Test your understanding of material for the Final

1. If commercial banks were allowed to purchase significant amounts of stock in the companies to which they
make loans, would this increase or decrease the extent of moral hazard in the financial system? Briefly explain.

2. [Related to the Making the Connection on page 283]. In 1960, federal regulations prohibited banks from paying
interest on checking accounts. Today, banks are legally allowed to pay interest on checking accounts, yet the
value of checking accounts has shrunk from more than 50% of commercial bank liabilities in 1960 to less than
12%. Because checking accounts now pay interest, shouldn’t they have become more popular with households
rather than less popular?

3. [Related to the Chapter Opener on page 279]. An article in the Wall Street Journal in 2012 noted: “A battle over
who gets stuck with tens of billions worth of bad housing loans made during the boom years explains why many
Americans still can’t get a mortgage.”
a. Who was battling over bad housing loans? Why were they battling?
b. Why would a battle over bad loans made years ago reduce the number of new loans that banks were willing to
make?

4. A few years ago, Congress was considering having the federal government set up a “lending fund” for small
banks. The U.S. Treasury would lend the funds to banks. The more of the funds the banks loaned to small
businesses, the lower the interest rate the Treasury would charge the banks on the loans. A member of Congress
was asked to comment on whether the bill would be helpful to small businesses. Here is part of the member’s
response:
The bank that’s struggling to write down their commercial real estate assets is having to take a hit to capital, and
this provides replacement capital on very, very favorable terms. So it deals with the left side of the balance sheet.
a. Would a loan from the Treasury be counted as part of a bank’s capital?
b. Does a bank’s capital appear on the left side of the bank’s balance sheet?

5. Why might the managers of a bank want the bank to be highly leveraged? Why might the bank’s shareholders
want the bank to be less highly leveraged?

6. Does the existence of reserve requirements make it easier for banks to deal with bank runs? Briefly explain.

7. Suppose that bank A sells $10 million in securities to bank B. Show the effect of this transaction on the balance
sheets of both banks.

8. Suppose that First Bank has $34 million in checkable deposits, Second Bank has $47 million in checkable
deposits and the reserve requirements for checkable deposits is 10%. If First Bank currently has $4million in
reserves and Second Bank has $5 million in reserves how much excess reserves does each bank have? Now
suppose that the customer of First Bank writes a check for $1 million to a real estate broker who deposits it in
Second Bank. After the check clears how much excess reserves does each bank have?

9. Suppose Ashley’s Finance Company raises most of its funds by issuing long-term bonds. It uses these funds for
floating-rate loans.
a) How does the company’s rate-sensitivity gap differ from those of most banks?
b) What deal could Ashley and Melvin make to reduce risk for both of their institutions?

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10. Canada does not have an institution like Fannie Mae that securitizes mortgages. How do you think this fact af-
fects the types of mortgages offered by Canadian banks? (Hint: Think about interest-rate risk.)

11. Robert Shiller of Yale University has suggested a variation on ARMs in which mortgage interest rates are tied to
inflation, not to short-term interest rates. Discuss the pros and cons of this idea for banks and for borrowers.

12. Suppose the Federal Reserve raises short-term interest rates, an action that is likely to reduce aggregate
output temporarily. Describe the various effects on the profits of commercial banks.

13. Suppose someone keeps $100 in cash under her pillow. One day, she takes it out and deposits it in a checking
account.
a) Does this action directly affect the monetary base or the money supply? Explain why or why not.
b) Does the action eventually lead to a change in the monetary base or the money supply? Explain why or why not.

14. Suppose the discount rate is below the federal funds rate, and banks can borrow as much as they want from
the Fed. How could a bank earn easy profits? Would the federal funds rate stay above the discount rate? Explain.

15. Which is more stable from day to day, the discount rate or the federal funds rate? Explain.

17. The following entries (in millions of dollars) are from the balance sheet of Rivendell National Bank (RNB):
U.S. Treasury bills $20
Demand deposits 40
Mortgage-backed securities 30
Loans from other banks 5
C&I loans 50
Discount loans 5
NOW accounts 40
Savings accounts 10
Reserve deposits with Federal reserve 8
Cash items in the process of collection 5
Municipal bonds 5
Bank building 4
If RNB’s assets have an average duration of five years and its liabilities have an average duration
of three years, what is RNB’s duration gap?

