Exercises: The Money Market and Monetary Policy

In a graph of the money market, what is measured on the vertical axis and what on the horizontal axis? State the direction in which the money demand curve shifts when the price level rises, and explain why.

The Federal Reserve buys $\$10$ billion of government bonds in the open market. Describe the effect on bank reserves, the money supply, and the nominal interest rate. State whether this is expansionary or contractionary monetary policy.

The reserve requirement is 10%. Compute the money multiplier. A customer deposits $\$1{,}000$ in a checking account; compute the maximum total increase in checking deposits that can result, assuming banks lend out all excess reserves and no cash is held outside banks.

The reserve requirement is 20%. The Federal Reserve buys $\$20$ million in bonds from banks, and banks lend out all excess reserves. (a) Compute the money multiplier. (b) Compute the maximum change in the money supply. (c) Explain why the actual change is likely to be smaller.

The Federal Reserve raises the reserve requirement from 10% to 20% and also raises the discount rate. (a) Compute the money multiplier before and after the change. (b) Compute the required reserves on $\$1{,}000$ of deposits before and after. (c) Describe the effect on lending, the money supply, the nominal interest rate, investment, and aggregate demand.

A customer deposits $\$2{,}000$ in a bank, and the reserve requirement is 20%. Each bank lends out all of its excess reserves, and every loan is redeposited in a bank. (a) Compute the amount lent by the first four banks in turn. (b) Compute the maximum total increase in deposits from the original $\$2{,}000$. (c) Compute the total amount of new loans created.

The US economy is in a recession and inflation is low. The Federal Open Market Committee (FOMC) decides to lower its target for the federal funds rate. (a) Describe the open market operation the Fed would use. (b) Use a money market graph to explain the change in the money supply and in the nominal interest rate. (c) Trace the effects on investment, aggregate demand, the price level, and real GDP in the short run. (d) Explain how the Fed could also use the discount rate or interest on reserves to support the same goal. (e) Explain the long-run effect on the price level and real GDP, assuming the economy returns to full employment.

A bank has deposits of $\$5{,}000$ million, reserves of $\$900$ million, and loans of $\$4{,}100$ million. The reserve requirement is 10%. (a) Compute required reserves, excess reserves, and the maximum new loans the bank could make. (b) Suppose the Fed buys $\$50$ million of securities from the public, and the sellers deposit the full amount in banks. Compute the maximum increase in total deposits if banks lend out all excess reserves. (c) Now suppose banks also hold excess reserves equal to 5% of deposits. Compute the new money multiplier and the maximum increase in deposits. (d) Explain what this shows about the Fed's control over the money supply.