Macro Practice Questions, Chapter-End Questions CHAPTER 33

The federal funds market is the market in which:

banks borrow reserves from one another on an overnight basis.

The reserves of a commercial bank consist of:

deposits at the Federal Reserve Bank and vault cash.

The multiple by which the commercial banking system can expand the supply of money is equal to the reciprocal of:

the reserve ratio.

A bank that has assets of $85 billion and a net worth of $10 billion must have:

liabilities of $75 billion.

In prosperous times, commercial banks are likely to hold very small amounts of excess reserves because:

the Federal Reserve Banks pay lower rates of interest on bank reserves than could be earned by the commercial banks loaning out the reserves

(Last Word) The greater the leverage in the financial system, all else equal:

the greater the instability of the financial system.

3. What is the difference between an asset and a liability on a bank's balance sheet? How does net worth relate to each? Why must a balance sheet always balance? What are the major assets and claims on a commercial bank's balance sheet? LO2

Answer: An asset of a commercial bank is something owned by the bank or owed to the bank (cash, securities, loans, etc...). A liability of the bank is a claim against the bank by non-owners (checkable deposits, etc...) and the owners of the bank. This last liability is the net worth of the bank. The balance sheet must balance by definition. That is, the sum of assets must equal the sum of liabilities plus net worth for the bank to ensure appropriate accounting of transactions. The major assets of a bank are reserves, securities, loans, and vault cash (this last one is relatively small when compared to the others). The major claim on the bank is checkable deposits.

4. Why does the Federal Reserve require commercial banks to have reserves? Explain why reserves are an asset to commercial banks but a liability to the Federal Reserve Banks. What are excess reserves? How do you calculate the amount of excess reserves held by a bank? What is the significance of excess reserves? LO2

Answer: Reserves provide the Fed a means of controlling the money supply. It is through increasing and decreasing excess reserves that the Fed is able to achieve a money supply of the size it thinks best for the economy. Reserves are assets of commercial banks because these funds are cash belonging to them; they are a claim the commercial banks have against the Federal Reserve Bank. Reserves deposited at the Fed are a liability to the Fed because they are funds it owes; they are claims that commercial banks have against it.

9. How would a decrease in the reserve requirement affect the (a) size of the money multiplier, (b) amount of excess reserves in the banking system, and (c) extent to which the system could expand the money supply through the creation of checkable deposits via loans? LO5

Answer: The monetary multiplier is k = 1/(1- required reserve ratio). (a) Thus, a decrease in required reserve ratio will result in an increase in the multiplier because each bank will need to hold less reserves and therefore can make more loans. (b) This also implies that the bank will see an increase in excess reserves after the fall in the required reserve ratio. (c) The ability to make more loans results in an increase in the potential money creation through the fractional reserve banking system.

1. Explain why merchants accepted gold receipts as a means of payment even though the receipts were issued by goldsmiths, not the government. What risk did goldsmiths introduce into the payments system by issuing loans in the form of gold receipts? LO1

Answer: When early traders began to use gold in making transactions, they soon realized that it was both unsafe and inconvenient to carry gold and to have it weighed and assayed (judged for purity) every time they negotiated a transaction. So by the sixteenth century they had begun to deposit their gold with goldsmiths, who would store it in vaults for a fee. On receiving a gold deposit, the goldsmith would issue a receipt to the depositor. Soon people were paying for goods with goldsmiths' receipts, which served as one of the first types of paper money. Merchants were willing to accept this receipt because they knew that it could be exchanged for gold or reused to purchase goods and services for the merchant. The potential problem was that if the goldsmith issued more receipts than he had in gold the goldsmith was vulnerable to "panics" or "runs." For example, if a goldsmith issued paper money equal to twice the value of his gold reserves he would be unable to convert all that paper money into gold in the event that all the holders of that money appeared at his door at the same time demanding their gold.

6. Suppose that the banking system in Canada has a required reserve ratio of 10 percent while the banking system in the United States has a required reserve ratio of twenty percent. In which country would $100 of initial excess reserves be able to cause a larger total amount of money creation? LO4 a. Canada. b. United States.

