Chapter Five: Policy Makers and the Money Supply

Introduction to Finance Markets

Investments and Financial Management
15th Edition Melicher Solutions Manual
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Chapter 5
Policy Makers and the Money Supply

CHAPTER PREVIEW

It is important to recognize that the Federal Reserve as administrator of monetary policy does not
operate in isolation but rather in conjunction with other policy makers (i.e., the president, Congress,
and the U.S. Treasury) in attempting to achieve national policy objectives. We will see in this chapter
that these policy makers influence the operation of the financial system and the economy through
their policies and actions directed towards influencing national policy objectives. We begin by
reviewing our country’s national economic policy objectives. This is followed by a discussion of
the four policy maker groups (Federal Reserve System, The president, Congress, and the U.S.
Treasury). We review how the government reacted to the perfect financial storm. Next, we cover
how the federal government influences the economy. We then turn our attention to policy
instruments of the U.S. Treasury and how the Treasury manages the national debt. Next, we cover
how the money supply is changed and discuss factors that affect bank reserves. We conclude with
a discussion of the monetary base and the money multiplier.

LEARNING OBJECTIVES

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• Discuss the objectives of national economic policy and the conflicting nature of these
objectives.
• Identify the major policy makers and briefly describe their primary responsibilities.
• Discuss how the U.S. government responded to the 2007-2009 perfect storm.
• Identify the policy instruments of the U.S. Treasury and briefly explain how the Treasury
manages its activities.
• Describe U.S. Treasury tax policy and debt management responsibilities.
• Discuss how the expansion of the money supply takes place in the U.S. banking system.
• Briefly summarize the factors that affect bank reserves.
• Explain the meaning of the monetary base and money multiplier.
• Explain what is meant by the velocity of money and give reasons why it is important to control
the money supply.

CHAPTER OUTLINE

I. NATIONAL ECONOMIC POLICY OBJECTIVES

A. Economic Growth
B. High Employment
C. Price Stability
D. Balance in International Transactions

II. FOUR POLICY MAKER GROUPS

A. Ethical Behavior in Government
B. Policy Makers in the European Economic Union

III. GOVERNMENT REACTION TO THE PERFECT FINANCIAL STORM

IV. GOVERNMENT INFLUENCE ON THE ECONOMY

V. POLICY INSTRUMENTS OF THE U.S. TREASURY

A. Managing the Treasury’s Cash Balances
1. Treasury Tax and Loan Accounts
2. Treasury Receipts and Outlays
B. Powers Relating to the Federal Budget and to Surpluses or Deficits
1. General Economic Effects of Fiscal Policy
2. Effects of Tax Policy
3. Effects of Deficit Financing
C. Recent Financial Crisis-Related Activities

VI. AMOUNT OF NATIONAL DEBT AND DEBT MANAGEMENT

VII. CHANGING THE MONEY SUPPLY

A. Checkable Deposit Expansion
B. Offsetting or Limiting Factors
C. Contraction of Deposits
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VIII. FACTORS AFFECTING BANK RESERVES

A. Changes in the Demand for Currency
B. Federal Reserve System Transactions
l. Open-Market Operations
2. Depository Institution Transactions
3. Federal Reserve Float
4. Treasury Transactions

IX. THE MONETARY BASE AND THE MONEY MULTIPLIER

X. SUMMARY

LECTURE NOTES

I. NATIONAL ECONOMIC POLICY OBJECTIVES

Commentators offer a vast array of national policy objectives. It is possible, however, to
narrow down the various objectives to a few broad, all-inclusive categories. They are:
economic growth, high and stable levels of employment, price stability, and inter-national
financial equilibrium. An interesting class discussion can be developed with respect to what
these objectives include.
Economic growth has afforded a dramatic increase in our standard of living and is a
reflection of the nation’s productivity. Aggregate growth of a nation’s gross domestic
product (GDP) could occur simply as a result of an increase in population. But, an increase
in the welfare of individuals depends on a growth in productivity. Increased productivity is
a function of an increasing stock of resources—capital, skilled workers—and improved
tools, technology, and skills.
High and stable levels of employment reduce the burden and costs of unemployment
and is a stated objective of the government. Although a certain amount of unemployment
is basic to a market system as plants and products become obsolete, wide swings in
unemployment levels are clearly undesirable. Business cycles create unemployment from
time to time, but it is in the nation’s best interests to moderate these swings as much as
possible.
Price stability is an important factor in accomplishing the objectives of growth and high
and stable levels of employment. Inflation has been one of the most disruptive factors in
our economy. It discourages savings and reduces investment in factors of production. It has
been argued that inflation is necessary to provide high employment levels, but experience
has proved that this is too high a price to pay. In the long run, the effects of inflation on
employment levels are just the opposite.
International financial equilibrium has become increasingly important as world markets
have become more integrated. It is not only in the United States’ best interests but those of
the rest of the world that we maintain national financial equilibrium.
(Use Discussion Question 1 here.)
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II. FOUR POLICY MAKER GROUPS

The four groups of policy makers in the U.S. are: (1) Federal Reserve System, (2) the
president, (3) Congress, and (4) U.S. Treasury. The policy makers establish policies or
decisions relating to: (1) monetary policy, (2) fiscal policy, and (3) debt management.
These policies or decisions influence the economic objectives of: (1) economic growth, (2)
high employment, (3) price stability, and (4) international balance.

