Chapter 29 : The Monetary System

Section A (MCQ)

1 d 2 d 3 c 4 a 5 a 6 c 7 a 8 c 9 a 10 a

Section B (Short answer question)

1. Banks don’t hold 100 percent reserves because it’s more profitable to use the
reserves to make loans, which earn interest, instead of leaving the money as
reserves, which earn no interest. The amount of reserves banks hold is related to
the amount of money the banking system creates through the money multiplier.
The smaller the fraction of reserves banks hold, the larger the money multiplier,
since each dollar of reserves is used to create more money.

2.
a. If the required reserve ratio is 5 percent, then First National Bank's

required reserves are $500,000 x .05 = $25,000.

b. With a required reserve ratio of 5 percent, the money multiplier is 1/.05 =

20. If First National lends out its excess reserves of $475,000, the money
supply will eventually increase by $475,000 x 20 = $9,500,000. The total
money supply = $10,000,000

3.
a. With a required reserve ratio of 10 percent and no excess reserves, the
money multiplier is 1/.10 = 10. If the Fed sells $1 million of bonds,
reserves will decline by $1 million and the money supply will contract by
10 x $1 million = $10 million.

b. Banks might wish to hold excess reserves if they need to hold the reserves
for their day-to-day operations, such as paying other banks for customers'
transactions, making change, cashing paychecks, and so on. If banks
increase excess reserves such that there's no overall change in the total
reserve ratio, then the money multiplier doesn't change and there's no
effect on the money stock.
Section C (Essay question)

Question 1

When Miss A deposits RM50,000 Bank Y will have an excess cash reserve of
RM40,000. The bank’s books of ledger (partial) will show:

Assets Liabilities
Cash RM50,000 Deposits – Miss RM50,000
A

Assume that Bank Y gives a loan of RM40,000 to Miss. B. This is represented only by a
book entry without any cash movement as shown in the bank’s ledger below:

Assets Liabilities
Cash RM50,000 Deposits – Miss A RM50,000

Loan – Ms. B RM40,000 Deposits – Miss B RM40,000

The money supply is now RM90,000. The excess cash reserve is RM32,000
(RM40,000 x 80%). Assume that this excess cash reserve of RM32,000 is lent out
to Miss C. The bank’s ledger of Bank Y is shown as below:

Assets Liabilities
Cash RM50,000 Deposits – Miss A RM50,000

Loan – Ms. B RM40,000 Deposits – Miss B RM40,000

C Loan – Ms. C RM32,000 Deposits- Miss RM32,000

The money supply is now RM122,000. The process of credit creation will
continue until the total money supply equals to RM250,000.
Money multiplier = 1/cash ratio = 1/0.20 = 5
Therefore, an original deposit of RM50,000 will expand the money supply until
RM250,000. In other words, the amount of money created is equal to RM200,000.
Question 2

a)

Money takes the form of currency and various types of bank deposits, such as checking
accounts.

The central bank controls the money supply primarily through open-market operations.
The purchase of government bonds increases the money supply, and the sale of
government bonds decreases the money supply. The central bank can also expand the
money supply by lowering reserve requirements or decreasing the discount rate, and it
can contract the money supply by raising reserve requirements or increasing the discount
rate.

b)

When banks loan out some of their deposits, they increase the quantity of money in the
economy. Because of this role of banks in determining the money supply, the central
bank’s control of the money supply is imperfect.

The central bank does not control the amount of money that consumers choose to deposit
in banks.

 The more money that households deposit, the more reserves the banks have, and
the more money the banking system can create.
 The less money that households deposit, the smaller the amount of reserves banks
have, and the less money the banking system can create.

The central bank does not control the amount that bankers choose to lend.

 The amount of money created by the banking system depends on loans being
made.
 If banks choose to hold onto a greater level of reserves than required by the
central bank (called excess reserves), the money supply will fall.
 Therefore, in a system of fractional-reserve banking, the amount of money in the
economy depends in part on the behavior of depositors and bankers.
 Because the central bank cannot control or perfectly predict this behavior, it
cannot perfectly control the money supply.