Chapter 16, Problem 3P

Subpart (a):

To determine

Change in the balance sheet.

Explanation of Solution

When the decline in the discount rate prompts commercial banks to borrow an additional $1 billion from the Federal Reserve Banks, the commercial bank’s reserves increase by $1billion.

Thus in column (1) of the consolidated balance sheet for all commercial banks,

On the asset side,

• The commercial banks' reserves increase from $33billion to $34 billion due to the addition of $1billion from the Federal Reserve Bank.

Whereas, on the liability side

• Loans from the Federal Reserve Banks increase from $3 billion to $4 billion.

In Column (1) for the Twelve Federal Reserve Banks

On the asset side,

• Loans to commercial banks increase from $3billion to $4 billion

And on the liability side,

• Reserves of commercial banks increase from $33billion to $34 billion.

		Consolidated Balance Sheet: All Commercial Banks
		Column (1)
Assets:
Reserves	$33	34
Securities	60	60
Loans	60	60
Liabilities and Net Worth:
Checkable deposits	$150	150
Loans from Federal Reserve Banks	3	4

			Consolidated Balance Sheet: 12 Federal Reserve Banks
			Column (1)
Assets:
Securities	$60		60
Loans to Commercial Banks	3		4
Liabilities and Net Worth:
Reserves of Commercial Banks	$33	34
Treasury deposits	3	3
Federal Reserve Notes	$27	27

Economics Concept Introduction

Concept Introduction:

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

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.

Subpart (b):

To determine

Change in the balance sheet.

Explanation of Solution

Case two is that the Federal Reserve Banks sell $3 billion in securities to members of the public, who pay for the bonds with checks.

In the Column (2) of the consolidated balance sheet for all Commercial banks.

On the asset side,

• The reserves of the commercial banks decreases from $33 to $30 as the Federal Reserve banks reduce the reserves of $3billion held by the commercial banks as a part of clearing of the checks.

On the liability side,

• The checkable deposits fall from $150 billion to $147 billion since public pays the Federal Reserve Bank via checks from commercial banks.

In the Column (2) for the consolidated balance sheet for the 12 Federal Reserve Banks,

On the asset side,

• Securities decreases by $3 billion, from $60 billion to $57 billion as they sold to public by the Federal Reserve Bank.

On the liability side,

• There is a decrease of reserves of commercial banks from $33 billion to $30 billion as the check gets cleared.

		Consolidated Balance Sheet: All Commercial Banks
		Column (2)
Assets:
Reserves	$33	30
Securities	60	60
Loans	60	60
Liabilities and Net Worth:
Checkable deposits	$150	150
Loans from Federal Reserve Banks	3	3

		Consolidated Balance Sheet: 12 Federal Reserve Banks
		Column (2)
Assets:
Securities	$60	57
Loans to Commercial Banks	3	3
Liabilities and Net Worth:
Reserves of Commercial Banks	$33	30
Treasury deposits	3	3
Federal Reserve Notes	$27	27

Economics Concept Introduction

Concept Introduction:

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

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.

Subpart (c):

To determine

Change in the balance sheet.

Explanation of Solution

Case three is that, the Federal Reserve Banks buy $2 billion of securities from commercial banks.

In the Column (3) of the consolidated balance sheet for all Commercial banks.

On the asset side,

• The securities held by the commercial banks decreases from $60 to $58 as the Federal Reserve banks buy $2billion of securities from commercial banks.
• Thus, by buying securities from commercial banks, the Federal Reserve Bank credits  the Commercial bank with $2billion. So the reserves of the commercial bank increases from $33billion to $35 billion.

On the liability side,

• Everything (checkable deposits, loans from Federal Reserve Bank) remains unchanged.

In the Column (3) for the consolidated balance sheet for the 12 Federal Reserve Banks,

On the asset side,

• Securities increases by $2 billion, from $60 billion to $62 billion as Fed buys securities worth $2 billion.

On the liability side,

• There is an increase of reserves of commercial banks from $33 billion to $35 billion as the Fed credits the commercial banks.