An interesting discussion can be developed with respect to which policy makers’

functions are dynamic, defensive, or accommodative in nature. Some overlap exists, of
course, but the discussion should bring out the reasons for these variations in functions.

(Use Figure 5.1 and Discussion Question 2 here.)

III. GOVERNMENT REACTION TO THE PERFECT FINANCIAL STORM

A “perfect financial storm” developed in the midst of the 2007-08 financial crisis and the
2008-09 great Recession. The housing price bubble that burst in mid-2006 led to rapidly
falling home prices and increased unemployment first in the housing industry and then
throughout the economy. These developments led to many mortgage loan defaults which,
in turn, caused declines in mortgage loan and mortgage-backed securities values. Many
banks and other financial institutions were on the verge of collapse because of inadequate
equity capital to offset the decline in the values of the mortgage loans and mortgage-backed
securities that they held.

As noted in Chapter 4, the Fed with the assistance of the U.S. Treasury helped financially
weak institutions merge with stronger institutions. The Fed provided rescue funds for
Fannie Mae and Freddie Mac in July, 2008 and the U.S. government assumed control of
these organizations in September, 2008.

In addition to the efforts of the Fed and the Treasury, the U.S. Congress and the president
responded with the passage of the Economic Stabilization Act of 2008, which because know
at the Troubled Asset Relief Program (TARP) which allowed the U.S. Treasury to purchase
up to $700 billion of troubled or toxic (mortgage-related) assets held by financial
institutions. In an effort to stimulate economic growth, the American Recovery and
Reinvestment Act of 2009 was passed and provided $787 billion to be used to provide tax
relief, appropriations, and direct spending.

(Use Discussion Question 3 here.)

IV. GOVERNMENT INFLUENCE ON THE ECONOMY

The federal government is charged with accomplishing those things for which the private
sector of the economy is less suited. Support of the armed forces is the most obvious
example. Students may want to discuss a wide range of functions that are not as clear-cut.

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As the government carries out its various functions and pursues its regulatory activities it
exerts a profound influence on the entire economy.
A government raises funds to pay for its activities in the following three ways: (1) levies
taxes, (2) borrows, and (3) prints money for its own use. The option of printing money has
tempted some governments in the past. To provide controls against excessive use of the
print money option, Congress delegated the power to create money to the Fed.
Taxation has dual influence on the economy since it reduces the purchasing power of
one group while increasing the purchasing power of groups benefiting from government
expenditures. The power to tax is the power to reshape the structure of the economy. The
Fed’s influence on interest rates and the way in which the U.S. Treasury manages the
national debt through refunding security issues also have a profound influence on the
economy.

V. POLICY INSTRUMENTS OF THE U.S. TREASURY

The two principal methods by which the U.S. Treasury exercises an influence on the
nation’s economic affairs are the management of its cash balances and its fiscal policy.
While cash balance management is an administrative function of the Treasury, fiscal policy
is a function of Congress and the administration that is implemented through the operations
of the Treasury.

The large cash balances of the Treasury are necessary to meet expenditures that occur
on an intermittent basis. Funds are allowed to build up with depository institutions as taxes
are collected. When needed for payments, funds are transferred to the Federal Reserve
Banks. The Treasury tries to keep balances in its accounts at the Federal Reserve Banks
relatively stable. Careful forecasts are made of daily receipts and expenditures from the
Treasury account so that funds from the Tax and Loan Accounts may be shifted in the right
amounts at the right time.

Fiscal policy has a significant effect on aggregate demand and economic activity. Not
only is government spending a large component of aggregate demand, but any change in
government spending has a multiplied effect on total spending. Increases in government
spending increase employment and income as well as consumer spending. Changes in taxes
also have a direct impact on disposable income and, in turn, consumer spending.

The effect of tax policy is a function not only of the level of taxes but of their incidence.
That is, taxes on high-income individuals have a different effect on the economy than taxes
on low- and middle-income individuals. Changes in corporate tax rates also have an
important effect on the economy. Increases in corporate taxes reduce the amount of money
a corporation has for current expenditures and for investment in additional plant and
equipment.
Deficit financing by the government is generally assumed to stimulate the economy, but
the method of financing the deficit also has a special effect. At times when credit demands
are great, the sale of Treasury obligations may tend to crowd out private borrowers, creating

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even greater pressure on the capital markets. When credit demands are slack, the capital
markets may easily absorb such Treasury financing, expanding the total credit.
The U.S. Treasury played an important role in helping the U.S. survive the 2007-09
financial crisis. The Treasury was actively involved in helping financially troubled financial
institutions merge with stronger institutions. The Economic Stabilization Act of 2008
provided the Treasury with funds to purchase troubled assets from financial institutions
although much of the funds were actually used to invest capital in banks with little equity
on their balance sheets.
(Use Discussion Questions 4 and 5 here.)

