1. Roy owns many bonds.

By conducting open-market operations, the Fed offers Roy $500 for

the bonds he owns. Roy sells the bonds to the Fed, and deposits the $500 into his bank account
at LL Bank.
a) Assuming the reserve ratio is 20%, complete the transactions in the following balance sheet:
The $500 demand deposit is immediately divided between reserves: $100 required and $400
excess reserves as follows:

b) By how much will the LL Bank’s reserves change due to the Fed’s action?
The $500 demand deposit creates only $400 of excess reserves, as $100 must be set aside as
required reserves.

c) What is the maximum amount of loans created by the entire banking system?
The $500 purchase of the bond creates a demand deposit of $500, of which $400 become
excess reserves. The excess reserves with a multiplier of 5 could create a maximum of $2,000
worth of loans.

d) What is the total change in money supply caused by the Fed’s action?
The total change in the money supply is $2,500. The original $500 payment for Roy’s bond by
the Fed was new money, as was the $2,000 in loans.

2. What is a monetary policy?

A macroeconomic policy set by the Fed to control the lending and borrowing power and
influence the interest rate through adjusting the money supply, open market operations,
discount rate, and federal funds rate.

3. How does the central bank control the lending and borrowing of commercial banks?
Central banks use the monetary policy to control the lending and borrowing and limit or expand
the money circulation. The central bank can raise the required reserve to reduce the loans
created and can increase the federal funds rate to limit the overnight interbank lending, hence
contracting the economy and reducing the money supply.

4. How does a change in monetary policy affect commercial banks and the amount of money?
The money supply expands by an amount multiplied by the money multiplier when bonds are
bought, required reserve is decreased and when the federal funds rate is lowered. Money
supply decreases by an amount multiplied by the multiplier when bonds are sold and when
interests increase.
5. Assume that the reserve requirement is 20% and that banks do not hold excess reserves. The
Fed buys $5 million in government bonds as an open market operation. What is the maximum
increase in the money supply in the banking system?
The open market operation results in a $25 million expansion in the money supply since the
money multiplier is used (1/20$).

6. How does a change in reserves or deposits change the quantity of money?

The amount of excess reserves determines the amount of money created since banks loan out
their excess reserves. For instance, any transaction that would result in more excess reserves
would eventually increase the money supply by this amount times the multiplier. Cash deposits
however, do not impact the money supply.

7. The current money supply is $353. The Fed decides to decrease the money supply to $303
using open-market operations.
a) Which open-market operation should the Fed use?
The central bank should sell bonds.

b) Assuming the money multiplier is 10, what is the worth of the bonds needed to reduce the
money supply to $303?
$5 (50/10)

8. Complete the following table to show the effect of each of the Fed’s monetary policies on
reserves, money supply, and federal funds rate (write increase or decrease).

9. If Adam deposits $5,000 of his cash holdings in his checking account at Moody Bank. The
reserve requirement is 20 percent and the bank holds no excess reserves.
a) What is the immediate effect of his deposit on the money supply? Explain why.
No immediate effect because the money deposited was already part of the money supply

b) What is the maximum amount of money Moody bank can initially lend out? Sow your work.
Initial money lent out is 80% of $5,000 = $4,000
c) What is the maximum amount of money the entire banking system can create? Show your
work
Maximum increase in the money supply = 5,000 × 1/20% - 5,000 = $20,000 The initial had to be
subtracted since it was already part of the money supply.

The Central bank buys $2,000 in bonds from Moody bank.

d) As a result of the central bank’s action, what is the change in the money supply if the
required reserve ratio is 100 percent?
Increase by $2,000 only since the money is coming from the central bank and the RAR is 100%
(The money multiplier will be equal to 1).

e) If the required reserve ratio is reduced to 10 percent, what is the maximum increase in the
total money supply from the Federal Reserve’s purchase of bonds? Show your work.
Money supply multiplier = 1/10% = 10
Change in the money supply = 10 × 2,000 = $20,000

f) If banks keep some of the deposit as excess reserves, how will this influence the change in the
money supply that was determined in part e)? Explain.
The increase in the MS will be less than $20,000 because banks will make fewer loans