18. A Congresswoman introduces a bill to outlaw credit rationing by banks. The bill would require that every
applicant be granted a loan, no matter how high the risk that the applicant would not pay back the loan. She
defends the bill by arguing: There is nothing in this bill that precludes banks from charging whatever interest rate
they would like on their loans; they simply have to give a loan to everyone who applies. If the banks are smart,
they will set their interest rates so that the expected return on each loan—after taking into account the
probability that the applicant will default on the loan—is the same.
Evaluate the Congresswoman’s argument and the likely effects of the bill on the banking system.

19. [Related to the Chapter Opener on page 387]. At a hearing before a committee of the House of
Representatives, Fed Chair Ben Bernanke was asked about the legislation that would direct the GAO to audit the
Fed’s monetary policy actions. He replied:
The term “audit the Fed” is deceptive. The public thinks that auditing means checking the books, looking at the
financial statements, making sure that you’re not doing special deals, and that kind of thing. All of those things are

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(already) completely open. . . .The nightmare scenario I have is one in which some future Fed chairman would
decide to raise the federal funds rate by 25 basis points, and somebody in this room would say, “I don’t like that
decision. I want the GAO to go in and get all the records, get all the transcripts, get all the preparatory materials
and give us an independent opinion on whether or not that was the right decision.”
Why would the situation Bernanke is describing be a “nightmare scenario”? Wouldn’t it be good to have the GAO
give an independent opinion on whether a particular monetary policy action was the right decision?

20. Evaluate the following statement: “Because the Fed does not have to ask Congress for money to fund its
operations, the principal–agent view of the Fed’s motivation cannot be correct.”

21. What are the two most important assets and the two most important liabilities on the Fed’s balance sheet?
Because currency is valuable, why is it a liability to the Fed rather than an asset?

22. An article in the Wall Street Journal titled “Why the Fed’s Balance Sheet Is Shrinking,” observed that: “As
people pay back their mortgages . . . the Fed’s holdings of mortgage backed securities shrink until it can use those
funds to buy more.”
a. What are mortgage-backed securities? Where do they appear on the Fed’s balance sheet?
b. What does it mean to say that the Fed’s balance sheet is “shrinking”? Why would people paying off their
mortgages cause the Fed’s balance sheet to shrink?
Source: Kristina Peterson and Eric Morath, “Why the Fed’s Balance Sheet Is Shrinking,” Wall Street Journal,
November 2, 2012.

23. In August 2010, the Federal Reserve announced that as the mortgage-backed securities it owns matured, it
would reinvest the funds by buying U.S. Treasury securities. How would these actions affect the size of the Fed’s
balance sheet? Would the Fed be more likely to take this action if it saw future U.S. economic growth as strong or
as weak? Briefly explain.

24. [Related to the Making the Connection on page 423]. In the fall of 2012, an article in the New York Times
speculated that the Federal Reserve “could announce a new round of asset purchases, expanding its balance
sheet for the third time since 2008.”
a. What are asset purchases?
b. How do asset purchases expand the Fed’s balance sheet?
c. Why had the Fed expanded its balance sheet since 2008?
Source: Binyamin Appelbaum, “Economic Stimulus as the Election Nears? It’s Been Done Before,” New York
Times, September 11, 2012.

25. Suppose that a bank with no excess reserves receives a deposit into a checking account of $10,000 in currency.
If the required reserve ratio is 0.10, what is the maximum amount that the bank can lend out?

26. In medieval times, goldsmiths would often offer to store gold in return for a fee. They provided anyone
depositing gold with a warehouse receipt, which represented a legal claim on the goldsmith to exchange the
receipt for the amount of gold written on it.
a. How are the medieval goldsmiths like modern banks, and how are they unlike modern banks?
b. Is multiple deposit creation possible in this system? Does your answer depend on whether the warehouse
receipts can be bought and sold and redeemed by someone other than the person who deposited the gold?

27. A Fed publication refers to the multiple expansion of deposits as “the heart of banking theory.”

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a. Why is the process of the multiple expansion of deposits so important to understanding how the banking
system operates?
b. The same publication refers to “the banking system’s ability to multiply loans and deposits with the individual
bank’s inability to do so.”
How is the banking system able to multiply loans and deposits if an individual bank is unable to do so?
Source: Thomas M. Humphrey, “The Theory of Multiple Expansion of Deposits: What It Is and Whence It Came,”
Federal Reserve Bank of Richmond Economic Review, March/April 1987 2007–2009. What effect did these
changes have on the size of the money multiplier?

28. Explain whether you agree with the following observation: “If the required reserve ratio were zero, the
process of multiple deposit expansion would go on forever.”

