Homework 6: Monetary System

1. What are the primary responsibilities of the Central Bank?

- Regulating banks and ensure the health of the banking system: This task is largely the
responsibility of the regional Federal Reserve Banks. In particular, the Fed monitors each bank’s
financial condition and facilitates bank transactions by clearing checks. It also acts as a bank’s
bank, which means that Fed makes loans to banks when banks themselves want to borrow. When
financially troubled banks find themselves short of cash, the Fed acts as a lender of last resort – a
lender to those who cannot borrow anywhere else – to maintain stability in the overall banking
system.
- Controlling the quantity of money: The central bank's more important job is to control the
quantity of money that is made available in the economy, called the money supply. Decisions by
policymakers concerning the money supply constitute monetary policy. At the Fed, monetary
policy is made by the Federal Open Market Committee (FOMC). The FOMC meets about every 6
weeks in Washington, D.C., to discuss the condition of the economy and consider changes in
monetary policy.
2. Why don’t banks hold 100-percent reserves? How is the amount of reserves banks hold
related to the amount of money the banking system creates?
- Banks do not hold 100-percent reserves because it would limit their ability to earn profits and
provide loans to borrowers. When banks hold 100-percent reserves, they are essentially keeping all
the deposited money idle in their vaults, which means they cannot lend it out to earn interest. By
adopting fractional-reserve banking, banks can lend out a portion of the deposits they receive
while maintaining a fraction of those deposits as reserves.
- The amount of reserves banks hold is related to the amount of money the banking system creates
through a concept known as the money multiplier. The money multiplier is the reciprocal of the
reserve ratio. If the reserve ratio is 1/10 (10 percent), each dollar of reserves can support $10 of
deposits. This means that banks can create money by making loans and expanding the money
supply up to ten times the amount of reserves they hold.
- For example, if a bank receives $100 in deposits and has a reserve ratio of 1/10, it will keep $10
as reserves and can lend out $90. The borrower who receives the $90 may deposit it in another
bank, which can then keep $9 as reserves and lend out $81. This process continues, with each bank
creating new loans and deposits based on the reserve ratio. Eventually, the total amount of money
created by the banking system can be significantly larger than the initial amount of reserves.
* In summary, banks don't hold 100-percent reserves because it would limit their ability to lend
and earn profits. The amount of reserves banks hold is related to the amount of money the banking
system creates through the money multiplier, which is determined by the reserve ratio. By holding
a fraction of deposits as reserves, banks can create new loans and deposits, effectively expanding
the money supply.
3. Bank A has a leverage ratio of 10, while Bank B has a leverage ratio of 20. Similar losses
on bank loans at the two banks cause the value of their assets to fall by 7 percent. Which
bank shows a larger change in bank capital? Does either bank remain solvent? Explain.
- Leverage Ratio:
Bank A: Leverage ratio = 10
Bank B: Leverage ratio = 20
- Losses on Bank Loans:
Similar losses on bank loans lead to a 7 percent reduction in the value of assets for both banks.
- Change in Bank Capital:
The change in bank capital can be calculated using the formula:
Change in Bank Capital = Initial Assets * Loss Rate - Initial Liabilities
+ Bank A:
Initial assets decrease by 7 percent: (Initial Assets * 0.07)
Change in bank capital for Bank A:
Change in Bank Capital (A) = Initial Assets * 0.07 - Initial Liabilities
+ Bank B:
Initial assets decrease by 7 percent: (Initial Assets * 0.07)
Change in bank capital for Bank B:
Change in Bank Capital (B) = Initial Assets * 0.07 - Initial Liabilities
- Comparison:
To determine which bank shows a larger change in capital, compare the values of Change in Bank
Capital (A) and Change in Bank Capital (B).
- Solvent or Not:
A bank remains solvent if its capital remains positive after the loss.
If the Change in Bank Capital is positive, the bank remains solvent; otherwise, it becomes
insolvent.
- Conclusion:
Calculate the specific values for initial assets and liabilities to determine the exact changes in
capital for both banks. If either bank's capital remains positive, it remains solvent; otherwise, it
becomes insolvent.
4. If the Central Bank wanted to use all of its policy tools to decrease the money supply, what
would it do?
If the central bank wanted to use all of its policy tools to decrease the money supply, it would
employ the following actions:
- Open-Market Operations: The central bank would sell government bonds in the open market. By
selling bonds, the central bank would reduce the amount of money in circulation. When people
buy these bonds, they would withdraw money from banks, leading to a decrease in reserves.
Consequently, banks would reduce lending, reversing the process of money creation.
- Increasing the Reserve Requirement: The central bank would raise the reserve requirement for
banks. By increasing the percentage of deposits that banks must hold as reserves, it would limit the
amount of money that banks can lend out. This reduction in lending would decrease the money
supply.
- Increasing the Interest Rate: The central bank would raise interest rates. When interest rates are
higher, borrowing becomes more expensive, which discourages individuals and businesses from
taking out loans. This decrease in borrowing would result in less money being created through
loans, leading to a decrease in the money supply.