Problem Set – Money and Banking

Problem Set – Money and Banking

1. Banks can hold reserves in the form of vault cash or as deposits with the Fed.

2. III is the correct description of what happened. Let’s analyze each statement in turn:

I. Tom’s net worth has increased by $100.

This is not the case. All Tom has done is to switch one asset (cash) for another (checking deposit). Hence, all the action is on the left-hand side of his balance sheet. Tom’s net worth is not affected.

II. Citizen’s Bank’s assets and its net worth have gone up by $100.

Citizen’s Bank’s assets—in particular, its cash reserves—have indeed increased; but this is offset by an increase in Citizen’s Bank’s liabilities. While the $100 checking deposit is an asset to Tom, it is a liability to the bank. The bank’s net worth is not affected.

III. The total value of Tom’s net worth has not changed. Citizen’s Bank’s assets and liabilities have both increased.

For reasons detailed in the discussion under II above, this is the accurate description of what happened on the respective balance sheets.

IV. Tom’s assets have decreased and Citizen’s Bank’s assets have increased.

This is dispensed with in the discussion under I and II, above.

3. a. The required reserve ratio is 8%. Cambridge Bank is holding $1.5 million as

cash reserves out of a total of $15 million in checking deposits. This is 10%. But because banks are holding 2% in excess reserves, the required reserve ratio must be 8%.

b. The required reserve ratio is 8% and banks are holding an extra 2% as excess reserves. The money multiplier is thus 1/(R+E) = 1/(.08+.02) = 1/0.1 = 10. Thus a deposit of $50,000 will result in total deposits of $500,000. Subtracting the change in cash held by public ($50,000) you get a change in money stock of $450,000.

∆ Money Stock = ∆Total Deposits + ∆ Cash held by public

= $500,000 + −($50,000)

= $450,000

4. a. The ratio of total reserves to deposits is...