29. [Related to the Chapter Opener on page 415]. According to an article in the Wall Street Journal:
“The identity of who buys gold has changed radically. . . . Just five years ago, jewelry accounted for two-thirds of
gold demand. Last year, it represented less than half.” If the demand for gold to be used in jewelry has declined,
who is buying gold? Does the change in who the most important demanders of gold are matter for long-term
movements in the price of gold? Briefly explain.
Source: Liam Denning, “Central Bankers Rub Gold Bugs the Right Way,” Wall Street Journal, February 17, 2012.

30. [Related to the Making the Connection on page 438] An article in the New York Times noted that many people
are increasing the types of investments in their retirement accounts beyond just stocks and bonds to include
gold:
“This is nothing but speculation. And as is the case with most speculation, the average investor is not likely to
make money.”
a. Why might investing in gold be considered “nothing but speculation”?
b. What does it mean to say that the average investor “is not likely to make money” investing in gold? Do you
agree? Briefly explain.
Source: Steven M. Davidoff, “The Risks of Tapping Your Retirement Fund for an Alternative Use,” New York Times,
October 30, 2012.

31. For (a) – (d), use the graphical analysis of equilibrium in the reserves market to predict changes in non-
borrowed reserves, borrowed reserves and federal funds rate. Assume the fed pays no interest on bank reserves.
a) The Fed conducts open market sales of securities
b) The Fed more strongly discourages banks’ use of discount window
c) Banks and non-bank public become concerned that a banking crises is imminent and that depositors will prefer
to invest in securities in financial markets
d) The Fed lowers the discount rate and conducts open market purchases of securities.

32. Consider the following data (all values are in billions):

June 1930 June 1931 June 1932
Currency 3.681 3.995 4.959
Checkable deposits 21.612 19.888 15.490
Bank Reserves 3.227 3.307 2.829
Calculate the values for each period for the currency-deposit ratio, the ratio of total reserves to deposits, the
monetary base, the money multiplier, and the M1 money supply. Can you explain why the currency deposit ratio
& the ratio of total reserves to deposits moved as they did between 1930 & 1932?

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33. State whether each of the following variables is most likely to be a goal, an intermediate target, an operating
target or a monetary policy tool.
a) M2
b) Monetary base
c) Unemployment rate
d) Open market purchases
e) federal funds rate

34. A recent proposal suggested that the Fed use the monetary base as its operating target to achieve a specified
nominal GDP range as its intermediate target. What are the pros and cons of this suggestion?

35. Suppose the First National Bank pays 6.5% interest on checkable deposits and that the required reserve ratio
is 10%. What is First National Bank's effective cost of funds?

36. Is it possible to deduce the Fed's intentions for monetary policy from observing the Fed's trading activity?

37. During Christmas time, when the public’s holdings of currency increase, what defensive open market
operations typically occur? Why?

38. If the fed sells $2 million of bonds to First national bank what happens to reserves and the monetary base?
Use T-accounts to explain your answer.

39. What steps can a bank take to deal with a significant outflow of deposits?

40. Given that inflation erodes the value of money, should the Federal Reserve pursue a goal of deflation? Would
deflation create some of the same problems as inflation in terms of the information communicated by price
changes and the arbitrary redistribution of income? Briefly explain.

41. A columnist in the Wall Street Journal has argued in favor of changing the Fed’s dual mandate to a single
mandate of price stability: “When an economy gets weak enough, extraordinary easing measures can be justified
as the necessary battle against potentially highly damaging deflation rather than to reduce unemployment.
a. What does the author mean by “extraordinary easing measures”?
b. How would these measures end deflation?
Why would deflation be “potentially highly damaging”?
c. Briefly explain whether you agree with the author’s argument that the Fed’s dual mandate should be replaced
with a single mandate of price stability.
Source: Neal Lipschutz, “Should Fed Chairman Have a Single Term, Single Mandate?” Wall Street Journal,
September 27, 2012.

42. The natural rate of unemployment varies over time, with changes in demographics, the structure of the
economy, and government policies. For its goal of high employment, why would it be crucial for the Federal
Reserve to be aware of variations in the natural rate of unemployment?

43. Suppose that the FOMC decides to lower its target for the federal funds rate. How can it use open market
operations to accomplish this goal?
How can the FOMC use open market operations to raise its target for the federal funds rate? Use a graph of the
federal funds market to illustrate your answers.

