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CHAPTER 3: Monetary Policy
Answers to End-of-Chapter Questions
1. What would happen to the monetary base if the U.S. Treasury collected $4 billion in
taxes, which it deposited in its account at the Federal Reserve, and the Federal Reserve
bought $2.5 billion in government securities? Do you know now why the Federal
Reserve and Treasury try to coordinate their operations in order to have minimal
effects on the financial markets?
The $4 billion in taxes would be paid via a transfer from the Treasury tax deposits at
commercial banks and would lower bank reserve deposits at the Federal Reserve and increase
the Treasury deposits in the Federal Reserve by $4 billion. There is no change in the
monetary base, but the bank reserve base has been reduced by $4 billion. If the Federal
Reserve purchases $2.5 billion in government securities, $2.5 of the $4 billion reduction in
bank reserves has been restored. With no other changes, this action reduces bank reserves,
bank liquidity, and may increase the federal funds rate. In a day or two the Treasury will
spend the taxes, the checks will be deposited in banks and the bank reserve accounts will go
up by the amount of the clearing checks. The Federal Reserve will then have to sell
government securities to return the bank reserve account level to its desired level.
2. If the Federal Reserve bought $3.5 billion in government securities and the public
withdrew $2 billion from their transactions deposits in the form of cash, by how much
would the monetary base change? By how much would financial institutions' reserves
change? By how much would financial institutions' required reserves change if all
proceeds from bond sales and all withdrawals from transactions accounts were
deposited in or taken from accounts subject to a 10% reserve requirement? By how
much would depository institutions' net excess reserves change?
Assuming the banks replenished their cash stock; the bank reserve account would have been
increased by the $3.5 billion purchase of government securities and decreased by the $2
billion payment for the Federal Reserve note issuance. The monetary base, comprised of
Federal Reserve notes outstanding, bank reserve accounts, and Treasury and foreign bank
deposits and Treasury coin would increase by $3.5 billion, the amount of the purchase of
government securities. The purchase of cash is a wash, netting increases in Federal Reserve
notes and decreases in bank reserve accounts to pay for the currency.
3. If a country named Lower Slobovia were to decide to use U.S. dollars as a medium of
exchange and therefore withdrew $10 billion in cash from its transaction deposits in the
United States, what would happen to the U.S. monetary base? What would happen to
depository institutions' actual reserve holdings? What would happen to U.S. financial
institutions' net excess reserves if the Lower Slobovians withdrew their money from
bank deposits subject to a 10% reserve requirement? What would probably happen to
the U.S. money supply?
2
Assuming the banks replenished their cash at the Federal Reserve, the monetary base will not
change. The Federal Reserve notes will increase by $10 billion and the bank reserve deposit
accounts will decrease by $10 billion. With the withdrawal of $10 billion in bank deposits,
the banks' required reserve requirements would decline by $1 billion (10% of $10 billion),
but their actual reserve balances would decline by $10 billion, assuming replenishment of
cash. Assuming no excess reserves, the destruction of bank reserves would cause a decline in
the money supply. Currency is a high power reserve; increases in currency in circulation
decrease bank reserves. The Federal Reserve is likely to replenish the reserves, assuming no
policy changes.
4. Assume a depository institution holds vault cash of $3 million, reserve deposits at the
Federal Reserve of $25 million, and has borrowed $2 million from the Federal Reserve’s
discount window. If that institution holds $300 million in transactions deposits and is
subject to a 3% reserve requirement on the first $50 million of those deposits and to a
reserve requirement of 10% on all transactions deposits over $50 million, what are its
required reserves? What are its excess reserves?
The bank has total reserves equal to the sum of their vault cash ($3) and reserve deposits at
the Federal Reserve ($25) or $28 million. The required reserves amount is $26.5 million
leaving the bank with $1.5 million in excess reserves. Of the $1.5 million in excess reserves,
$2 million is borrowed from the Federal Reserve, leaving the bank in a -$.5 million net
borrowed reserve position.
5. What is the essential difference between the Keynesian and the Monetarist view of how
money affects the economy?
In general the early monetarists assumed that velocity is relatively constant, so that
controlling M1 is the essential factor in influencing the non-inflationary output of the
economy. The Keynesians assumed that velocity is a variable so that changes in the money
supply often affect only the financial sector (interest rates) and not necessarily the real sector
of spending and investments. Investment spending is related to the expected rate of return on
investments relative to the level of interest rates. The neo-Keynesians have a short-run view
of the world. The quantity theorists take a long-run view - where labour markets and prices
have time to adjust to equilibrium.
6. What effects are decreases in reserve requirements likely to have on:
a.
b.
c.
d.
e.
bank reserves
Federal funds rates
bank lending
Treasury bill rates
the bank "prime rate"?
Explain your answers.
a.
b.
c.
d.
e.
none
reduce them
increase it
reduce them
reduce it
3
Reductions in reserve requirements will not directly affect the amount of reserves available to
financial institutions. However, such a reduction would provide depository institutions with
additional excess reserves. As financial institutions sought to invest their excess reserves to
earn an interest return, first federal funds rates then Treasury bill rates and other short-term
rates (such as the prime rate) would fall. Simultaneously, institutions with excess reserves
would be more willing than before to make loans, and the demand for such loans would
increase as the rate falls.
7. Given your answer to the above question, what, if anything, would you expect would
happen to:
a.
b.
c.
d.
e.
f.
g.
housing investment
plant and equipment
investment
intended inventory
investment
government expenditures
consumption
exports
imports
a.
b.
increase
increase
c.
increase
d.
e.
f.
g.
increase
increase
increase
decrease
Why?
As market interest rates decline, loans become readily available, money supplies expand, the
public's liquid asset holdings increase, and the market value of financial assets rises. In
addition, disintermediation pressures may diminish. As a result of the decline in interest rate,
increase in liquidity, and increase in credit availability more expenditures will be undertaken
in all segments of the economy. A decline in interest rates and weak import demand from a
recession, as in 1990-1991, weakened the dollar, enhancing exports. The decline in stock
indexes in 2001 and 2002 weakened the dollar as foreign investors sold U.S. stocks and
reinvested elsewhere, enhancing exports and raising the costs of imports.