Answer: a. Canada Feedback: A single dollar of initial excess reserves will be able to cause a larger total amount of money creation in Canada. This is true because Canada has a lower required reserve ratio. As a result, more money can be created by banks through the process of multiple-deposit expansion. For instance, suppose we are looking at Canada and that the initial $100 of excess reserves starts with Canada Bank A. Given the Canadian required reserve ratio of 10 percent, Canada Bank A could legally lend out $90 of the initial $100, holding the other $10 back for reserves. Suppose that Canada Bank A does indeed make $90 in loans, which later get deposited into Canada Bank B. Then Canada Bank B will be able to lend out $81, holding the other $9 back in reserves in order to meet the 10 percent required reserve ratio. Compare those first two rounds of lending in Canada with the similar first two rounds that would take place in the United States with its higher reserve ratio of 20 percent. To make things concrete, suppose that the initial $100 of excess reserves starts with U.S. Bank A. U.S. Bank A could then legally lend out only $80 of the $100, because the required reserve ratio of 20 percent would mean that it would have to hold the other $20 back for reserves. Suppose that U.S. Bank A does indeed make $80 in loans, which later get deposited into U.S. Bank B. Then U.S. Bank B will be able to lend out $64, because it would have to hold back $16 (= 0.20 × $80) in required reserves. Thus the first two rounds of lending in Canada result in $90 and then $81 of new loans and money creation while the first two rounds in the United States result in only $80 and then $64 of new loans and money creation. Subsequent rounds will also have Canada exceeding the United States in the amount of loans extended and checkable-deposit money created. Thus, the higher reserve ratio in the United States reduces the overall level of money creation relative to what is possible in Canada because at each round of lending U.S. banks have to hold back more money as reserves.

4. A single commercial bank in a multibank banking system can lend only an amount equal to its initial preloan _________________. LO3 a. Total reserves. b. Excess reserves. c. Total deposits. d. Excess deposits.

Answer: b. Excess reserves Feedback: A single commercial bank in a multibank banking system can lend only an amount equal to its initial preloan excess reserves. This is true because when a bank makes a loan, it faces the possibility that checks for the entire amount of the loan will be drawn and cleared against it. So, to be safe, the bank will limit its lending to the amount of its excess reserves. That way, after that amount is lent out, the bank will have sufficient total reserves to meet the reserve requirements for all of its loans, including the newly issued loans.

3. The actual reason that banks must hold required reserves is: LO2 a. To enhance liquidity and deter bank runs. b. To help fund the Federal Deposit Insurance Corporation, which insures bank deposits. c. To give the Fed control over the lending ability of commercial banks. d. To help increase the number of bank loans.

Answer: c. To give the Fed control over the lending ability of commercial banks Feedback: By varying the required reserve ratio, the Fed can increase or decrease the total volume of lending made by commercial banks. For example, a higher required reserve ratio means that banks must hold more of their total deposits as reserves. And because any money that is held as reserves cannot be lent out, raising the required reserve ratio also means reducing the amount of money that banks can loan out. Keep in mind that the true point of required reserves is to give the Fed this control over lending. By contrast, it is a common fallacy to think that the point of reserves is to provide banks with a ready supply of funds to meet unexpectedly large cash withdrawals from depositors (as happens during bank panics). This line of thinking is not true because the legally required amount of reserves is not nearly large enough to deal with bank panics, which is why the government has also created the FDIC and NCUA to provide deposit insurance and why the Fed always stands ready to act as a lender of last resort to any banks suffering from bank panics. The deposit insurance and the availability of the Fed as a lender of last resort protect the banking system against bank panics while required reserves give the Fed control over lending.

Which of the following would reduce the money supply? A. Commercial banks use excess reserves to buy government bonds from the public. B. Commercial banks loan out excess reserves. C. Commercial banks sell government bonds to the public. D. A check clears from Bank A to Bank B.

Commercial banks sell government bonds to the public.

Which of the following is correct? A. Both the granting and repaying of bank loans expand the aggregate money supply. B. Granting and repaying bank loans do not affect the money supply. C. Granting a bank loan destroys money; repaying a bank loan creates money. D. Granting a bank loan creates money; repaying a bank loan destroys money.

Granting a bank loan creates money; repaying a bank loan destroys money.

In a fractional reserve banking system:

banks can create money through the lending process.