Managing in a Global Economy

Demystifying International
Macroeconomics 2nd Edition
Marthinsen Solutions Manual
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 Chapter
The Power of Financial Institutions to Create Money
8
Review Questions
1. Is it accurate to say that, as banks lend money in the form of
checking accounts, the M1 and M2 money supplies rise when the
loan is made and then fall when the loan is spent? Explain.
▪ No. The money supply rises when the loan is made and falls when it is
repaid. When the checking account is spent, the purchasing power is
simply transferred from one individual to another.
2. Is it accurate to say that, as banks lend money in the form of
checking accounts, that the M1 and M2 money supplies rise when
the loan is made and then fall when the loan is paid back? Explain.
▪ Yes. This is an accurate statement.
3. Suppose the required reserve ratio is 15%, and a Japanese bank
has the following assets, liabilities, and stockholders’ equity:
reserves = ¥85 million, checking accounts = ¥500 million, loans =
¥400 million, borrowings from the Bank of Japan = ¥80 million,
stockholders’ equity = ¥75 million, securities = ¥150 million, and
other assets = ¥20 million. Given this information, calculate the
amount of excess reserves or the reserve deficiency for this bank.
▪ Total Reserves = ¥85 million
– Required Reserves = 15% × ¥500 million = ¥75 million
Excess Reserves = ¥10 million
4. If $1,000 is deposited in a bank with reserve requirements equal to
100%, explain how much the bank can lend. In general, how do
banks with 100% reserve requirements increase their loans?
Explain.
▪ The bank can lend nothing from the deposit because the change
in total reserves ($1,000) is exactly equal to the change in
required reserves ($1,000), which means the change in excess
reserves equal zero.
▪ The bank could lend by increasing its stockholder’s equity
and/or increasing its nondeposit liabilities, such as borrowing
from other financial institutions. The bank could also lend the
proceeds of liquidated or maturing assets, such as notes and
bonds, and any profits that are earned.
5. Suppose a bank has $2 million in excess reserves and $8 million in
required reserves. A required reserve ratio of 10% is applicable to

Copyright © John E. Marthinsen

Managing in a Global Economy Instructor’s Manual, Chapter 7 1
 all deposits at the bank. What is the total amount of deposits at the
bank? Explain.
▪ Deposits = Required Reserves/Reserve Ratio
▪ Therefore, $80 million = $8 million/0.10
6. Can a banking system’s excess reserves be negative? Explain. If
they can be and are negative, explain three ways the banking
system can eliminate the deficiency. If they cannot be negative,
explain why.
▪ Yes, the banking system can have negative excess reserves if
required reserves exceed total reserves. In this situation,
financial intermediaries are violating central bank rules and
would need to make adjustments to correct the deficiency.
▪ To meet their reserve requirements, financial intermediaries
could
o borrow from the central bank,
o increase deposits,
o call in loans and/or not renew them, and/or
o sell assets, like securities, which will increase reserves.
7. If the reserve requirement is 10%, and a depositor withdraws
$500 from her checking account, by how much will the bank’s
excess reserves change? Explain.
▪ Excess reserves fall by $450 because total reserves fall by $500
and required reserves fall by $50.
8. Determine whether the following statements are true, false, or
uncertain. Please correct the false statements.
a. Having a high level of excess reserves is important to a
banker because excess reserves reflect good bank
management.
▪ False. Earning profits while taking reasonable risks is
a sign of good bank management. Excess reserves are
funds that could have been invested or lent but were
not. They might be held to mitigate risk but the
amounts held should be measured against sacrificed
returns.
b. Excess reserves are important to a banker because they
indicate the profits that can be divided among the bank’s
owners.
▪ False. Reserves are assets in a financial intermediary’s
balance sheet, and profits (revenues minus costs) are
part of its income statement, which eventually

Copyright © John E. Marthinsen

Managing in a Global Economy Instructor’s Manual, Chapter 7 2
 increase stockholders; equity. Profits are not excess
reserves.
c. Excess reserves are important to a banker because, if they
are not maintained, banking regulators may fine or shut
down the bank.
▪ False. Banks only have to meet their required reserve
obligations. They are not required to hold excess reserves.
9. Assume the required reserve ratio on all deposit liabilities is 15%.
Calculate the level of excess reserves for Sovereign Bank. How
much can Sovereign Bank safely lend?

