Econ 116

Spring 2009

Problem Set 3 Solutions

1.
Assume that a bank has on its asset side reserves of 500 and loans of 3000 and
on its liability side deposits of 3500. Assume that the required reserve ratio is 10
percent.
(a)

How much is the bank required to hold as reserves given its deposits of 3500?
Balance Sheet of Bank
Liabilities
D0 3500

Since rrr (required reserve ratio or reserve to deposit Assets

ratio)=0.10, then minimum amount of reserves the bank R0500
should hold is R*/D=0.10 => R*/3500=0.10=>R*=350. L0 3000
Bank is required to hold by law at least $350.
(b)

How much are its excess reserves?

Since the bank is holding $500, 500-350=$150 is the amount of excess reserves.
(c)

By how much can the bank increase its loans?

The bank can increase its loans by the amount of total excess reserves, which is $150.
So they can make additional loans worth of $150.
(d) Suppose a depositor comes to the bank and withdraws 200 in cash. Show the
banks new balance sheet, assuming the bank obtains the cash by drawing down its
reserves. Does the bank now hold excess reserves? Is it meeting the required reserve
ratio? If not, what can it do?
Now the bank has $300 in reserves which is $50 less than Balance Sheet of Bank (after
the required reserve amount. In this case, at the end of the the withdrawal) Assets
Liabilities R0300
day, when the bank closes its balances, it can either borrow
D0 3200
from the Fed (using the discount rate) or from other
L0 3000
commercial banks (using the federal funds rate) to achieve
required reserve ratio.

2.
The T-account analysis in class showed that the Fed can increase the money
supply by buying government securities. Why does this action lower the interest rate?
What assumptions are you making about the demand for money in your answer?
Explain carefully.
r

MS

To increase money supply, Fed, through open

market operations, purchases bonds from public.
This will drive up the price of the bonds in the
open market. Since we know that bond prices are
negatively related to interest rates, interest rates
will decrease.

MS

r*
MD

r**
M
*

M*
*

3.
Since the U.S. Treasury must sell government securities to finance any deficit
that it may run, is it ever possible for a deficit to be financed by printing money?
Explain carefully. (Hint: the answer is yes.) How is the interest rate affected, if at all,
when deficits are financed without printing money?
Yes, The Fed could buy newly issued government bonds directly from the government
(the Treasury).As Fed buys these bonds from the Treasury, and as Treasury spends
the money, money supply in the economy will increase through the money multiplier,
which will reduce interest rates.
If government finances its deficit by borrowing from public (through bonds), there
won't be any change in the money supply. (Think of this as a transaction between 2
parties one borrowing from the other). Since there is no change in the money supply,
interest rates will stay the same.
4.
As recently as last year when Professor Fair went to an ATM machine to
withdraw money from his interest bearing money market account he withdrew $300.
Now he withdraws $500. Is this rational on his part? Why or why not? (Professor Fair
will not feel bad if you say he is not rational as long as this is the correct answer.)
In this question, we have to understand Professor Fairs demand for money. Assuming
Professor Fair lives in a Keynesian world, then his money demand will depend on three
variables, price level, interest rates, and his income level. MD = f(P,r,Y). In this
equation, as Interest rate increases, your money demand will decrease (Since you can
earn more by depositing your money to the bank and youll have less money in your
hand). As your income increases your money demand will increase (As your income
increases youll engage in more transactions.) Finally, as prices increase your money
demand will increase (Youll need more money for your transactions.) Assuming price
level and Professor Fairs income level didnt change over the last year, and knowing
that Fed decreased the interest rates, we can claim that his average money holdings
increased over the last year due to the decrease in interest rates. So he is perfectly
rational.

5.
Say you bought a 10-year government bond last year that yielded 4.5 percent
per year. Assume that since that time the 10-year government bond rate has dropped
to 3.0 percent. Are you better off or worse off after this drop? Explain carefully. How is
this related to Professor Serebryakov?

To make our answer simple, suppose we have a console bond (a bond that pays a fixed
amount forever). Then, Pb=(1/r), where Pb is the price of the bond, and r is the
interest rate. In this equation, if the interest rate drops, you are obviously better off,
since the price of the bond will increase (note, since you already own the bond when
the interest rates decrease, you will still earn the same coupon from the bond and
receive a higher price should you wish to sell).