VI. AMOUNT OF NATIONAL DEBT AND DEBT MANAGEMENT

The national debt is the total debt owed by a government. Annual U.S. government
expenditures have exceeded annual tax receipts in every fiscal year since the end of the
1960s, except for fiscal 1998. Large annual budget deficits exceeded $1 trillion annually
for the fiscal periods 2009 through 2012. The U.S. national debt now exceeds $16 trillion.
The vast array of maturities, represented by the national debt, requires almost constant
attention to refunding efforts. Refinancing maturing debt issues with long-term
obligations has a far different impact on the economy than refinancing with short- or
intermediate-term obligations. During periods of intense inflation, the sale of long-term
issues may assist orderly growth and stability by reducing the purchasing power of the
public. During slack periods, the sale of short-term obligations may attract idle funds and
depository reserves with little adverse effect on the economy. This may lead to credit
expansion.
(Use Discussion Question 6 here.)

VII. CHANGING THE MONEY SUPPLY

The Federal Reserve System attempts to regulate and control the supply of money and the
availability of credit. Today, Federal Reserve notes are backed by gold certificates, Special
Drawing Rights (SDRs), and U.S. government and agency securities (the primary source).
SDRs are a form of reserve asset or “paper gold” created by the International Monetary
Fund to provide worldwide monetary liquidity and to support international trade.
The supply of Federal Reserve notes expands and contracts to meet changes in the
demand for currency. The instructor may wish to elaborate on this statement or ask students
for examples of why demand for currency might change during a year’s time. One answer
is the increased demand for currency during the Christmas holiday shopping season.
(Use Discussion Question 7 here.)
The banking system (comprised of commercial banks and other depository institutions)
of the U.S. can expand and contract the volume of checkable deposits to meet the needs for
funds by individuals, businesses, and governments. The ability to alter the money supply
and deposits is based on the use of a “fractional reserve” system (i.e., reserves equal to some
portion of deposits must be held with the Federal Reserve).

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A primary deposit adds new reserves to the bank where deposited. A derivative deposit
occurs when reserves created from a primary deposit are made available through bank loans
to borrowers who leave them on deposit in order to write checks against the funds.
As an aid to students’ understanding of the process of expansion and contraction of the
money supply, have them rework the examples given in this section with different values
(e.g., a new primary deposit of $25,000 and a reserve requirement of 12 percent). Students
can also be assigned the task of developing a new version of Table 5.1 based on initial
reserves of $25,000 and a 12 percent reserve requirement.
(Use Table 5.1 and Discussion Questions 8 through 11 here.)

VIII. FACTORS AFFECTING BANK RESERVES

Total reserves in the banking system consist of reserve deposits and vault cash. Reserve
balances are held at the Federal Reserve Banks by commercial banks and other depository
institutions. Vault cash is coin and paper currency held on the premises of depository
institutions. The extent to which the process of deposit expansion or contraction takes place
is governed by the level of excess reserves that a depository institution has (i.e., reserves
above the level of required reserves).
There are two kinds of factors which affect total reserves: those which affect the
currency holdings of the banking system and those which affect deposits at the Fed.
Currency flows in response to changes in the demand for it by households and firms.
Reserve balances are affected by a variety of transactions involving the Fed and banks, by
the Treasury, or by other factors.
When the Fed, through its open market operations, purchases securities such as
government bonds, it adds to bank reserves. For example, the Fed buys a government
security from Bank A for $10,000, the check for which is deposited in First National Bank.
As a result,
1. First National’s reserve balance at its Reserve Bank is increased by $10,000. The
Reserve Bank has a new asset—a bond worth $10,000.
2. Deposits in Bank A are increased by $10,000 ($2,000 in required reserves and $8,000
in excess reserves).
Just the opposite occurs when the Fed sells securities in the market.
When a bank borrows from its Reserve Bank, it is borrowing reserves; so reserves are
increased by the amount of the loan. Similarly, when a loan to the Reserve Bank is repaid,
reserves are reduced by the amount so repaid.
Changes in reserve requirements change the amount of deposit expansion that is
possible with a given level of reserves. With a reserve ratio of 20 percent, excess reserves
of $100 can be expanded to $100 of additional loans and deposits. If the reserve ratio is
reduced to 10 percent, it is possible to expand $100 of excess reserves to $1,000 of
additional loans and deposits. Additional expansion also takes place because when the
reserve ratio is lowered; part of the required reserves becomes excess reserves. This process
is reversed when the reserve ratio is raised.

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Bank reserves are also affected by the transactions of the Treasury. Treasury funds from
tax collections or the sale of bonds are generally deposited in its accounts in banks, which
increases bank reserves. When the Treasury has a need for funds to make payments from
its accounts at the Reserve Banks, it transfers funds from banks to its accounts at the Reserve
Banks. This process reduces bank reserves.
Other factors also affect the level of bank reserves. Federal Reserve float is the
temporary increase in bank reserves that results when checks are credits to the reserve
account of the depositing bank before they are debited from the accounts of the banks on
which they are drawn. Bank reserves are also affected by changes in the level of deposits
of foreign central banks and governments at the Reserve Banks.
(Use Figure 5.2 and Discussion Questions 12 through 14 here.)

