Economics s350k
Summer 2014
Practice Problem Set 3
1. Use t-accounts to show that the Fed can control the monetary base better than it can control either currency or reserves. What does this result tell us?
2. Suppose that a bank has $100,000 in excess reserves that it loans out. Assuming that the required reserve ratio is 20%, use t-accounts to illustrate the multiple deposit creation process. Use this to obtain the simple deposit multiplier.
3. Explain why the multiplier falls when people hold currency or when banks hold excess reserves.
4. Suppose that the required reserve ratio is 20%, the currency to deposit ratio is .25, the excess reserve to deposit ratio is .05, and the monetary base is 1,000. (a) Find the money supply. (b) Let open market operations increase the monetary base by 200. Use the money multiplier to find the new value of the money supply.
5. Explain how and why the money multiplier changes when (a) the required reserve ratio increases, (b) the currency to demand deposit ratio increases, and (c) the excess reserve to demand deposit ratio increases. Who determines each of these quantities?
6. (a) Explain why the demand curve for reserves slopes downward. (b) Explain the shape of the supply curve for reserves.
7. Use the supply and demand model for bank reserves to explain and illustrate the effects of (a) an open market operation to buy bonds, (b) a decrease in the discount rate, (c) an increase in required reserves, and (d) a change in the interest rate paid on reserves.
8. Describe the three traditional tools available to the Fed for controlling the money supply. What tool has the Fed added to its arsenal recently, and why is this important?
9. What is meant by the phrase lender of last resort? Why is this important? Explain and show graphically how the Fed uses discount rate policy to act as a lender of last resort and how this limits the amount the federal funds rate can rise.
Questions added after Wednesday's class:
10. What are the advantages and disadvantages of the Fed's four conventional policy tools?
11. Why did the Fed begin using unconventional policy tools during the Great Recession?
12. Describe the liquidity provisions the Fed put in place during the Great Recession. Did they work?
13. How can quantitative easing provide liquidity to banks? What are the potential channels through which quantitative easing can stimulate the economy?
14. Describe the three rounds of quantitative easing. Did quantitative easing work? Describe operation twist. Why did the Fed adopt this policy?