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44. The December 13, 2005, press release of the Federal Open Market Committee (FOMC) stated that the FOMC
“decided today to raise its target for the federal funds rate by 25 basis points to 4¼ percent.” The press release
also stated that “In a related action, the Board of Governors unanimously approved a 25-basis point increase in
the discount rate to 5¼ percent.”
a. Using a graph of the federal funds market, show the equilibrium federal funds rate and the discount rate before
the policy action of December 13, 2005, when the federal funds rate was 4% and the discount rate 5%.
b. Use your graph to explain how the Fed would raise the federal funds rate by 25 basis points (¼%). Show in your
graph the 25-basis-point increase in the discount rate. What policy action would the Fed use to bring about this
increase in the target federal funds rate?
Source: Board of Governors of the Federal Reserve System, “Press Release,” December 13, 2005,
www.federalreserve.gov/boarddocs/press/monetary/2005/20051213/.

45. [Related to the Chapter Opener on page 447]. In a letter to a member of Congress, Fed Chairman Ben
Bernanke made the following statement: The monetary accommodation provided by the Federal Reserve has
substantially helped the U.S. economy by easing financial conditions. . . . The easing in financial conditions has
promoted economic activity through a variety of channels, including reducing the cost of capital, boosting the
aggregate wealth of U.S. households, and improving the competitiveness of U.S. businesses in the global
marketplace.
a. What does Bernanke mean by “monetary accommodation”?
b. What does Bernanke mean by “easing financial conditions”?
c. Briefly explain how easing financial conditions promoted economic activity through each of the three
“channels” that Bernanke mentions.
Source: Letter from Ben S. Bernanke to Representative Darrell E. Issa, August 22, 2012.

46. The following statement appeared in a feature in the New York Times that provides an overview of the Federal
Reserve System: “The federal funds rate is set by the Fed’s Open Market Committee, composed of the chairman,
the six other governors, and five of the 12 regional bank presidents, on a rotating basis.” Do you agree that the
federal funds rate is set by the FOMC? Briefly explain.
Source: “Federal Reserve System,” New York Times, October 17, 2012

47. State whether each of the following variables is most likely to be a goal, an intermediate target, an operating
target, or a monetary policy tool:
a. M2
b. Monetary base
c. Unemployment rate
d. Open market purchases
e. Federal funds rate
f. Nonborrowed reserves
g. M1
h. Real GDP
i. Discount rate
j. Inflation ra

48. In a column in the Wall Street Journal, two economists at the Council on Foreign Relations argue: “Simply put,

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the Fed must choose between managing the level of reserves and managing rates. It cannot do both.” Do you
agree? Briefly explain.
Source: Benn Steil and Paul Swartz, “Bye-Bye to the Fed-Funds Rate,” Wall Street Journal, August 19, 2010.

49. Using the Taylor rule, calculate the target for the federal funds rate for October 2012, using the following
information: equilibrium real federal funds rate of 2%, target inflation rate of 2%, current inflation rate of 1.2%,
and an output gap of 5.9%. In your calculations, the inflation gap is negative if the current inflation rate is below
the target inflation rate. How does the targeted federal funds rate calculated using the Taylor rule
compare to the actual federal funds rate of 0% to 0.25%?

50. John Taylor has argued that: “Considerable empirical work supports the view that interest rates were too low
for too long in 2003-2005 and were a major factor in the housing boom and bust that resulted.”
a. What evidence is there that interest rates were too low in 2003–2005?
b. How might interest rates that were too low in 2003–2005 have contributed to the housing boom and bust?
Source: John Taylor, First Principles: Five Keys to Restoring America’s Prosperity, New York: W.W. Norton &
Company, 2012, p. 133.

51. Suppose the banking system holds no excess reserves. If the required reserve ratio is 0.10 and the money
multiplier is 2.5, what is the value of the currency-deposit ratio?

52. Is it possible to deduce the Fed’s intentions for monetary policy from observing the Fed’s trading activity?

53. Suppose that households decrease their demand for checkable deposits. If the Fed is using an interest rate as
an intermediate target, will it have to take any action to maintain the target?

54. According to the Taylor rule, what should the federal funds rate target be if inflation is 5%, the target rate of
inflation is 2%, the equilibrium real federal funds rate is 2%, full-employment real GDP is $9 trillion, and current
real GDP is $8.55 trillion?

