ch16 - CHAPTER 16 THE FED, MONEY, AND CREDIT Solutions to...

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CHAPTER 16 THE FED, MONEY, AND CREDIT Solutions to the Problems in the Textbook : Conceptual Problems: 1. The three tools the Fed has to conduct monetary policy are open market operations, discount rate changes, and reserve requirement changes. If the Fed wants to increase the money supply, it has the following options: first, the Fed can buy government bonds from the public (mostly banks), thereby increasing bank reserves. These open market purchases will induce banks to extend their loans, which will create more money. Second, it can lower the discount rate, so it becomes less costly for banks to borrow reserves from the Fed. This also will induce banks to create more money by extending more loans. Finally, the Fed can lower the required-reserve ratio, which again will allow banks to lend more. 2. The currency-deposit ratio is the ratio of currency outstanding to bank deposits. The Fed cannot directly influence this ratio, since it is determined by the behavior of the public and influenced by the convenience 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) or interest rates (that would change the opportunity cost of holding cash), the Fed may indirectly affect how much currency the public is willing to hold. 3.a. 3.a. IS 2 3.b. i IS LM 2 i IS 1 LM LM 1 i 2 i 2 i 1 i 1 0 0 Y 2 Y 1 Y Y 1 Y 2 Y If most disturbances come from the money sector (a shift in money demand), interest rate targets work better than money targets. In the IS-LM diagram below we can see that as money demand increases due to changing expectations, the LM-curve will shift to the left and the interest rate will increase. By increasing money supply and shifting the LM-curve back to the right, the central bank can 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 money supply. If spending increases, the IS-curve shifts to the right and the interest rate increases. If the 250
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central bank tried to get the interest rate back to its original level by increasing money supply, the disturbance would intensify, since the LM-curve would also shift to the right. Thus, the central bank should 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 their deposits. 4.b. If a bank is in trouble because it has made some bad investment decisions, people may expect it to fail. Thus they may want to withdraw their deposits before it is too late. Since other depositors are likely to behave in the same way, a run on the bank can be anticipated. Even a fairly financially sound bank may not be able to withstand a run, since most assets are tied up in loans. Almost all U.S. banks are FDIC insured and therefore a run on a bank is very unlikely. With FDIC insurance, depositors
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This note was uploaded on 12/18/2010 for the course SOES 2003 taught by Professor Jian during the Fall '10 term at Uni. Southampton.

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ch16 - CHAPTER 16 THE FED, MONEY, AND CREDIT Solutions to...

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