Question

1.  Suppose the Fed conducts an open market purchase by buying $10 million in Treasury bonds from Acme Bank. Sketch out the balance sheet changes that will occur as Acme converts the bond sale proceeds to new loans. The initial Acme bank balance sheet contains the following information: Assets – reserves 30, bonds 50, and loans 50; Liabilities – deposits 100 and equity 30.

2. (a) Suppose the Fed decides it needs to pursue an expansionary policy. Assume the reserve requirement is 20 percent, and there are no excess reserves. Show how the Fed would increase the money supply by $2 million through open market operations.

(b) Some individuals have suggested raising the required reserve ratio for banks to 100 percent:

(i) What could the money multiplier be if this change were made?

(ii) What effect would such a change have on the money supply?

(iii) How could that effect be offset (in ii above)?

Answer 1

Question 1

The initial balance sheet of Acme Bank is as follows -

Assets	Amount (in million $)	Liabilities	Amount (in million $)
Reserves	30	Deposits	100
Bonds	50	Equity	30
Loans	50
Amount	130	Amount	130

Now, Fed conducts an open market purchase by buying $10 million in Treasury bonds from Acme Bank.

This will reduce bonds held by Acme Bank by $10 million and would increase Reserves by $10 million.

Now, Acme Bank uses these excess reserves of $10 million to make new loans.

As bank will make new loans, its loans will increase by $10 million.

Also, as bank make loan, it opens deposit account in name of borrower.

So, deposits will also increase by $10 million.

Following is the balance sheet of Acme Bank after making new loans -

Assets	Amount (in million $)	Liabilities	Amount (in million $)
Reserves	40	Deposits	110
Bonds	40	Equity	30
Loans	60
Amount	140	Amount	140