10. XYZ Bank has the simplified balance sheet below.

a) Based on XYZ Bank’s balance sheet, calculate the required reserve ratio.
The required reserve ratio = 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑒𝑠𝑒𝑟𝑣𝑒𝑠/ 𝐷𝑒𝑚𝑎𝑛𝑑 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠 = 15000 /60000 = 0.25 or
25%

b) Suppose that the Federal Reserve purchases $3,000 worth of bonds from XYZ Bank. What will
be the change in the dollar value of each of the following immediately after the purchase?
i. Excess reserves: increase by $3,000.
ii. Demand deposit: The change is zero (There were no new deposits).
c) Calculate the maximum amount that the money supply can change as a result of the $3,000
purchase of bonds by the Federal Reserve.
The money supply will increase by 3,000 × 1 /25% = $12,000.

d) When the Federal Reserve purchases bonds, what will happen to the price of bonds in the
open market? Explain.
The price of bonds will increase because the purchase of bonds increases the money supply,
which decreases the interest rate.

e) Suppose that instead of the purchase of bonds by the Federal Reserve, an individual deposits
$3,000 in cash into her checking (demand deposit) account. What is the immediate effect of the
cash deposit on the M1 measure of the money supply?
The cash deposit will not immediately change the money supply.

11. Suppose that the reserve requirement is 20% and banks hold no excess reserves.
a) Suppose that John deposits $100 of cash from his pocket into his checking account. Calculate
each of the following.
i. The maximum dollar amount the commercial bank can initially lend. $80
ii. The maximum total change in demand deposits in the banking system. $500
iii. The maximum change in the money supply. $400

b) Suppose that the Federal Reserve buys $5 million in government bonds on the open market.
As a result of the open market purchase, calculate the maximum increase in the money supply
in the banking system.
the Federal Reserve’s action will increase the money supply by at most $25 million: 1/20% X $5
million = $25 million

c) Given the increase in the money supply in part (b), what happens to real wages in the short
run? Explain.
Real wages will fall because as the money supply increases due to Fed action, this causes
inflation.
12. The Fed wants to increase the supply of reserves. Thus, it purchases $1 million worth of
bonds from the public. Explain the effect of this open-market operation and present it
graphically.
The purchase of bonds in the open market increases the money supply in the economy by
exchanging bonds for cash. Consequently, prices increase and interest rates decrease as
illustrated below:

13. A country’s central bank conducts an open-market sale of government bonds.

a) Use a correctly labelled graph of the money market to show how the open-market sale of
bonds will affect each of the following:
i. The money supply
ii. The interest rate
When bonds are sold, the money supply decreases and the interest rate increases as illustrated
below:
b) Is the interest rate identified in part a) real or nominal?
The money market graph determines the nominal interest rate.

c) What condition will make the nominal and the real interest rates equal?
Only if the expected inflation rate is zero will nominal and real interest rates be equal.

14. Assume that the Fed purchases bonds through open-market operations.
a) Use a correctly labelled graph to show the effect of this purchase on the interest rate.
When bonds are purchased, the money supply increases and the interest rate decreases as
illustrated below:

b) Explain how the change in interest rate will affect output and the price level in the short run.
The interest rate decreases, investment and interest-sensitive consumption spending increase,
AD increases, and the output and price level increase.

15. The federal funds rate is used as a monetary policy tool.

a) Define the term “federal funds rate”.
The federal funds rate is the interest rate on short-term loans between banks.

b) What open-market operation helps reduce the federal funds rate?

The Fed should buy bonds.

c) What is the effect of the operation that you identified in part b) on the nominal interest rate?
The nominal interest rate will fall

d) Define the real interest rate.

The real interest rate is the difference between the nominal interest rate and the inflation rate.
e) Assume that the Fed’s action results in inflation. What would be the impact of the
openmarket operation that you identified in part b) on the real interest rate? Explain
The real interest rate will fall because the nominal rate has decreased and inflation has
increased.

