quest 2

What does it mean that we have a "fractional reserve" banking system? Provide an example.

A fractional reserve banking system is a banking system in which banks are only required to hold a portion of deposits as reserves. For instance, Bank A might have $50,000 in deposits from their customers, but they only actually hold $10,000 in their vault in reserves. This would imply a (required or desired) reserve ratio of 20%. The implication of this type of banking system is that if all (or even many) of the customers for a given bank demand their money at the same time, the bank will not have sufficient reserves to accommodate them.

How does the money multiplier change with changes in the required reserve ratio? Explain why this is true intuitively.

A higher required reserve ratio means that banks will not have as many excess reserves and therefore are forced to make smaller or fewer loans. This effect weakens the feedback loop that is central to the money creation process as more money is held out of each iteration. This is reflected in a lower money multiplier.

What are some limitations of using real GDP to evaluate standards of living? Mention at least three, and explain how they would cause real GDP to over or underestimate living standards.

GDP does not include household production (making it an underestimate of economic activity) GDP does not include black market activity (making it an underestimate of economic activity) GDP does not include environmental quality (could lead to overestimate or underestimate of standards of living depending on country) GDP does not include political freedoms (could lead to overestimate or underestimate of standards of living depending on country) GDP does not include leisure (could lead to overestimate or underestimate of standards of living depending on country)

Suppose that the Fed is trying to slow down an over-heating economy through contractionary monetary policy. To do this, they sell $10 billion worth of securities to the banking sector. a. What will the Fed's action force banks to do? Explain.

If the Fed sells securities to the banking sector, banks' excess reserves will decrease, meaning that they will be forced to make fewer loans. This will end up contracting the money supply and pushing interest rates up.

Suppose the Fed wants to increase the money supply in hopes of eventually lowering interest rates. Should it buy or sell bonds? Explain.

If the Fed wants to lower interest rates, which it would do in a recession, it would buy bonds from the banking sector. This would give

Create a T-account for a bank. Correctly place the following terms on it, as done in class: assets, liabilities, equity, deposits, loans, reserves, securities.

In the left hand column under assets, there should be loans, reserves and securities. The right hand column would be liabilities, and it would include deposits. Below that you would put equity, because we know that Assets = Liability + Equity, or alternatively Asset - Liabilities = Equity. Equity is not a liability, but putting it on the liability side of the balance sheet helps remind us that the contents of both columns should be equal.

Suppose that you were trying to compare living standards across two different countries using GDP data. Which would be a better measure real GDP or nominal GDP/capita? Explain your choice.

It would be more important to control for differences in population. Between real GDP and nominal GDP/capita, nominal GDP/capita is probably the better option. You might also want to think about the role of exchange rates for a question like this.

Suppose that you were trying to compare living standards in the United States over time. Would you use nominal GDP? Why or why not?

Since nominal GDP just calculates prices multiplied by quantities without controlling for changes in price, we would worry about using it. We could get large changes in nominal GDP due to inflation, without any real change in living standards (tied to actual output or national income).

What is the FDIC, and what problem within our fractional reserve banking system does it help overcome? Explain the problem in-depth.

The FDIC, or Federal Deposit Insurance Corporation, insures your bank deposits up to $250,000 per bank (with some caveats). This helps alleviate the problem of a "run on the bank." Even if the bank runs out of money, you are insured, so there is no need for you to follow the masses and try to withdraw your money.

How does the Fed's ability to conduct monetary policy rely on the fractional reserve banking system? How would things be different if banks were required to hold 100% of deposits as reserves?

The Fed relies on the fractional reserve banking system for monetary policy because it needs banks to be able to loan out excess reserves. If banks were required to hold 100% of deposits, the first bank that received additional funds from the Fed could increase its loans. The next bank that received a deposit though would be forced to hold 100% of the deposit and the money creation process would stop. Essentially, there would be no multiplier effect for the Fed's actions (i.e. mm = 1).

Suppose a bank receives $50,000 from the Fed for some government bonds. If the required reserve ratio is 10%, how much new excess reserves does the bank have? Show your work.

This question is a little tricky. Since the bank's deposits do not increase, its amount of required reserves do not increase either. Thus, the entire $50,000 is considered excess reserves. However, if this bank loans this money out to an individual who deposits it in his/her bank, that bank would be required to hold more reserves. Required reserves only increase when customer deposits increase.

Suppose a bank decides to lend out $50,000. If the currency drain ratio is 25%, how much will the person that received the loan hold as currency?

We have two pieces of information: C+D=50,000, and C/D = .25. We can rearrange the second equation to be C = .25D and substitute for C in the first equation. Solving for D we get 40,000. We can get C by plugging 40,000 in for D in the first equation, so that C = 10,000. Remember currency drain is defined relative to the size of the deposit, not the size of the loan!

Use what you know about calculating GDP to fill in the missing values in the table below. It is much easier for me to give partial credit if you show your work. Fair warning, the answers to this question may not come out "nice." Feel free to round to something reasonable (like 1 decimal point).

Year Good Price Quantity Nominal GDP Real GDP Real GDP growth (annual %) 2013* Shoes 125 6 1500 1500 Rope 200 3 Carabineers 5 30 2014 Shoes 150 6 2600 1975 31.67% Rope 250 5 Carabineers 10 45 2015 Shoes 200 6 3200 2000 1.27% Rope 300 5 Carabineers 10 50

If the required reserve ratio and the currency drain ratio are both 20%, what is the money multiplier in this economy?

b. Remember mm = (1+C/D)/(R/D+C/D). So we have mm = (1+.2)/(.2+.2) = 3

What is the overall change in the money supply from the Fed's action? Be careful with this... (Hint: Notice the bold in the question above).

mm = (change in the quantity of money)/(change in the monetary base). So 3 = (change in the quantity of money)/-$10 billion. The change in the quantity of money = -$30 billion.