IX. THE MONETARY BASE AND THE MONEY MULTIPLIER

The monetary base consists of reserve deposits held in Reserve Banks, vault cash or currency
held by banks and other depository institutions, and currency held by the nonbank public. The
money multiplier at any point in time can be directly calculated by dividing the money stock
by the monetary base. A useful exercise is to have students determine the money multiplier
at different times by referring to selected issues of the Federal Reserve Bulletin or from the
Fed’s Web site to find information on the money stock and the monetary base.
(Use Discussion Questions 15 and 16 here.)
The velocity of money measures the rate of circulation of the money supply expressed
as the average number of times each dollar is spent on purchases of goods and services. The
velocity of money is calculated as nominal GDP (expressed in current dollars) divided by
the Ml definition of money stock or supply. It is useful to have students determine the
velocity of money at different points in time by referring to selected issues of the Federal
Reserve Bulletin or by accessing the Fed’s Web site to find information on the size of
nominal GDP and the amount of the money stock.
(Use Discussion Questions 17 and 18 here.)

DISCUSSION QUESTIONS AND ANSWERS

1. List and describe briefly the economic policy objectives of the nation.
The nation’s economic policy objectives are four-fold, as follows:
a. Economic growth: This encompasses not only growth of total output but also growth on
a per capita basis.
b. High and stable levels of employment: It is a stated objective of the government to
promote stability of employment and production at levels close to the nation’s total
potential.
c. Price stability: Inflation causes inequities and discourages investment. Consistently stable
prices help create an environment in which the other economic objectives are achieved
more easily.
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d. International financial equilibrium: The increasing importance of international trade and

of the flow of funds in the international capital markets imposes a strong incentive for
maintaining international financial equilibrium.

2. Describe the relationship between policy makers, types of policies, and policy objectives.

As indicated in Figure 5.1 of the textbook, there are multiple policy makers, types of policies,
and policy objectives. The sequence, of course, is for policy makers to make decisions to
achieve objectives. More specifically, certain policy makers have special responsibility for
certain types of decisions. For example, the Federal Reserve System has primary responsibility
for monetary policy. Yet policy makers are subject to influence by other policy makers in the
exercise of their duties. For example, it is well known that the President, the Congress, and
the Treasury all impose considerable pressure on the Federal Reserve authorities.

3. Describe how the U.S. government responded to the perfect financial storm.

As noted in Chapter 4, the Fed with the assistance of the U.S. Treasury helped financially
weak institutions merge with stronger institutions. The Fed provided rescue funds for Fannie
Mae and Freddie Mac in July, 2008 and the U.S. government assumed control of these
organizations in September, 2008.

In addition to the efforts of the Fed and the Treasury, the U.S. Congress and the president
responded with the passage of the Economic Stabilization Act of 2008, which because know
at the Troubled Asset Relief Program (TARP) which allowed the U.S. Treasury to purchase
up to $700 billion of troubled or toxic (mortgage-related) assets held by financial institutions.
In an effort to stimulate economic growth, the American Recovery and Reinvestment Act of
2009 was passed and provided $787 billion to be used to provide tax relief, appropriations,
and direct spending.

4. Describe the effects of tax policy on monetary and credit conditions.

Tax policy of the federal government has a direct effect on monetary and credit conditions
through its influence on the volume of savings and funds available for investment. Further,
tax policy, as it relates to corporate activity, has a direct relationship to the demands for funds
in the capital markets and in turn the supply of funds for short-term investment in government
bonds.

5. Federal government deficit financing may have a very great influence on monetary and credit
conditions. Explain.

Budgetary deficits result in government competition for private funds. At times when credit
demands are great, private borrowers may be crowded out. At times when credit demands are
slack, deficits may simply result in putting idle bank reserves to work. When deficits are so
large that the private sector cannot absorb them, the Fed may create credit by purchasing
government obligations, leading to the possibility of rising inflation.

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6. Discuss the various objectives of debt management.

Although it has been argued that the Treasury should conduct its debt management activities
in such a way as to provide a dynamic influence on the economy, it has, in fact, been largely
content to play as neutral a role as possible and to limit its influence to encouraging orderly
growth and stability. Other objectives include holding down interest costs, maintaining stable
government securities markets, and accommodating individuals’ investment needs by
tailoring securities to meet them.

7. Explain how Federal Reserve notes are supported or backed in our financial system.

Federal Reserve notes are backed or supported by: (a) gold certificates; (b) Special Drawing
Rights (SDRs), which represent a form of reserve asset or “paper gold” created by the
International Monetary Fund; (c) eligible paper (business notes and drafts); and (d) United
States government and agency securities. Today, U.S. government securities represent the
primary source of backing for Federal Reserve notes. Gold certificates, which reflect the stock
of U.S. gold holdings, represent a much smaller secondary support or backing.

8. Why are the expansion and contraction of deposits by the banking system possible in our
financial system?

The expansion and contraction of deposits is possible in the United States because our banking
system utilizes or operates under a “fractional reserve” system. This means that banks and
other depository institutions are required to hold reserves equal to some portion or fraction of
their deposits rather than on a dollar-for-dollar basis. The process of deposit expansion and
contraction takes place as a result of the operations of the whole banking system, but it arises
out of the independent transactions of individual banks or other depository institutions.

