Question

1. Suppose that commercial banks keep no excess reserves, and that as the money supply changes, people do not change the amount of cash in their pockets. The required reserve ratio is 0.25. The Federal Reserve System wishes to reduce the money supply by $800 million, through the use of open market operations. (a) What open-market operation will the Fed engage in? (b) Show how this operation will affect the balance sheet of the Fed. (c) Show how this operation will initially affect the balance sheet of a single commercial bank. (d) Trace the money contraction process through the balance sheets of two more commercial banks, carefully showing the change in the country’s money supply at each step. (e) Show the eventual consolidated balance sheet of the commercial banking system, resulting from this open market operation. (f) Suppose that as the money supply falls, people decide to hold less cash in their pockets. Explain why the reduction in the money supply will be greater or less than $800 million.

Answer 1

(a) U.S. government securities will be sold by the fed in the open market.

The answer to b, c and d are the same and here it is;

Fed sells securities worth $200 million. Assuming Bank A purchases it, its required reserve will fall or drop by $50 million (0.25 required reserve). However, this will lead to a reserve shortage of $150 million. This will have to be made up by borrowing or selling assets or refusing to lend further the amount of loans that come due. Reduction in loan commitments reduces the second deposits of Bank B (reducing its reserve requirements but creating further reserve shortages) and the whole process proceeds just as in the case of expansion, until money supply is reduced by $800 million.

If We have a table of Banking System of assets and liabilities

Under Assets , we have that

Securities - $200m

Reserves - $200m

Loans - $800m

And under liability we will have

Demand deposit - $800m

e) If people decide to hold less cash in their pockets, it means that there's infusion of fresh funds into the banking system. This reduces the effect of multiple contraction. The reduction of money supply would be less than $800 million in the bank.