Question

. Concepts:

Definition and calculation of the money supply

A bank’s balance sheet l

The Federal Reserve system

The money multiplier

Suppose the country of Grenada has the following monetary asset information as of December 2016:

Cash in hands of the public = $300b (where ‘b’ represents billion)

Demand Deposits (DD) = $400b

Other Checkable Deposits = $150b

Traveler’s checks = $50b

Savings Type accounts = $2000b

Money Market Mutual Funds (MMMF) = $1000b

Small Time Deposits = $500b

Large Time Deposits = $450b

(a) Calculate M1 for Grenada.

(b) Calculate M2 for Grenada.

(c) Which item is not included in the calculations of M1 and M2?

2. Using the t-accounts of Bank 1 and Bank 2 given in chapter 15, describe what happens when jane brown writes a $50 check on her account at the Bank 1 to pay her friend Joe Green, who in turn deposits the check in his account at Bank 2.

3. Suppose Nancy deposits $100,000 in Bank 1 and Ming borrows $80,000 from Bank 1 to buy a Dodge Viper. The required reserve ratio for all banks (set by the Fed) is 20%. The Dodge company deposits the money from Ming’s Viper purchase in Bank 2. Assume that there are no currency drains.

(a) Fill in the following balance sheets, for Bank 1 and Bank 2, respectively:

Bank 1 ‘s Balance Sheet Assets Liabilities Reserves: Demand Deposits: Loans: Bank

2’s Balance Sheet Assets Liabilities Reserves: Demand Deposits: Loans:

(b) What is the level of required reserves Bank 1 must hold after Nancy’s deposit?

(c) What is the level of required reserves Bank 2 must hold after Dodge’s deposit?

(d) Are these two Required Reserves the same? If so, why? If not, why not? 4.

This question will test your understanding of the money multiplier. Suppose the Fed buys $5000 bonds from Bob. In return for the Bonds it gives Bob a check for $5000. Suppose Bob banks with Bank A, and the RR ratio for all banks is 20%. Assume there are no currency drains in this question and that banks do not hold excess reserves. Answer the following questions. (a) What will be the change in DD on the balance sheet of Bank A? (b) What is the total change in required reserves and excess reserves on the balance sheet of Bank A? (c) Suppose Bank A lends out all their ER to George. What will be the amount of the loan (Hint: Q2 multiple choice might help?) (d) Suppose that George deposits the loan in Bank B, and Bank B again loans out all its ER from George’s deposit to Pete. Again, what will be the amount of the loan? What will be the change in DD on the balance sheet of Bank B? (e) If this process repeats itself again and again (i.e. Pete deposits all his money in Bank C and Bank C loans out all its ER from Pete’s deposit to say, Jay, etc), we need to know the money multiplier. Write out a formula for the money multiplier in terms of the RR ratio. (f) How much will the money supply increase/decrease in the economy due to this purchase of bonds by the Fed? (Hint: to convince yourself, look at problem 1(c): What happens to the money supply when DD increase/decrease?) (g) Suppose that instead of having an RR ratio of 20%, the government wants to use a purchase of $5000 worth of bonds to reach an overall increase in the money supply of $35,000. What will be the RR ratio need to be in order to reach that goal? (h) Finally, suppose that the same goal ($35,000) is to be achieved, but this time the RR ratio is fixed at 20%. How many bonds will the government need to purchase in order to reach their goal?

Answer 1

Suppose the country of Grenada has the following monetary asset information as of December 2016:

Cash in hands of the public = $300b (where ‘b’ represents billion)

Demand Deposits (DD) = $400b

Other Checkable Deposits = $150b

Traveler’s checks = $50b

Savings Type accounts = $2000b

Money Market Mutual Funds (MMMF) = $1000b

Small Time Deposits = $500b

Large Time Deposits = $450b

a) M1 include those components which are most liquid in an economy.

M1= Cash in hands of the public + Demand Deposits+Other Checkable Deposits+Traveler’s checks

M1= $300b + $400b + $150b + $50b= $900b

b) M2 include M1 and some less liquid components as compare to component in M1.

M2= M1+Savings Type accounts+Money Market Mutual Funds+Small Time Deposits

M2= $900b+$2000b+$1000b+$500b= $4400b

c) The Large time deposits are not included in both M1 and M2 instead they included in M3 it is so because of Large time deposit are not a liquid component.