9. Trace the effect on its accounts of a loan made by a bank that has excess reserves available
from new deposits.
Assets Liabilities
Reserves $10,000 Deposits $10,000

Loan of $8,000 and required reserves = 20%.

Assets Liabilities
Reserves $10,000 Deposits $18,000
Loans 8,000

A check for $8,000 is written against the deposit arising out of the loan.
Assets Liabilities
Reserves $2,000 Deposits $10,000
Loans 8,000

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10. Explain how deposit expansion takes place in a banking system consisting of two banks.

We describe in the Finance text the process of deposit expansion involving bank loans. It is
assumed, of course, that this is a “closed” banking system; that is, loans made by one bank
will come back as deposits in either of the two banks in the two-bank system. For example, a
derivative deposit arising out of a loan from the first bank is transferred by check to the second
bank (or possibly even the first bank) where it is received as a primary deposit, and so on.

11. Explain the potential for deposit expansion when required reserves average 10 percent and
$2,000 in excess reserves are deposited in the banking system.

The potential for deposit expansion would be determined by dividing the dollar amount of
initial excess reserves by the reserve requirement percentage. In this example, we divide
$2,000 by .10, which would result in a deposit expansion limit of $20,000. The total amount
of deposits can increase 10 times the original deposit. The original new deposit ($2,000)
becomes required reserves, and loans which can be made equal nine times the initial reserves
that were provided.

12. Trace the effect on bank reserves of a change in the amount of cash held by the public.

A decrease in the amount of cash held by the public increases bank reserves; an increase in
cash decreases bank reserves. The effects on an individual bank and its Federal Reserve Bank
are summarized in the text.

13. Describe the effect on bank reserves when the Federal Reserve sells U.S. government
securities to a bank.

When the Federal Reserve sells U.S. government securities, the result is a decrease in bank
reserves. A check is written on a bank to pay for the purchase of the securities. Deposits in the
bank are decreased and deposits held by the bank at its Reserve Bank are also decreased. The
transactions would be just the opposite of those presented in the text.

14. Summarize the factors that can lead to a change in bank reserves.

The factors that can lead to a change in bank reserves are shown in Figure 5.2 and may be
summarized as follows:
a. Nonbank public (change in the nonbank public’s demand for currency to be held outside
the banking system)
b. Federal Reserve System (open market operations and changes in: reserve requirements,
bank borrowings, float, foreign deposits held in Federal Reserve Banks, and other Federal
Reserve accounts)
c. United States Treasury (changes in Treasury expenditures out of accounts held at Federal
Reserve Banks, and changes in Treasury cash holdings)

15. What is the difference between the monetary base and total bank reserves?
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Total bank reserves consist of bank and other depository institution deposits held in Federal
Reserve Banks plus vault cash or currency held by banks and other depository institutions. In
contrast, the monetary base consists of bank reserves (as previously defined) plus currency
held by the nonbank public. Thus, the monetary base adds a basic component of the money
supply to the bank reserves definition.

16. Briefly describe what is meant by the money multiplier and indicate the factors that affect its
magnitude or size.

The money multiplier times the monetary base produces the Ml definition of the money
supply. The money multiplier represents the multiple extent to which a given monetary base
can support a larger money supply or stock. The size of the money multiplier is affected by:
(a) the ratio of currency held by the nonbank public to checkable deposits; (b) the ratio of bank
reserves to total deposits; (c) the ratio of noncheckable deposits to checkable deposits; and (d)
the ratio of government deposits to checkable deposits.

17. Define the velocity of money and explain why it is important to anticipate changes in money
velocity.

The velocity of money measures the rate of circulation of the money supply expressed as the
average number of times each dollar is spent on purchases of goods and services and is
calculated as nominal GDP divided by Ml. Changes in money velocity affect the growth rate
in real economic activity and the rate of inflation.

18. Why does it seem to be important to regulate and control the supply of money?

Changes in money supply have been found to lead to changes in economic activity in the past.
Rapid Ml growth has sometimes been offset by a decline in the velocity of money with the
result being moderate economic growth with relatively low inflation. Monetary policy making
by the Federal Reserve needs to take into consideration both money supply growth targets and
possible changes in velocity in order to achieve future desired effects on real GDP and
inflation.

EXERCISES AND ANSWERS

1. Go to the St. Louis Federal Reserve Bank’s website at http://www.stlouisfed.org, and access
current economic data via the Research & Data tab.

a. Find M1 and the monetary base, and then estimate the money multiplier.

The instructor will need to periodically update the money supply (M1) and monetary base
(MB) amounts, and calculate the money multiplier (M1/MB).

b. Determine the nominal gross domestic (formally national) product (GDP in current
dollars). Estimate the velocity of money using M1 from (a) and nominal GDP.

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The instructor will need to periodically update the GDP (in current dollars) and the money
supply (M1) amounts, and calculate the money velocity (GNP/M1).

c. Indicate how the money multiplier and the velocity of money have changed between two
recent years.

The instructor, based on updated calculation in (a) and (b), will need to identify the extent to
which changes in the money multiplier and/or the velocity of money have changed.

