Question

1. Suppose commercial banks borrow from Federal Reserve Banks at the discount rate. What is the impact of this transaction on commercial bank reserves?

a. Commercial bank reserves will increase.

b. Commercial bank reserves will decrease.

c. Commercial banks reserves will be unchanged.

2. Suppose the Fed reduces the reserve ratio. What impact will this transaction have on commercial bank reserves?

a. Commercial bank reserves will increase.

b. Commercial bank reserves will decrease.

c. Commercial bank reserves will be unchanged.

3. Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp and prolonged inflationary trend. What changes in the reserve ratio should you recommend?

a. I should recommend increasing the reserve ratio to reduce lending and reduce spending.

b. I should recommend decreasing the reserve ratio to increase lending and increase spending.

4. Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp and prolonged inflationary trend. What changes in the discount rate should you recommend?

a. I should recommend increasing the discount rate to reduce lending to reduce spending.and demand-pull inflation.

b. I should recommend decreasing the discount rate to increase lending and increase spending real GDP.

c. I should recommend making no change to the discount rate as it does not affect borrowing or spending.

5. Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp and prolonged inflationary trend. What changes in open market operations should you recommend?

a. I should recommend open market sales to reduce the money supply and reduce demand-pull inflation.

b. I should recommend open market purchases to increase the money supply to increase real GDP.

c. I should recommend open market sales to increase the money supply to increase real GDP.

d. I should recommend no change in open market operations.

6. The liquidity trap occurs when

a. The reserve ratio is increased and borrowing must be reduced.

b. Increased money supply or reduced interest rates fail to encourage increased demand.

c. People decide to hold more of their personal financial assets in cash instead of as checkable deposits.

d. Monetary policy fails to reduce inflation.

Answer 1

1. Reserves are a proportion of deposits in the bank that the bank is mandated to hold as cash or deposits at the Fed. When the commercial bank borrows from the Fed, the excess funds are loaned out which increases the deposits due to multiplier effect and thus the bank reserves increase.

Ans: a. Commercial bank reserves will increase.

2. When the Fed reduces the reserve ratio, the amount of required reserves decreases and hence the commercial bank reserves will decrease and the excess reserves increase.

Ans: b. Commercial bank reserves will decrease.

3. When an economy is experiencing a sharp inflationary trend, a tight/contractionary monetary policy has to be adopted. Such a policy involves increasing the required reserve ratio, increasing the discount rate, open market sale of government securities etc. All the above-mentioned policies reduce the money supply and thus reduce the aggregate demand and help reduce the inflationary trend.

Ans: a. I should recommend increasing the reserve ratio to reduce lending and reduce spending.

4. See explanation in Q3

Ans: a. I should recommend increasing the discount rate to reduce lending to reduce spending and demand-pull inflation.