Question

1. Suppose the current require reserve ratio is 10% and all commercial banks hold 5% excess reserves.
   1. Suppose the Fed had an open market sale of U.S. government securities for $100,000 to Megabank (a commercial bank). (20 points)
      1. How does this change affect the balance sheets of Megabank and the Fed? (Write out two t-accounts to show the changes, one for Megabank and one for the Fed.
      2. How much change in monetary base is caused by this open market operation? Also, calculate how much change in the money supply is caused by this open market operation.
         1. Suppose the Fed enforce the above open market operation and also decrease the reserve requirement from 10% to 7%. How much change in monetary base is caused by these two policies together? Also, calculate how much change in the money supply is caused by these two policies together. (10 points)
         2. Briefly explain why your answers for (a-ii) and (b) are different. (5 points)

Answer 1

Answer:

Let us make a hypothetical Balance sheet for Commercial bank and one for Fed as follows:

Commercial Banks Balance Sheet

Assets	Liabilities
Reserves	300,000	Deposits	2,000,000
Loans	1,700,000
Total	2,000,000	Total	2,000,000

Federal Banks Balance Sheet

Assets	Liabilities
Securities	400,000	Deposits of govt.	1,500,000
Loans to banks	1,600,000	Reserves of commercial banks	300,000
		Notes in circulation	200,000
Total	2,000,000	Total	2,000,000

a.

i.

After open market operation balance sheets will be as follows:

Commercial Banks Balance Sheet

Assets	Liabilities
Reserves	200,000	Deposits	2,000,000
Securities	100,000
Loans	1,700,000
Total	2,000,000	Total	2,000,000

Federal Banks Balance Sheet

Assets	Liabilities
Securities	300,000	Deposits of govt.	1,500,000
Loans to banks	1,600,000	Reserves of commercial banks	200,000
		Notes in circulation	200,000
Total	2,000,000	Total	2,000,000

ii.

Change in monetary base will be tightening by $100,000.

Money supply will decrease by $1,000,000, i.e. $100,000/Reserve Rate=$100,000/10%.

a.

Because of decrease in reserve requirement from 10% to 7% monetary base is expanded/broadened by 3% of deposits, i.e. 3%*$2,000,000=$60,000. With both policies together monetary base is tightened by $40,000. Money supply will now be decreased by $40,000/7%=$571,428.

b.

In a(ii), Because of open market operations monetary base and money supply decreased because banks purchased securities against money.

In (b) by decrease in reserve requirement monetary base is expanded but not enough to compensate the tightening held by open market operations. But still tightening of monetary base is relaxed due to decrease in reserve requirement..