Chapter 16, Problem 3RQ

Subpart (a):

To determine

Effect of transactions.

Explanation of Solution

The effect of the transactions a, b, c on the consolidated balance sheet for commercial banks as well as Federal Reserve Banks is demonstrated in the tables given below. In the table, Column (a) shows the causes of Transaction (a): When Federal Reserve Banks purchases securities from banks. Column (b) demonstrates Transaction (b): When Commercial banks borrow from Federal Reserve Banks at the discount rate. And Column (c) shows Transaction (c) : The Fed reduces the reserve ratio.

Column (a) also answers the transaction (d): Commercial banks increase their reserves after the Fed increases the interest rate and pays reserves.

		Consolidated Balance Sheet: All Commercial Banks (in $ billions)
		(a)	(b)	(c)
Assets:
Reserves	$30	32	31	30
Securities	60	58	60	60
Loans	60	60	60	60
Liabilities and Net Worth:
Checkable deposits	$150	150	150	150
Loans from Federal Reserve Banks	3	3	4	3

		Consolidated Balance Sheet: 12 Federal Reserve Banks (in $ billions)
		(a)	(b)	(c)
Assets:
Securities	$60	62	60	60
Loans to Commercial Banks	3	3	4	3
Liabilities and Net Worth:
Reserves of Commercial Banks	$30	32	31	30
Treasury deposits	3	3	3	3
Federal Reserve Notes	$27	27	27	27

Assume the reserve ratio is 20%.

Suppose Fed purchases $2 billion worth of securities. This would increase commercial bank reserves by $2 billion (from $30 billion to $32 billion) and reduce securities by $2 billion (from $60 billion to $ 58 billion). This responds to the direct and immediate effect to the consolidated balance sheet.

With checkable deposits of $150 billion, required reserves are $30 billion $\left(0.2\times 150\text{ billion}\right)$. Therefore, excess reserves are $2 billion $\left(32\text{ billion}-30\text{ billion}\right)$. In the longer term the bank can increase the money supply part of credit creation by $10 billion more $\left(2\text{ billion}\times \frac{1}{0.2}\right)$.

Economics Concept Introduction

Concept Introduction:

Reserve Ratio: it is the ratio or percentage of deposit that banks must hold in liquid form.

Money Supply: It is the total money in circulation in the economy. It involves currency notes, deposits and other forms of liquid asset.

Money Multiplier: It is the ratio of reserves to the total amount of reserves in the banking system. It is the amount that bank generates or creates with each unit of reserves.

Open Market Operation (OMO): It is the monetary control mechanism employed which involves buying and selling of government securities in the open market to routine (expand or contract) the amount of money in the banking system.

Subpart (b):

To determine

Effect of transactions.

Explanation of Solution

Suppose the commercial banks borrow $1 billion from the Fed at the discount rate. This would increase commercial bank reserves by $1 billion (from $30 billion to $31 billion) in the asset side of the commercial bank and also would increase loans from Fed to $4billion (from $3 billion) in the liabilities side. This responds to the direct and immediate effect to the consolidated balance sheet.

Now, the excess reserve is $1 billion $\left(31\text{ billion}-30\text{ billion}\right)$. So, in the longer term the bank can increase the money supply (by making loans) by $5 billion $\left(1\text{ billion}\times \frac{1}{0.2}\right)$.

Economics Concept Introduction

Concept Introduction:

Reserve Ratio: it is the ratio or percentage of deposit that banks must hold in liquid form.

Money Supply: It is the total money in circulation in the economy. It involves currency notes, deposits and other forms of liquid asset.

Money Multiplier: It is the ratio of reserves to the total amount of reserves in the banking system. It is the amount that bank generates or creates with each unit of reserves.

Open Market Operation (OMO): It is the monetary control mechanism employed which involves buying and selling of government securities in the open market to routine (expand or contract) the amount of money in the banking system.

Subpart(c):

To determine

Effect of transactions.

Explanation of Solution

There is no immediate effect on the consolidated balance sheet due to the change in the reserve ratio. But in the longer term, when the reserve ratio decreases from 20% to say, 18%; the required reserve is now $27 billion. So the excess reserve is now $ 3 billion $\left(30\text{ billion}-27\text{ billion}\right)$. The bank can increase money supply by $16.67 billion $\left(3\text{ billion}\times \frac{1}{0.18}\right)$.

Economics Concept Introduction

Concept Introduction:

Reserve Ratio: it is the ratio or percentage of deposit that banks must hold in liquid form.

Money Supply: It is the total money in circulation in the economy. It involves currency notes, deposits and other forms of liquid asset.

Money Multiplier: It is the ratio of reserves to the total amount of reserves in the banking system. It is the amount that bank generates or creates with each unit of reserves.

Open Market Operation (OMO): It is the monetary control mechanism employed which involves buying and selling of government securities in the open market to routine (expand or contract) the amount of money in the banking system.

Subpart (d):

To determine

Effect of transactions.

Explanation of Solution

Commercial banks increase their reserves after the Fed increases the interest rate that it pays on reserves can be depicted by Columns A it shows that the increase in reserves came from selling securities. Column B also shows increase in reserves but it came from loans from the Federal Reserve Banks and it is unlikely that Fed would lend at an interest rate lower than it pays commercial banks for the reserve. When the Fed increases the interest rate it pays on reserve, the commercial bank increases reserves by decreasing loan to its customers.

Economics Concept Introduction

Concept Introduction:

Reserve Ratio: it is the ratio or percentage of deposit that banks must hold in liquid form.

Money Supply: It is the total money in circulation in the economy. It involves currency notes, deposits and other forms of liquid asset.

Money Multiplier: It is the ratio of reserves to the total amount of reserves in the banking system. It is the amount that bank generates or creates with each unit of reserves.

Open Market Operation (OMO): It is the monetary control mechanism employed which involves buying and selling of government securities in the open market to routine (expand or contract) the amount of money in the banking system.