Sovereign Bank

Assets Liabilities & Equity

Reserves 40,000 Deposits 200,000

Federal funds loans 20,000 Borrowing from the central bank 80,000

Loans 200,000 Federal funds borrowing 100,000

Securities 300,000 Other liabilities 150,000

Other 40,000 Stockholders’ equity 70,000

▪ Total Reserves = 40,000

– Required Reserves = 15% × 200,000 = 30,000
Excess Reserves = 10,000
▪ Sovereign Bank can safely lend its excess reserves.

10. Suppose the required reserve ratio for the banking system is 25%.
Answer the following questions based on the balance sheet of
Lafayette Bank:

Copyright © John E. Marthinsen

Managing in a Global Economy Instructor’s Manual, Chapter 7 3
 Lafayette Bank

Assets Liabilities & Equity

Cash in the vault 60,000 Deposits 500,000

Deposits at the central bank 100,000 Borrowing from the central bank 70,000

Loans 800,000 Borrowing from other banks 400,000

Securities 100,000 Other liabilities 100,000

Other 30,000 Stockholders’ equity 20,000

a. Calculate the level of excess reserves for Lafayette Bank.

▪ Total Reserves = 60,000 + 100,000 = 160,000
– Required Reserves = 25% × 500,000 = 125,000
Excess Reserves = 35,000
b. How much can Lafayette Bank safely lend?
▪ Lafayette can safely lend its excess reserves of $35,000.
c. Show the changes in Lafayette Bank’s balance sheet after
the loan (in checking account form) has been made.

Lafayette Bank

Assets Liabilities & Equity

500,000
Cash in the vault 60,000 Deposits
+35,000

Deposits at the central bank 100,000 Borrowing from the central bank 70,000

800,000
Loans Borrowing from other banks 400,000
+35,000

Securities 100,000 Other liabilities 100,000

Other 30,000 Stockholders’ equity 20,000

d. Show the entire balance sheet after the loan has been spent
and cleared.

Lafayette Bank

Assets Liabilities & Equity

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Managing in a Global Economy Instructor’s Manual, Chapter 7 4
 500,000
+35,000
Cash in the vault 60,000 Deposits
-35,000
500,000

100,000
Deposits at the central bank -35,000 Borrowing from the central bank 70,000
65,000

800,000
Loans +35,000 Borrowing from other banks 400,000
835,000

Securities 100,000 Other liabilities 100,000

Other 30,000 Stockholders’ equity 20,000

11. Suppose the banking system’s only deposit liabilities are checking
accounts, and the reserve requirement on them is 10%. If the
banking system has excess reserves of $30 million and checking
deposits of $500 million, calculate the banking system’s total
reserves.
▪ Total Reserves ≡ Excess Reserves + Required Reserves.
Therefore, total reserves equal $80 million ($80 million = $30
million + [10%  $500]).
12. If interest rates fall, what, if anything, should happen to the M2
multiplier? Briefly explain.
▪ The M2 money multiplier should fall because (Cc/D) and (U/D)
rise, and (N/D) falls. This occurs because the opportunity cost
of holding (non-interest-earning) cash relative to checking
deposits and holding (non-interest earning or low-interest-
earning) customary reserves relative to checking deposits falls;
so people hold more cash and banks hold more customary
reserves relative to checking accounts. Similarly, the cost of
holding checking accounts instead of holding higher-interest-
earning near money falls; so people hold relatively less near
money compared to checking accounts.
13. What happens to the M2 money multiplier, if anything, after
holidays, when people withdraw less cash from banks to pay for
presents?

