Groupe ISCAE LFG2 Thursday, January 21, 2021

Problem Set: Monetary and Financial Economics

(Key)
Fall Term 2020-2021

Pr Jihane Aayale, PhD

E-mail: jaayale@iscaextra.net

Problem 1

- Suppose banks in this economy operate at a 6% reserve ratio. Draw

the balance sheets for an initial deposit of +200 and the deposit
creation that follows. The following balance sheets show the initial
new deposit and the deposit creation that follows.
The new deposit provides the banks with a 200 increase in cash
(reserve asset) in exchange for 200 in new deposit liabilities.
All Banks

Assets Liabilities

Cash +200 Deposits +200

Banks hold 188 in excess reserves based on the reserve ratio of 6%

(200-12). They make loans equal to their excess reserves 188, and pay
for those loans by creating new deposit liabilities, 188. 

All Banks

Assets Liabilities

Cash +188 Deposits +188

- Suppose the public doesn’t withdraw cash, and that the banks
expand their lending by + 900. Calculate the deposit multiplier ∆D.
Assuming the public uses bank deposits as money and does not
withdraw cash from the banking system, the banks expand their
lending and create new deposits to a total of +900, based on the initial

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increase in cash reserves and the reserve ratio of 6%. The deposit
multiplier is: ∆D = ∆R/rr =200/0.06 = 3333,33.
All Banks

Assets Liabilities

Cash +200
Deposits +200

Loans +900 Deposits +900

Total +1100 Total +1100

- Now if banks have a reserve ratio of rr = 12% and the public has a
currency ratio of cr = 13%, by how much would a new cash deposit
of $2000 to the banking system expand bank deposits and currency
holdings.
If banks have a reserve ratio of rr = 12% and the public has a
currency ratio of cr = 13% a new cash deposit of $2000 to the
banking system would allow an expansion of bank deposits by:
∆D=∆MB×[1/(rr+cr)]

∆D = 2000 × [1/(0.12 + 0.13)] =8000
Deposit expansion beyond the initial $2000 would be the result of a
$2000 increase in bank lending.
With an expansion of bank deposits by $8000 the public would
increase cash holdings by $1040 (i.e. 13%).
If the banks could encourage a lower currency ratio a larger share of
the monetary base would be available to the banks as reserves to
support bank lending and deposit creation. A lower currency ratio
increases the deposit and money supply multipliers and bank lending.

Problem 2

- Suppose the MB = 6,000 , the rr = 0.15 and the cr = 0.20, how

much is the money supply.
MS = (1+cr) / (rr+cr) × MB = 20571,42

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- Suppose now that MB= 4900, how much is the money supply.
Illustrate the change graphically. Comment.
MS = (1+cr) / (rr+cr) × MB = 16800

If high powered money were to decrease to 4900 the money supply

would be decreased by 3771,42 to 16800. The money supply function
in the diagram is shifted to the left to show this effect.
- Suppose now that the cr= 7% , and that the interest rates increase.
What’s the impact on the money multiplier and the money supply.
If the cr falls as interest rates rise the money multiplier would
increase as interest rates increased giving a positive relationship
between the interest rate and the money supply. The diagram shows a
money supply function with ∆M/∆i > 0.

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Questions

1. What is the impact of a fall in American interest rates relative to

euro rates on the bond market, as well as on the exchange rate.
Illustrate graphically?
A fall in American interest rates relative to euro rates makes euro
bonds more attractive to portfolio managers than American bonds.
Reduced demand for American bonds by foreign bondholders reduces
the supply of euros on the market while increased demand for euro
bonds by American bondholders increases the demand for euros. The
diagram shows these changes in supply and demand and the rise in
the exchange rate that result.

2. Bank Al-Maghrib purchases of 10M MADs in the open market.

What is the impact on the monetary base, the bank reserves and
the cash holdings of the public. With rr =0.025, cr =0.075.
The purchase of 10 million in the open market by a central bank
creates 10 million in monetary base, which increase the reserves of
the commercial banks, provided it is not held as cash by the non-bank
public.
With a reserve ratio rr=0.025 and a cash ratio cr=0.075 a 10 million
increase in monetary base results in:

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1. An increase in money supply of 107.5 million.