2. Important policy objectives of the federal government include economic growth, high
employment, price stability, and a balance in international transactions. The achievement of
these objectives is the responsibility of monetary policy, fiscal policy, and debt management
carried out by the Federal Reserve System, the President, the Congress, and the U.S.
Treasury. Describe the responsibilities of the various policy makers in trying to achieve the
four economic policy objectives.

The president of the United States along with his advisors formulates fiscal policy.
Congress enacts legislation to implement fiscal policy (after exercising its authority to
modify the policy). The Fed has primary responsibility for monetary policy, while the
Treasury handles debt management.

3. An economic recession has developed and the Federal Reserve Board has taken several actions
to retard further declines in economic activity. The U.S. Treasury now wishes to take steps to
assist the Fed in this effort. Describe the actions the Treasury might take.

Although the U.S. Treasury usually leaves monetary policy to the Fed, it can lend some
influence. To assist the Fed in easing monetary conditions, the Treasury would probably roll
over maturing debt with short-term obligations. In so doing it would not draw funds from the
public sector that might flow into capital investment by business. In addition, the Treasury
could draw down its accounts at Federal Reserve Banks. This would have the effect of
increasing the reserves of the banking system since Treasury disbursements would exceed the
Tax and Loan Account funds coming into Federal Reserve Banks.

4. The president and members of Congress are elected by the people and are expected to behave
ethically. Let’s assume that you are a recently elected member of Congress. A special-interest
lobbying group is offering to contribute funds to your next election campaign in the hope that
you will support legislation being proposed by others that will help the group achieve its stated
objectives. What would you do?

Congress people and others often are faced with such a dilemma. One the one hand funding
raising is a necessary part of running for Congress. On the other hand, donors often would like
something in return for their donations. It is not wrong to support legislation that you believe
is fair and honest and represents consistent ethical behavior on your part. Of course, it is
important to separate donor gifts from influencing your decision. If donors are also behaving
ethically, they should expect that your decision whether or not to support a specific legislative
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proposal should be the best, ethically-based decision that you can make—any not one that is
influenced by support from a special-interest lobbying group.

PROBLEMS AND ANSWERS

1. Assume that Banc One receives a primary deposit of $1 million. The bank must keep
reserves of 20 percent against its deposits. Prepare a simple balance sheet of assets and
liabilities for Banc One immediately after the deposit is received.

ASSETS LIABILITIES
Reserves $1 million Deposits $1 million

2. Assume that Bank A receives a primary deposit of $100,000 and that it must keep reserves
of 10 percent against deposits.

a. Prepare a simple balance sheet of assets and liabilities for the bank immediately after the
deposit is received.

ASSETS LIABILITIES
Reserves $100,000 Deposits $100,000

b. Assume Bank A makes a loan in the amount that can be “safely lent.” Show what the
bank’s balance sheet of assets and liabilities would look like immediately after the loan.

ASSETS LIABILITIES
Reserves $100,000 Deposits $190,000
Loans $90,000

c. Assume that a check in the amount of the “derivative deposit” created in Part b was
written and sent to another bank. Show what Bank A’s (the lending bank’s) balance sheet
of assets and liabilities would look like after the check is written.

ASSETS LIABILITIES
Reserves $10,000 Deposits $100,000
Loans $90,000

3. Rework Problem 2 assuming Bank A has reserve requirements that are 15 percent of
deposits.

a. Prepare a simple balance sheet of assets and liabilities for the bank immediately after the
deposit is received.

ASSETS LIABILITIES
Reserves $100,000 Deposits $100,000

b. Assume Bank A makes a loan in the amount that can be “safely lent.” Show what the
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bank’s balance sheet of assets and liabilities would look like immediately after the loan.

ASSETS LIABILITIES
Reserves $100,000 Deposits $185,000
Loans $85,000

c. Now assume that a check in the amount of the “derivative deposit” created in (b) was
written and sent to another bank. Show what Bank A’s (the lending bank’s) balance sheet
of assets and liabilities would look like after the check is written.

ASSETS LIABILITIES
Reserves $15,000 Deposits $100,000
Loans $85,000

4. Assume that there are two banks, A and Z, in the banking system. Bank A receives a
primary deposit of $600,000 and it must keep reserves of 12 percent against deposits.
Bank A makes a loan in the amount that can be safely lent.

a. Show what Bank A’s balance sheet of assets and liabilities would look like immediately
after the loan.

Bank A:
ASSETS LIABILITIES
Reserves $600,000 Deposits $1,128,000
Loans $528,000

b. Assume that a check is drawn against the primary deposit made in Bank A and is
deposited in Bank Z. Show what the balance sheet of assets and liabilities would look like
for each of the two banks after the transaction has taken place.

Bank A:
ASSETS LIABILITIES
Reserves $72,000 Deposits $600,000
Loans $528,000

Bank Z:
ASSETS LIABILITIES
Reserves $528,000 Deposits $528,000

c. Assume that Bank Z makes a loan in the amount that can be safely lent against the funds
deposited in its bank from the transaction described in (b). Show what Bank Z’s balance
sheet of assets and liabilities would look like after the loan.

Bank Z:
ASSETS LIABILITIES
Reserves $528,000 Deposits $992,640
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Loans $464,640

5. The SIMPLEX financial system is characterized by a required reserves ratio of 11 percent;

initial excess reserves are $1 million; and there are no currency or other leakages.
a. What would be the maximum amount of checkable deposits after deposit expansion
and what would be the money multiplier?

