Economics 304 Homework - Lesson 7 - The Fed and the Money Supply Correct Answers

Name: Economics 304 Homework - Lesson 7 - The Fed and the Money Supply Correct Answers
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Author: Lily Foster

Analysis of the Federal Reserve and money supply mechanisms with correct answers.

Lily Foster

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Economics 304 Homework - Lesson 7 - The Fed and the Money Supply
Correct Answers
90 points total: Instructions: Please show all work or points will be taken off. Good luck!
1. (35 points total) In this problem, we are going to calculate the money multiplier one
year prior to the Great Recession (12/2006) and compare it to the money multiplier five
years hence (12/2011). The implication as you may have guessed is that since the Fed
has been paying interest on excess reserves (10/2008), the excess reserve to deposit ratio
has risen which implies a lower money multiplier.1 To do so, we will use the data
from FRED (Federal Reserve Economic Data). Note, after clicking on hyperlink, look
to the upper left and click on "view data" to retrieve the data that you need to do the
problem. To make sure we are on the 'same page,' the amount of excess reserves in
December, 2006 is $1.862 billion (we are using beginning of month data).
Data you need for problem 1:
Monetary Base
2006-12-01 837.701
2011-12-01 2603.613
Excess Reserves
12/06 1.862
12/11 1502.318
Currency
2006-12-01 749.5
2011-12-01 999.8
Required Reserves
2006-12-01 41.420
2011-12-01 96.514
Demand Deposits
2006-12-01 610.8

2
2011-12-01 1164.6
a) (10 points) Calculate the money multiplier for Dec 2006, one year prior to the Great
Recession. Please show all work.
b) (10 points) Calculate the money multiplier for Dec 2011, five years hence and a little
more than three years after the Fed got the authority to pay interest on excess reserves.
Click Here for the press release.
c) (5 points) What is the percent change in the money multiplier in this five year period?
d) (10 points) Now consider the change in the monetary base during this same five year
period and compare it to the change in excess reserves. Is it a true statement to say most
of the open market purchases that caused the monetary base to "blow up" ended up on
bank's balance sheets as excess reserves. Be very specific with your answer using actual
numbers. Which change is bigger and why??
2. (35 points total) You are the director of monetary affairs at the Fed and you are in
charge of keeping track of the money supply, making sure it does not fall, as it did in the
Great Depression, but also making sure it does not ‘blow up’ as we know it might,
knowing that the banks are sitting on piles and piles of excess reserves (see pic below).
You have the following initial conditions:
RR/D= .10

3
C = 400 b
D = 1000 b
ER = 500 b
a) (6 points) i) Calculate the MB.
ii) Calculate the money multiplier.
iii) What is the money supply (use mm x MB to calculate this)?
Show work
Now you know that if these banks get rid of their excess reserves all at once, the amount of open market
sales that you need to conduct (to keep a handle on the money supply) will be massive and raise more than
one eyebrow in Washington (from the politicians) as the infamous ‘exit strategy’ will be full speed ahead.
The Fed’s treasured independence would be tested once again and you want to avoid that. Suppose that
you had major influence and convinced the banks that it would be much more stabilizing for all parties if
they gradually lent out their excess reserves rather than lending them out all at once. As such, you
convince the banks to cut (lower) their excess reserve to deposit ratio in half (note: the ER/D ratio is cut in
half not ER itself). Assuming importantly that:
• The C/D and RR/D remain the same as in the initial conditions (they are stable)
• The monetary base does not change
b) (4 points) Repeat part a) except for part i).
c) (5 points) Given that 10% is the optimal growth rate of the money supply (from its initial value in part
a), what type and how many open market operations do you need to conduct to achieve this target, given
what happened to the money supply in part b)? Assume importantly that the money multiplier is stable at
its new level (after the banks cut E/D in half, i.e., part b).
We now pretend that this crisis is well behind us and now it is time to go back to targeting the funds rate.
You are facing the following conditions:
Reserve Market
Initial Conditions
rr/D= .10
C = 200 b
D = 1000 b
ER = 00
M = C + D
d) (5 points) If Rd = 400 – 100 iff, given the information above, what is the market clearing federal
funds rate? This happens to be the fed funds target.
Show work.
e) (5 points) Suppose two things happen simultaneously:1) reserve demand is increasing and is now
expected to be: Rd = 500 - 100 iff and 2) Chairman Bernanke calls you up and wants you to increase the
funds rate by 150 basis points (one and one half percentage points) beyond its equilibrium value in part d).
What type and how many open market operations must you conduct to satisfy Chairman Bernanke? Show
all work.

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University

University of Texas

Subject

Economics

Economics 304 Homework - Lesson 7 - The Fed and the Money Supply Correct Answers

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