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CHAPTER 16THE FED, MONEY, AND CREDITSolutionstotheProblemsintheTextbook:Conceptual Problems:1.The three tools the Fed has to conduct monetary policy are open market operations, discount ratechanges, and reserve requirement changes. If the Fed wants to increase the money supply, it has thefollowing options: first, the Fed can buy government bonds from the public (mostly banks), therebyincreasing bank reserves. These open market purchases will induce banks to extend their loans, whichwill create more money. Second, it can lower the discount rate, so it becomes less costly for banks toborrow reserves from the Fed. This also will induce banks to create more money by extending moreloans. Finally, the Fed can lower the required-reserve ratio, which again will allow banks to lendmore.2.The currency-deposit ratio is the ratio of currency outstanding to bank deposits. The Fed cannotdirectly influence this ratio, since it is determined by the behavior of the public and influenced by theconvenience of obtaining cash and by seasonal patterns (increased Christmas shopping, for example).However, by changing either bank regulations (that would affect the ease of obtaining cash) orinterest rates (that would change the opportunity cost of holding cash), the Fed may indirectly affecthow much currency the public is willing to hold.3.a.3.a.IS2 3.b.iISLM2i IS1LMLM1i2i2i1i100Y2Y1YY1Y2 YIf most disturbances come from the money sector (a shift in money demand), interest rate targetswork better than money targets. In the IS-LM diagram below we can see that as money demandincreases due to changing expectations, the LM-curve will shift to the left and the interest rate willincrease. By increasing money supply and shifting the LM-curve back to the right, the central bankcan get the economy back to the original equilibrium.3.b. If most disturbances come from the expenditure sector, the central bank is better off targeting moneysupply. If spending increases, the IS-curve shifts to the right and the interest rate increases. If the1
central bank tried to get the interest rate back to its original level by increasing money supply, thedisturbance would intensify, since the LM-curve would also shift to the right. Thus, the central bankshould keep money supply (and thus the LM-curve) stable to keep the disturbance at a minimum.4.a. A bank run occurs when depositors, worried about the safety of their assets, rush to withdraw theirdeposits. 4.b. If a bank is in trouble because it has made some bad investment decisions, people may expect it tofail. Thus they may want to withdraw their deposits before it is too late. Since other depositors arelikely to behave in the same way, a run on the bank can be anticipated. Even a fairly financially soundbank may not be able to withstand a run, since most assets are tied up in loans. Almost all U.S. banksare FDIC insured and therefore a run on a bank is very unlikely. With FDIC insurance, depositors