1. Below, you will find a balance sheet for First Third Bank.

Assets

Liabilities and Equity

Reserves

$200

Demand deposits

$2,000

Loans

$1,800

Equity (net worth)

$0

Assume that there is a required reserve ratio of 10 percent.

(a) What is the dollar value of new loans that First Third Bank can make?
Explain.
The RRR is 10%, implying that the bank should keep 10% of the deposits in
reserves.
Currently the bank has 200$ as reserves which is exactly 10% of
2000(demand deposits). So the bank cannot issue out any new loans.
(b) Mr. Winestock deposits $100 in cash in his checking account. What is the
immediate impact of this transaction on the money supply? Explain.
Note that checking account is a different name for demand deposit
Money supply increase when there is an increase in demand deposit.
Here, The money supply increases since there is an increase in demand
deposit

(c) Calculate the maximum amount of new loans that First Third Bank can now
make.
New deposit = 100$
RRR = 10%
The bank has to keep 10% of 100, that is 10$ in the reserves and the rest can
be loaned out.
So the maximum amount of new loans that first third bank can now make is
the extra reserves, ER = 100 10 = 90$
Money multiplier, mm = 1/ Reserve ratio = 1/0.1 = 10
(d) As a result of Mr. Winestocks $100 cash deposit, calculate the maximum
change over time in each of the following in the banking system.
(i)

Loans
Max change in loans = ER * money multiplier = $90 * 10 = $900

(ii)

Demand deposits
Maximum change in DD = deposit * money multiplier = $100*10 = $ 1000

(e) As a result of Mr. Winestocks $100 cash deposit, calculate the maximum
change over time in the money supply.
Max change in MS = ER* mm
= 90 * 10
= 900
(f) Provide one reason why the actual change in money supply can be smaller
than the maximum change you identified in part (e).
The bank may choose to keep additional reserves instead of loaning out all
the excess reserves it has: consumers do not deposit each and every money
they take out in loans.
(g) If the public decides to hold some money in the form of currency rather than
in demand deposits, how will this influence the change in the money supply
that was determined in part (e)? Explain.
The cash holdings reduce the deposits and it will result in lesser extra
reserves.
Also, we know max change in MS = ER*mm. So when ER is reduced, the
money supply also reduces. So the money supply will be lesser than the
maximum.
(h) Suppose that the Federal Reserve purchases $5,000 worth of bonds from
First Third Bank. What will be the change in the dollar value of each of the
following immediately after the purchase?
(i) Excess reserves

(iii)

When FR purchases5000 worth of bond, the excess reserves rises by the

same amount, so excess reserves rises by $5000
Demand deposit
DD has no effect since the purchase increases ER and reduces the bank
holdings

(j) Calculate the maximum amount that the money supply can change as a result
of the $5,000 purchase of bonds by the Federal Reserve.
Mm = 1/0.1 = 10
Max change in MS = ER * mm

= 5000 * 10
= 50000
(k) When the Federal Reserve purchases bonds, what will happen to the price of
bonds in the open market? Explain.
When the Federal reserve purchases bonds, the extra reserves increases.
This will increase the money supply. If the extra reserves are increased, more
money is available for loans, resulting in reduced interest rates. Hence, the
bond purchase increase, the money supply and hence reduces the interest
rates
Now, assume that the Federal Reserve decides to target a lower federal funds rate.
(l) What open market operation can the Federal Reserve use to achieve the
lower target?
When Federal reserve buys government bonds, the price of these bonds
increases, and hence reducing the interest rates.
That is, when FR buys bond, price of the bond increases leading to the
money supply increase and hence reducing the rates.
(m)
Given your answer to part (k), what will happen to the price of
government bonds?
When FR buys bond, price of the government bond increases
(n) Using a correctly labeled graph of the money market, show the effect of the
open market operation from part (k) on the nominal interest rate.

As explained by the graph, as the money supply increase, the interest rates reduces.
(o) Assume that the Federal Reserve sells government bonds from commercial
banks. Based only on this transaction, will the level of required reserves in
the commercial banks increase, decrease, or remain the same? Explain
When FR sells government bonds to commercial banks, the required reserves
is not affected,but the price of the bond and the money supply.
These effects might have an impact in the long run, but not on the short run.
(p) Another monetary policy action involves changing the discount rate. Define
the discount rate.
Discount rate is the rate that the federal reserve charges banks and
depository instituions for borrowing from federal reserves lending facility
discount window.