depositors' demands for withdrawing currency (especially during a banking panic), and (2) they would not be as willing to make loans during a recession, when banking panics are more likely to occur. When banks increase their reserve-to-deposit ratio and their holdings of reserves, the money supply contracts. Why? There is less money being lent out overall, resulting in fewer purchases of goods and services, and consequently fewer deposits being created after the loans are spent. In this case, the money supply fell by almost one-third (from $45.85 billion to $30.79 billion).
3. Restore the original values in the applet by clicking on the Reset button. Assume that due to a banking panic, consumers withdraw $1 billion in deposits (and reserves) from banks. If the Federal Reserve wants to keep the money supply at its initial level ($45.85 billion), what can it do to offset the withdrawal of deposits by consumers/savers? In particular, determine what adjustments the Federal Reserve must make to the level of bank reserves in the economy to meet its objective. What type of open market operations must the Federal Reserve carry out to meet its objective?
  answer: Initially, the money supply drops by $12.33 billion as a result of the increase in currency holdings of $1 billion. To keep the money supply at its original level, the Federal Reserve must increase the level of reserves in the banking system. For example, the Federal Reserve could use open market operations to buy government securities, increasing the level of reserves in the banking system. To keep the money supply at its original level the Federal Reserve would need to increase reserves to $3.075 (keeping R/D constant). That is, the Federal Reserve would need to buy $.925 billion ($3.075 billion - $2.15 billion) in government securities.

4.

 Restore the original values in the applet by clicking on the Reset button. What happens to the money supply if the Federal Reserve reduces the required reserve-deposit ratio to 0.05?
  answer: Assuming that banks reduce their desired reserve-deposit ratio, the money supply increases. Why? Each dollar of deposits requires fewer reserves to be held against it, so the bank can lend out money, creating additional deposits (money) in the banking system.

5.

 Restore the original values in the applet by clicking on the Reset button. What happens to the money supply if banks decided to hold a larger quantity of reserves against their deposits? What could the Federal Reserve do to offset this change in behavior and keep the money supply at its current level?
  answer: If the desired reserve-deposit ratio increases, the money supply falls. Why? Each dollar of deposits now has more reserves held against it, so the bank has less money to lend out, creating fewer deposits (money) in the banking system.

6.

 Restore the original values in the applet by clicking on the Reset button. If the Federal Reserve increases reserves in the banking system by $100 million, what will be the effect on the money supply, given a desired reserves-to-deposit ratio of .20 and an initial level of reserves of $6 billion? Why is the effect on the money supply greater than $100 million?
  answer: With C=$3.85, R = $6.0 and R/D = 0.20, the money supply is $33.85 billion. If the Federal Reserve increases reserves by $100 million ($0.1 billion), R becomes $6.1 billion and the money supply increases to $34.35 billion, an increase of $0.5 billion or $500 million. The money supply increases by more than $100 million because while the first bank lends out the full $100 million in excess reserves, once the loans are spent this will increase deposits and excess reserves in other banks. These banks then loan out their excess reserves, creating more deposits (money) and more excess reserves. This process continues until there are no more excess reserves to lend, which occurs after the money supply increases by $500 million.