55. What is meant by inflation targeting? Does the Fed engage in inflation targeting?

56. The effect on multiple deposit expansion

(a) is greater if banks use excess reserves to make loans than if they use them to buy securities.
(b) is greater if banks use excess reserves to buy securities than if they use them to make loans.
(c) is the same whether banks use excess reserves to buy securities or to make loans.
(d) is dependent upon the types of loans banks make and the types of securities banks buy.

57. The difference between currency outstanding and currency in circulation is equal to
(a) vault cash.
(b) bank reserves.
(c) coins issued by the U.S. Treasury.
(d) zero; they are the same thing.

58. Using a monetary aggregate for an intermediate target

(a) will cause the inflation rate to accelerate.
(b) will cause interest rates to fluctuate.
(c) requires the use of an interest rate as an operating target.

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(d) is required by the Federal Reserve Act.
(e) none of the above

59. The bank you own has the following balance sheet:

If the bank suffers a deposit outflow of $ 50 million with a required reserve ratio on deposits of 10%, what actions
should you take?

60. If a deposit outflow of $ 50 million occurs, which balance sheet would a bank rather have initially, the balance
sheet in Question 3 or the following balance sheet? Why?

61. Why has the development of overnight loan markets made it more likely that banks will hold fewer excess
reserves?

62. What are the benefits and costs for a bank when it decides to increase the amount of its bank capital?

63. Using the T- accounts of the First National Bank and the Second National Bank, describe what happens when
Jane Brown writes a $ 50 check on her account at the First National Bank to pay her friend Joe Green, who in turn
deposits the check in his account at the Second National Bank.

64. What happens to reserves at the First National Bank if one person withdraws $ 1,000 of cash and another per-
son deposits $ 500 of cash? Use T- accounts to explain your answer.

65. Suppose that you are the manager of a bank that has $ 15 million of fixed- rate assets, $ 30 million of rate-
sensitive assets, $ 25 million of fixed- rate liabilities, and $ 20 million of rate- sensitive liabilities. Conduct a gap
analysis for the bank, and show what will happen to bank profits if interest rates rise by 5 percentage points.
What actions could you take to reduce the bank’s interest- rate risk?

66. If a bank depositor withdraws $ 1,000 of currency from an account, what happens to reserves, checkable
deposits, and the monetary base?

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67. If a bank sells $ 10 million of bonds to the Fed to pay back $ 10 million on the loan it owes, what will be the
effect on the level of checkable deposits?

68. If the Fed sells $ 2 million of bonds to the First National Bank, what happens to reserves and the mon-etary
base? Use T- accounts to explain your answer.

69. If the Fed sells $ 2 million of bonds to Irving the Investor, who pays for the bonds with a briefcase filled with
currency, what happens to reserves and the monetary base? Use T- accounts to explain your answer.

70. During the Great Depression years from 1930– 1933, both the currency ratio c and the excess reserves ratio e
rose dramatically. What effect did these factors have on the money multiplier?

71. The money multiplier declined significantly during the period 1930– 1933 and also during the recent financial
crisis of 2008– 2010. Yet the M1 money sup-ply decreased by 25% in the Depression period but increased by more
than 20% during the recent financial crisis. What explains the difference in outcomes?

72. If the Fed lends five banks an additional total of $ 100 million but depositors withdraw $ 50 million and hold it
as currency, what happens to reserves and the monetary base? Use T- accounts to explain your answer.

73. Using T- accounts, show what happens to checkable deposits in the banking system when the Fed lends an
additional $ 1 million to the First National Bank.

74. Using T- accounts, show what happens to checkable deposits in the banking system when the Fed sells $ 2
million of bonds to the First National Bank.

75. If the Fed reduces reserves by selling $ 5 million worth of bonds to the banks, what will the T- account of the
banking system look like when the banking system is in equilibrium? What will have happened to the level of
checkable deposits?

76. During the holiday season, when the public’s holdings of currency increase, what defensive open market
operations typically occur? Why?

77. “ The only way that the Fed can affect the level of borrowed reserves is by adjusting the discount rate.” Is this
statement true, false, or uncertain? Explain your answer.

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78. “ The federal funds rate can never be below the interest rate paid on reserves.” Is this statement true, false, or
uncertain? Explain your answer.

79. Why is paying interest on reserves an important tool for the Federal Reserve to manage crises?

80. Why is it that a decrease in the discount rate does not normally lead to an increase in borrowed reserves? Use
the supply and demand analysis of the market for reserves to explain.

81. Why is the composition of the Fed’s balance sheet a potentially important aspect of monetary policy during a
crisis?

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