16. Assume that the reserve requirement is 10%, and banks hold no excess reserves. Suppose
that the Fed buys $5 million in government bonds on the open market.
a) Calculate each of the following:
i. The change in the monetary base of the country
The monetary base is the sum of currency in circulation and the total reserves held by the entire
banking system. Therefore, the monetary base increases by $5 million because reserves
increase by $5 million.

ii. The maximum increase in money supply in the entire banking system. Show your work.
1/10% × $5 million = $50 million. Note that the initial amount is not deducted since it was not
part of the money supply

b) Given the increase in the money supply identified in part a), what happens to real wages in
the short run? Explain.
As the money supply increases, inflation occurs, which lowers real wages

17. How is monetary policy used to correct an output gap?

In order to correct a recessionary gap, where current output is below the potential output level,
the money supply should increase. this is achieved through monetary policy by buying bonds,
reducing the discount rate, and reducing the reserve ratio. Consequently, the nominal interest
rate decreases and the output increases, while the unemployment rate decreases and the price
level increases. The opposite occurs when an inflationary gap needs to be corrected.

18. What is the impact of monetary policy on the economy in the short run?
19. What are the lags of monetary policy?
Monetary policy involves a time lag between changing the interest rates and having the desired
impact on the investment and output levels. In addition, a change to any interest rate affects all
the other types of interest rates.

20. In a given country, it is easy for people to get approval for credit cards, which encourages
them to make more transactions, thus reducing the demand for money.
a) Using a money market graph, show how this affects the nominal interest rate.
The nominal interest rate decreases as the money demand decreases as illustrated below:

b) What will happen to bond prices in the short run following the change in the nominal interest
rate you identified in part a)?
Bond prices will increase in the short run

c) Given the interest rate change identified in part a), what will happen to the price level in the
short run? Explain.
Interest-sensitive spending (investment and consumption) will increase. As a result, both the
aggregate demand and price level will increase.

d) Identify an open-market operation that the Fed could use to keep the nominal interest rate
constant at the level that existed before the increase in the use of credit cards assuming that
the reserve requirement is 10%.
The Fed should sell bonds, which will decrease the money supply and raise the interest rate
back to its previous level.
21. Consider the following graph for an economy operating at Y:

a) Should the central bank use an expansionary or tight monetary policy to move the
equilibrium at Yf instead of Y? Explain.
Y is below full employment. Hence, an expansionary monetary policy is needed in order to
increase the money supply so as to lower the interest rate, increase investment, and shift the
AD curve to AD1.

b) Suggest an open-market operation to restore full employment at Yf.

The Fed should buy bonds on the open market.

c) How would the policy identified in part b) affect the nominal interest rate in the short run?
The purchase of bonds by the Fed increases the money supply and reduces the nominal interest
rate.

d) What happens to real output in the short run following the central bank’s action?
Real output increases as AD increases

e) What happens to the price level in the short run following the central bank’s action?
The price level increases as AD increases
22. What monetary policy action should the central bank take to maintain a stable interest rate
when the government is implementing an expansionary fiscal policy? Explain.
An expansionary fiscal policy increases the inflation rate and results in higher nominal interest
rate and lower private investment. Hence, the central bank should buy bonds in order to
increase the money supply and decrease the nominal interest rate back to its initial level.

23. How will an increase in government deficit spending affect interest rates and bond prices?
Explain.
An increase in government spending leads to a budget deficit and forces the government to
borrow more. Therefore, the competition over the limited savings available in the economy
increases. This raises the interest rate and crows out private investment. The price of bonds
decreases because it is inversely related to the interest rate.

24. When is it best to use a policy mix and what is the impact on the economy?
A policy mix combines fiscal and monetary policies to influence AD, real output, employment,
and the price level. For example, in order to correct a budget deficit without causing a
recession, a loose monetary policy can be used in line with a contractionary fiscal policy: Tax
rates increase, allowing revenues to be generated, while interest rates decrease to encourage
investment and promote an increase in output. As a result, the budget deficit is corrected
without causing recession and unemployment. When an economy is facing a severe recession,
the government may engage in an expansionary fiscal policy to increase aggregate demand.
Simultaneously, the central bank may engage in an expansionary monetary policy to boost
investment and restore full employment. However, it is possible for these two policies to work
against each other.