Maximum deposit expansion: $1,000,000/.11 = $9,090,909

Money multiplier: 1/.11 = 9.091 = 9.1 (rounded)

b. How would your answer in (a) change if the reserve requirement had been 9
percent?

Maximum expansion for a 9% reserve requirement: $1,000,000/.09 = $11,111,111

Money multiplier for a 9% reserve requirement: 1/.09 = 11.111 = 11.1 (rounded)

6. Assume a financial system has a monetary base of $25 million. The required reserves ratio is
10 percent and there are no leakages in the system.

a. What is the size of the money multiplier?

Money multiplier: 1/.10 = 10.0

b. What will be the system’s money supply?

Money supply: $25 million × 10.0 = $250 million

7. Rework Problem 6 assuming the reserve ratio is 14 percent.

Money multiplier for a 14% reserve requirement: 1/.14 = 7.143 = 7.1 (rounded)
Money supply: $25 million × 7.1 = $177.5 million
Note: This problem assumes that no currency is held by the public.

8. The BASIC financial system has a required reserves ratio of 15 percent, initial excess
reserves are $5 million, cash held by the public is $1 million and is expected to stay
at that level, and there are no other leakages or adjustments in the system.

a. What would be the money multiplier and the maximum amount of checkable deposits?
Money multiplier: 1/.15 = 6.667 or 6.7 (rounded), or
Money multiplier (m) = (1 + .00)/[.15(1 + .00 + .00) + .00] = 1/.15 = 6.667 = 6.7
(rounded)
Maximum checkable deposits: $5 million x 6.667 = $33,335,000; or if m is rounded,
$5 million x 6.7 = $33,500,000

b. What would be the money supply amount in this system after deposit expansion?

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Money supply = Checkable deposits plus cash held by the public =

$33,335,000 + $1,000,000 = $34,335,000
If m is rounded, money supply = $33,500,000 + $1,000,000 = $34,500,000

9. Rework Problem 8, assuming that the cash held by the public drops to $500,000 with
an equal amount becoming excess reserves and the required reserves ratio drops to 12
percent.

Excess reserves = $5 million + $.5 million = $5.5 million

Money multiplier = 1/.12 = 8.333 or 8.3 (rounded)
Maximum checkable deposits: $5.5 million x 8.333 = $45,831,500
Money supply = $45,831,500 + $500,000 = $46,331,500
Using an m of 8.3 gives: ($5.5 million x 8.3) + $.5 million = $46,150,000

10. The COMPLEX financial system has these relationships: the ratio of reserves to total
deposits is 12 percent and the ratio of noncheckable deposits to checkable deposits is
40 percent. In addition, currency held by the nonbank public amounts to 15 percent of
checkable deposits. The ratio of government deposits to checkable deposits is 8
percent, and the monetary base is $300 million.
a. Determine the size of the M1 money multiplier and the size of the money supply.

Money multiplier (m):

m = (1 + k)/[r(1 + t + g)k]
= (1 + .15)/[.12(1 + .40 + .08) + .15] = 1.15/.328 = 3.506 = 3.5 (rounded)
Money supply (M1) = Monetary base × Money multiplier (m)
Money supply: $300 million × 3.5 = $1.05 billion

b. If the ratio of currency in circulation to checkable deposits were to drop to 13 percent,

what would be the impact on the money supply?

Money multiplier (m):

(1 + .13)/[.12(1 + .40 + .08) + .13] = 1.13/.308 = 3.669 = 3.7 (rounded)
Money supply: $300 million × 3.7 = $1.11 billion
The money supply increases by $.06 billion ($1.11 billion versus $1.05 billion).

c. If the ratio of government deposits to checkable deposits increases to 10 percent while

the other ratios remained the same, what would be the impact on the money supply?

Money multiplier (m):

(1 + .13)/[.12(1 + .40 + .08) + .13] = 1.13/.308 = 3.669 = 3.7 (rounded)
Money supply: $300 million × 3.7 = $1.11 billion
The money supply increases by $.06 billion ($1.11 billion versus $1.05 billion).

d. What would happen to the money supply if the reserve requirement increased to 14
percent while noncheckable deposits to checkable deposits fell to 35 percent? Assume
the other ratios remain as originally stated.
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 Chapter Five: Policy Makers and the Money Supply

Money multiplier (m):

(1 + .15)/[.14(1 + .35 + .08) + .15] = 1.15/.350 = 3.286 = 3.3 (rounded)
Money supply: $300 million × 3.3 = $990 million (or $.990 billion)
The money supply decreases by $.15 billion ($1.05 billion versus $.990 billion).

11. Challenge Problem ABBIX has a complex financial system with the following relationships.
The ratio of required reserves to total deposits is 15 percent, and the ratio of noncheckable
deposits to checkable deposits is 40 percent. In addition, currency held by the nonbank public
amounts to 20 percent of checkable deposits. The ratio of government deposits to checkable
deposits is 8 percent and the initial reserves are $900 million.

a. Determine the M1 multiplier and the maximum dollar amount of checkable deposits.
Money Multiplier and Deposit Expansion
Money multiplier (m) = (1 + .20)/[.15(1 + .40 + .08) + .20] = 1.20/.42 = 2.857 = 2.9
(rounded)
Checkable deposits = Initial reserves × m = $900 million × 2.9 = $2,610 million or $2.61
billion

b. Determine the size of the M1 money supply.