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Managing in a Global Economy Instructor’s Manual, Chapter 7 5
 ▪ (Cc/D), the preferred asset ratio for currency in circulation relative to
checking accounts, falls, causing the M2 money multiplier to rise because
banks have more reserves to lend.
14. Is it possible for a country’s money supply to grow rapidly at the
same time as its monetary base is falling? If not, explain why not.
If it is possible, explain how it is possible, and mention factors that
might cause the growth.
▪ Yes. M2  M2 Money Multiplier × Monetary Base. Even if the monetary
base falls, M2 may rise if the M2 money multiplier increases.
▪ Among the major factors that cause the money multiplier to grow are
lower reserve requirements, lower (Cc/D), lower (U/D), and higher (N//D).
The major causes of monetary base growth are central bank actions that
increase its balance sheet size. These actions will be described in Chapter
9, “Who Controls the Money Supply and How?”
15. Is it accurate to say that the public decides what portion of the
money supply will be held as currency in circulation? Explain.
▪ Yes. The public can convert checking accounts and near money
into cash (or vice versa) any time it wants.
16. In 2001, Domingo Cavallo, Argentina’s economy minister, wanted
Banco Central de la República Argentina (the central bank of
Argentina) to reduce the reserve requirement applied to private
banks. Suppose Argentina's total bank deposits equaled Ps 100
billion (100 billion pesos), the banking system had zero excess
reserves, and the reserve ratio was 10%. Calculate the effect, if
any, that Cavallo’s policy would have on Argentina's monetary
base, as well as the banking system’s total reserves and excess
reserves, if the reserve ratio was reduced to 8%. What would be
the qualitative change in Argentina’s M2 money multiplier?
▪ The change in the reserve ratio would have no effect on the
monetary base because total reserves of financial
intermediaries plus currency in circulation would not change.
▪ Total reserves would not change because cash in the vault plus
deposits at the central bank would not change.
▪ Excess reserves would rise because required reserves fall and
total reserves stay the same.
▪  Total Reserves = Ps 0
▪ –  Req. Reserves = –(–2% × Ps 100,000 million) = +Ps 2 million
 Excess Reserves = + Ps 2 million
▪ The money multiplier would rise as a result of the reduction in the reserve
ratio because banks have a greater lending ability.

Copyright © John E. Marthinsen

Managing in a Global Economy Instructor’s Manual, Chapter 7 6
 17. Suppose Argentine deposits at private banks (i.e., checking
accounts) fell by $3 billion as people rushed to convert deposits
into cash. Explain the effect this withdrawal of deposits from
private banks by the public had on Argentina’s monetary base,
M2 money multiplier, and excess reserves. Assume the reserve
ratio is 10%.
▪  Monetary base = 0.
▪ M2 money multiplier falls as (C/D) rises.
▪  Total Reserves = – Ps 3
million
–  Required Reserves = – (10% × – Ps 3 million) = + Ps 0.3
million
 Excess Reserves = –Ps 2.7 million

Discussion Questions
18. Japan suffered throughout the 1990s and into the 2000s from the
after-effects of an asset price bubble that burst in 1990. The asset
price bubble was caused by excessive money growth in the late
1980s that drove up the price of real estate. Explain how
plummeting real estate prices put severe pressure on Japan’s
domestic banking system.
▪ Plummeting asset prices caused many borrowers to
default on their loans, which meant that banks ended up
owning the depreciated assets of borrowers (e.g.,
houses). When banks sold these assets, the losses
reduced their, already low, stockholders’ equity and put
them at risk of insolvency.
19. It is the end of the banking day. You are the money trader at a
bank that has $50 million of excess reserves, but there are no
customers walking through the doors to borrow. What do you do?
▪ Usually, the trader will lend the funds overnight on the
interbank market. He or she could also purchase short-term
securities.

Copyright © John E. Marthinsen

Managing in a Global Economy Instructor’s Manual, Chapter 7 7