Chapter 15 Homework Solutions

2. During Christmastime, when the public’s holdings of currency increase, what defensive open market operations typically occur?

An increase in currency holdings causes the currency ratio to rise and the money multiplier to fall. As a result, there will be a decrease in the money supply. To maintain the money supply, the Fed must make a defensive purchase of bonds on the open market, raising the monetary base to counter the decline in the multiplier.

6. “The only way 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.

This statement is false. The Fed could affect the level of borrowed reserves in two ways. First, they could directly limit the amount of discount loans an individual bank can take out. Second, they could reduce non-borrowed reserves to such a point that even with a fixed discount rate, borrowed reserves will rise, as outlined in the diagram below:

In the diagram above, the Fed cuts non-borrowed reserves by making open-market sales of bonds. This causes the federal funds rate to rise above the discount rate, prompting banks to borrow from the Fed. As a result, the total reserves held by banks (R2) will be equal to NBR2 supplied by the Fed and reserved borrowed directly from the Fed (BR).

7. Using the supply and demand analysis of the market for reserves, show what happens to the federal funds rate, holding everything else constant, if the economy is surprisingly strong, leading to an increase in checkable deposits.

As checkable deposits increase, banks will have to hold more reserves (for fixed required and excess reserve ratios). The demand for reserves will shift to the right, causing the federal funds rate to increase. If the increase in reserve demand is large enough, the federal funds rate may rise as high as the discount rate. It will not rise above the discount rate, since any rate above id will cause banks to borrow directly from the Fed at the discount window.

9. “Discounting is no longer needed because the presence of the FDIC eliminates the possibility of bank panics.” Discuss.

This statement is false. First, FDIC insurance only covers the first $100,000 of individual bank deposits. While most people have deposits beneath this threshold, there are significant deposits above this level that would cause a strain if fears of bank insolvency were to spread. Second, the FDIC does not have the funds to cover all deposits (even those under $100,000) if there were a true bank panic with multiple bank runs. Current estimates indicate that the FDIC could cover 1% of insured deposits. The key here is that FDIC is enough if there are only a handful of bank failures. What Fed discounting does is to stop the spread of a bank panic from the few unstable financial institutions to the banking system en masse. Without it, a small banking crisis could easily turn into a massive one as people realize that there’s no w ay the FDIC could insure all eligible bank deposits.

11. You often read in the newspaper that the Fed has just lowered the discount rate. Does this signal that the Fed is moving to a more expansionary monetary policy? Why or why not?

The Fed generally keeps the discount rate above the federal funds rate. As long as the discount rate remains above this threshold, then lowering it will not expand the money supply (since borrowed reserves will remain at zero). In fact, the Fed generally lowers the discount rate alongside a targeted reduction in the federal funds rate. The only exceptions are when the Fed drops the discount rate below the federal funds rate to provide liquidity in the midst of a burgeoning financial panic (stock market crash in 1987, 9/11). As these events are blessedly rare, a mundane announcement of a drop in the discount rate is generally not a signal of expansionary policy by the Fed.

12. How can the procyclical movement of interest rates (rising during expansions and falling during contractions) lead to a procyclical movement in the money supply as a result of Fed discounting? Why might this movement of the money supply be undesirable?

Interest rates rise during an expansion because there is an increase in reserve demand. People are increasing bank deposits, which forces banks to hold more reserves. The increase in reserve demand will push the federal funds rate up. If the federal funds rate rises above the discount rate, we will see an increase in borrowed reserves as banks find it cheaper to borrow directly from the Fed. The increase in borrowed reserves will cause the monetary base and (assuming no change in currency, required reserve, or excess reserve ratios) the money supply to increase. During a recession, the opposite happens with banks demanding fewer reserves as deposits fall. The federal funds rate falls below the discount rate and borrowed reserves drop back to zero.

The diagram below depicts the increase in borrowed reserves during an expansion:

This kind of procyclical movement in the money supply is undesirable. During an expansion, unemployment is low, but inflation starts to increase. To maintain stability, the Fed should be cutting the money supply. By not raising the discount rate during an expansion, inflation may actually accelerate. During a recession, unemployment is high and inflation is low. By not lowering the discount rate, the drop in the money supply will actually cause unemployment to get worse.

14. “Considering that raising reserve requirements to 100% makes complete control of the money supply possible, Congress should authorize the Fed to raise reserve requirements to this level.” Discuss.

While it is true that such a move would give the Fed more control of the money supply, the economic costs of such a policy would outweigh any benefits from greater control. Banks would be completely out of the business of making loans in this scenario, removing the service they provide as financial intermediaries. If you wanted to save your money you would have to directly find someone willing to borrow and vice versa. Both search costs and risk assessment costs would rise, leading to a significant decline in borrowing and lending. Since investment in such things as new business, capital equipment, or even education are highly dependant on a vibrant financial system, we would see the level of investment in this country decline drastically, leading to much lower economic growth in the future.
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RD

RS1

RS2

NBR1 = R1
(BR = 0)

NBR2

R2

id = iff,2

iff,1

iff

R

BR = R2 – NBR2

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R

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iff,1

iff,2

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RD2

NBR1 = R1

id = iff,2

RS

RD1

RD2

iff

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R2 = NBR + BR

R1 = NBR

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