Supply_of_Money_and_Credit

Supply_of_Money_and_Credit - The Supply of Money and Credit...

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Unformatted text preview: The Supply of Money and Credit - Balance Sheet Exercises Principles of Macroeconomics - Spring 2007 The money supply is determined by the combined actions of the Federal Reserve System (FED), Commercial Banks (CBs), and households. For the exercises we work through here, we will assume that bank capital (or net worth) of CB’s equals the dollar value of physical capital holdings (and omit these entries from the balance sheets). We will consider the impact of changes in FED policy, in commercial bank willingness to lend, and in household cash management on levels of reserves, excess reserves, loans and deposits, and the supply of money and credit. Suppose we separate the balance sheet of Bank A from that of all other commercial banks. We assume the balance sheet positions of Bank A and of “All Other CB’s” are initially as follows: Note that we are assuming that households hold no time deposit balances. There will be no difference between the M1 and M2 money supplies. The FED’s balance sheet and the Consolidated CB balance sheet (constructed from the balance sheets above) are as follows: In addition to assuming that the public holds no time deposit balances, we also assume that it holds no cash outside of commercial banks (CU = Currency held outside of commercial banks by the public = 0). All cash transactions are executed through use of Demand Deposits. Finally assume that the required reserve ratios set by the FED for demand and time deposits are r DD = 10 percent and r TD = 5 percent. (The symbol r DD = Required Reserve Ratio for Demand Deposits (DD), and the symbol r TD = Required Reserve Ratio for Time Deposits.) Problem 1: From the balance sheet positions above, determine: M1 = _________________ M2 = _________________ Here Legal Reserves (RE) = Vault Cash (VC) + Deposits of Commercial Banks with the FED (DCB). Required Reserves (RR) = r DD × DD + r TD × TD. Excess Reserves (XR) = RE - RR. M1 is the narrow definition of the money supply: M1 = CU + DD. M2 = M1 + TD = CU + DD + TD. Problem 2: Open Market Purchase (OMP) of Securities by the FED The FED’s most frequently used tool to alter the supply of money and credit is open market operations, purchases or sales of government securities. Suppose the FED purchases 20 dollars of securities from a brokerage firm, issuing a check drawn on itself to pay for the securities. The check is deposited into a demand deposit (checking account) the brokerage firm has in Bank A. Bank A presents the check to the FED, and the FED honors the check by increasing the balance Bank A holds with the FED. All Other CBs ASSETS LIABILITIES VC...........................480 DD.........................9,500 DCB.........................470 TD................................0 S............................2,750 L...................................0 L............................5,800 9,500 9,500 BANK A ASSETS LIABILITIES VC..............................20 DD............................500 DCB...........................30DCB....
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This note was uploaded on 03/18/2011 for the course ECON 415 taught by Professor Holland during the Spring '09 term at Purdue.

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Supply_of_Money_and_Credit - The Supply of Money and Credit...

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