		Consolidated Balance Sheet: All Commercial Banks
		Column (3)
Assets:
Reserves	$33	35
Securities	60	58
Loans	60	60
Liabilities and Net Worth:
Checkable deposits	$150	150
Loans from Federal Reserve Banks	3	3

		Consolidated Balance Sheet: 12 Federal Reserve Banks
		Column (3)
Assets:
Securities	$60	62
Loans to Commercial Banks	3	3
Liabilities and Net Worth:
Reserves of Commercial Banks	$33	35
Treasury deposits	3	3
Federal Reserve Notes	$27	27

Economics Concept Introduction

Concept Introduction:

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

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.

Subpart (d):

To determine

Change in the balance sheet.

Explanation of Solution

		Consolidated Balance Sheet: All Commercial Banks
		(1)	(2)	(3)
Assets:
Reserves	$33	34	30	35
Securities	60	60	60	58
Loans	60	60	60	60
Liabilities and Net Worth:
Checkable deposits	$150	150	147	150
Loans from Federal Reserve Banks	3	4	3	3

		Consolidated Balance Sheet: 12 Federal Reserve Banks
		(1)	(2)	(3)
Assets:
Securities	$60	60	57	62
Loans to Commercial Banks	3	4	3	3
Liabilities and Net Worth:
Reserves of Commercial Banks	$33	34	30	35
Treasury deposits	3	3	3	3
Federal Reserve Notes	$27	27	27	27

Case 1: Transaction (a) – Column (1)

The potential change in the money supply in regard to the change in reserves that is created can be calculated by using the deposit multiplier, which equals with the ratio of the maximum possible change in checkable deposits to the change in reserves.

The deposit multiplier = 0 (0/1) as there is no change in the checkable deposit even if reserves increase by $1 billion. Thus, there is no direct and immediate effect on the money supply, since the increase in reserves of commercial banks does not immediately reflect in the loans or checkable deposits after the transaction.

The reserves of the commercial banks increase by $1billion from $33 billion to $34 billion.

The reserve ratio affects the money-creating potential in two ways:-

• Changes the amount of excess reserves
• Changes the size of Money multiplier.

The money multiplier is given as 1/R where, R is the reserve ratio.

Assuming a 20% reserve ratio; the money multiplier is 5 (=1/0.20) and there is an increase in reserves by $1 billion. Also there is no change in the excess reserves as there is no change in the checkable deposit.

Thus, by combining the two factors, the money creation potential of commercial banks increase by $5billion (=$1billion x 5).

Case 2: Transaction (b) – Column (2)

There is an immediate effect on the money supply here because the banks checkable deposits have fallen by $3billion from $150to $147 billion immediately after the transaction. The deposit multiplier is 1(3/3). Thus, there is an immediate decline in the money supply by $3 billion from $33 billion to $30 billion.

The reserves of the commercial banks decreased from $33 to $30 billion.

Assuming a 20% reserve ratio, the money-creating potential of the commercial banking system has decreased by $12 billion.

Given the money multiplier is 5 (=1/0.20), the reserves has decreased by $3 billion which implies a decrease in money creating a potential of $15billion (=5x$3 billion). Also, checkable deposits have fallen by $3 billion which results in creationof additional excess reserves of $0.6 billion (= .20 (required reserve ratio) x $3 billion (decrease in checkable deposits)). This results in increase in money creating potential by $3billion (=5 x $0.6). Combining the above factors, the overall effect on the money-creating potential decreases by $12 billion (=$ 15billion - $3 billion)

Case 2: Transaction (c) – Column (3)

The deposit multiplier = 0 (0/2) as there is no change in the checkable deposit even if reserves increase by $2 billion. Thus, there is no direct and immediate effect on the money supply, since increase in reserves of commercial banks is not immediately reflected in the loans or checkable deposits after the transaction.

The reserves of the commercial banks increased from $33 to $35 billion.

Assuming a 20% reserve ratio; the money multiplier is 5 (=1/0.20) and there is an increase in reserves by $2 billion. Also there is no change in the excess reserves as there is no change in the checkable deposit.

Thus, by combining the two factors, the money creation potential of commercial banks increase by $10billion (=$2billion x 5).

Economics Concept Introduction

Concept Introduction:

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

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.