Currency = .20 × $2,610 million = $522 million

Money supply (M1) = Currency + Checkable deposits = $522 million + $2,610 million =
$3,132 million or $3.132 billion

c. What will happen to ABBIX’s money multiplier if the reserve requirement decreases to 10
percent while the ratio of noncheckable deposits to checkable deposits falls to 30 percent?
Assume the other ratios remain as originally stated.

Money multiplier (m) = (1 + .20)/[.10(1 + .30 + .08) + .20] = 1.20/.338 = 3.550 = 3.5
(rounded)

d. Based on the information in (c), estimate the maximum dollar amount of checkable deposits,
as well as the size of the M1 money supply.

Checkable deposits = Initial reserves × m = $900 million × 3.5 = $3,150 million or $3.15
billion
Currency = .20 × $3,150 million = $630 million
Money supply (M1) = $630 million + $3,150 million = $3,780 million or $3.78 billion

e. Assume that ABBIX has a target M1 money supply of $2.8 billion. The only variable that
you have direct control over is the required reserves ratio. What would the required
reserves ratio have to be to reach the target M1 money supply amount? Assume the other
original ratio relationships hold.

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 Chapter Five: Policy Makers and the Money Supply

Target money supply: $2.8 billion

Target checkable deposits = money supply – currency = $2.8 million - $630 million = $2.17
billion
Target money multiplier: $2.17 billion/$.9 billion = 2.411 or 2.4 (rounded)

Money multiplier (m) = (1 + .20)/[r(1 + .40 + .08) + .20] = 1.2/x = 2.4

Let x = the denominator = 1.2/2.4 = .50
.50 = [r(1 + .40 +.08) + .20]
Required reserves ratio = .50 - .20 – r(1.48) = .30/1.48 = r = .20
Check: m = (1 + .20)/[.20(1 + .40 + .08) + .20] = 1.2/.50 = 2.4
Checkable deposits = $.9 billion x 2.4 = $2.16 billion
Money supply = $.63 billion + $2.16 billion = $2.79 billion or $2.8 billion (rounded)

f. Now assume that currency held by the nonbank public drops to 15 percent of checkable
deposits and that ABBIX’s target money supply is changed to $3.0 billion. What would the
required reserves ratio have to be to reach the new target M1 money supply amount?
Assume the other original ratio relationships hold.

Target money supply: $2.8 billion

Target checkable deposits = money supply – currency = $3.0 million - $630 million = $2.37
billion
Target money multiplier: $2.37 billion/$.9 billion = 2.633 or 2.6 (rounded)

Money multiplier (m) = (1 + .15)/[r(1 + .40 + .08) + .15] = 1.15/x = 2.6

Let x = the denominator = 1.15/2.6 = .44
.44 = [r(1 + .40 +.08) + .15]
Required reserves ratio = .44 - .15 – r(1.48) = .29/1.48 = r = .20
Check: m = (1 + .15)/[.20(1 + .40 + .08) + .15] = 1.15/.44 = 2.6
Checkable deposits = $.9 billion x 2.6 = $2.34 billion
Money supply = $.63 billion + $2.34 billion = $2.97 billion or $3.0 billion (rounded)

SUGGESTED QUIZ

1. Define or discuss briefly:

a. National economic policy objectives
b. Total reserves
c. Types of transactions that affect bank reserves
d. Monetary base
e. Money multiplier
2. Develop a table showing the multiplying capacity in five rounds of a new primary deposit of
$1,000 with 10 percent required reserves.
Solution:

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 Chapter Five: Policy Makers and the Money Supply

Multiplying Capacity of Money in Bank Transactions

Amount Amount Amount for

Transaction Deposited Lent Reserves
1 $1,000.00 $ 900.00 $100.00
2 900.00 810.00 90.00
3 810.00 729.00 81.00
4 729.00 656.10 72.90
5 656.10 590.49 65.61
Totals $4,095.10 $ 3,685.59 $409.51

3. Determine the size of the money multiplier when: the ratio of reserves to total deposits is 10
percent; the ratio of noncheckable deposits to checkable deposits is 30 percent; currency held
by the nonbank public is 20 percent of checkable deposits; and the ratio of government
deposits to checkable deposits is 10 percent. Also determine the money supply if the monetary
base is $10 million.
Solution:
Money multiplier = (1 + .20)/[.10(1 + .30 + .10) + .20]
= 1.20/.340 = 3.529 = 3.5 (rounded)
Money supply = $10 million × 3.529 = $35.29 million
[Or, if the rounded money multiplier is used: $10 million × 3.5 = $35 million]

4. Discuss the importance of managing the U.S. Treasury’s cash balances in maintaining stable
monetary conditions.

5. Describe the techniques used by the Treasury in managing the debt to help achieve an
economic climate which would encourage orderly growth and stability.

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