2. An increase in public cash holdings of 7.5 million.
3. An increase in bank reserve balances of 2.5 million.

Problem 3

What is likely to happen to the size of V(velocity of money) if:

- People start to make much greater use of credit cards? Increase
- There is a wave of mergers among firms leading to greater vertical
integration of industry? (Lower transaction costs=> Increase).
- Many people who used to pay gas, electricity and telephone bills
each quarter, now do so by monthly direct debit payments?
Increase
- Instead of buying fresh food daily from their local markets, people
buy frozen food in major shopping expeditions once a month?
Decrease
- People, who used to receive their salaries once a week in cash are
now paid monthly directly into their bank accounts? Decrease

Problem 4

- Suppose that initially central bank owns 100 in T bonds, 0 in

discounted loans and 150 in international reserves. Out of this, 200
were issued as currency, the rest are held by the private sector as
reserves.
Central Bank

Assets Liabilities

Discounted loans 0
Reserves +50

International Reserves +150

Currency in circulation +200
T-bonds +100

Total +250 Total +250

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- Suppose that the CB intervenes with OMOs buying T bonds for 50.
The counterpart will be credited 50 on his reserves account
Central Bank

Assets Liabilities

Discounted loans 0
Reserves +100

International Reserves +150

Currency in circulation +200
T-bonds +150

Total +300 Total +300

- Show the initial balance sheet situation and how it is affected by

the monetary operation. What is the final effect on the monetary
base?
The MB is the central bank’s liquidity (Monetary Base = Currency +
Reserves). There are different channels for changing the MB, as part
of the management of money supply through the MB: Buying
treasury bonds, running Open Market Operations, providing Discount
Loans and Buying-selling international reserves.
The final effect on the monetary base here is an increase in the
MB=300.

Problem 5

- Suppose that initially central bank owns 100 in T-bonds, 0 in

discounted loans and 150 in international reserves. Out of this, 200
were issued as currency, the rest are held by the private sector as
reserves (same as above).
Central Bank

Assets Liabilities

Discounted loans 0
Reserves +50

International Reserves +150

Currency in circulation +200
T-bonds +100

Total +250 Total +250

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Groupe ISCAE LFG2 Thursday, January 21, 2021
- Suppose that the CB intervenes with OMOs selling T-bonds for 20.
The counterpart will pay in cash. At the same time a commercial
bank arrives at the discount window and demands a loan for 50,
which will be credited on his reserve account
Central Bank

Assets Liabilities

Discounted loans +50

Reserves +100

International Reserves +150

Currency in circulation +180
T-bonds +80

Total +280 Total +280

Show the initial balance sheet situation and how it is affected by the
monetary operation. What is the final effect on the monetary base?
The final effect on the monetary base here is an increase in the
MB=280.

Problem 6

- Consider a situation where there is no reserve requirement and

banks do not hold excess reserves. The capital to deposit ratio is
equivalent to 1, that is, wealth is divided half-half into deposits and
cash.
Bank1

Assets Liabilities

Securities +10

Loan to Bank2 +10

- Consider a monetary expansion of the monetary base through OMO

for 10. Bank 1 obtains an extra 10 on its reserve account
- Bank 1 will provide a loan to a depositor of Bank 2, which will
provide a loan to a depositor of Bank 3,...

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Bank2

Assets Liabilities

Reserves +10
Checkable Deposits +5

Currency in circulation +5

Bank2

Assets Liabilities

Loan to Bank3 +10

Checkable Deposits +5

Currency in circulation +5

Bank3

Assets Liabilities

Reserves +10
Checkable Deposits +5

Currency in circulation +5

Compute the balance sheet items for each bank and then compute the
multiplier. What is the overall effect on the money supply?
The CB has increased the MB by 10, this can be written
mathematically like the following:

10+(1 − rr+cr)10+(1 − rr+cr)210+(1 − rr+cr)310+ .... = 10∑ ∞ i=0 (1

− r)i= 1/(rr+cr) *10
With ∆D=∆MB×[1/(rr+cr)] (no excess reserves)
This means ∆D=∆MB×[1/(cr)] (no required reserves)
∆D=10×[1/(0,5)]=20
MS = (1+cr) / (cr) × MB =(1+0,5)/0,5 *10= 30

Application

Research on data on the currency components of M1, M2 and M3 of

Morocco. Produce a plot of total currency from 1999 to 2020.
You can produce the figure either in Excel or directly on data
websites. Comment on the trends, what jumps out at you from the

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figures? What historical events do you think can account for what we
see in the figures? Briefly explain.