Review Questions for Economics 110

1.     Explain the effect that the Federal Reserve Bank open market purchase of government securities would have on each one of the following economic variables:

    a.    Reserves of the banking system.
    b.    Excess reserves of the banking system
    c.    The nation's money supply
    d.    Interest rates charged on loans
    e.    Investment expenditures (I)
    f.    The economy's equilibrium level of output (income)

Solution to Problem 1

2.    Assume an economy currently is experiencing rapid inflationary price increases. To eliminate the inflation, indicate how the federal government or Federal Reserve Bank could use each one of the following. Explain how each change you indicate would help in the fight against inflation.

    a.    Taxes
    b.    The required reserve ratio
    c.    Federal government spending
    d.    Open market operations

Solution to Problem 2

3.
The required reserve ratio (m) is 10%. Wilber National Bank has no excess reserves.

A.  The Federal Reserve Bank then buys (purchases) $250,000 of U.S. government securities on the open market from Mr. X who has his checking account at Wilber National Bank. Show how you determine your answer and indicate the numerical effect this open market purchase will have on the amount of Wilber National Bank’s

 1) reserves:
 2) excess reserves:
 3) required reserves:

B. How much may Wilber National Bank now lend out?

C. What is the potential maximum change in the money supply as  a result of this open market operation?
 (Show how you determine your answer.)

D. Explain why the resultant change in the money supply may actually be less than the answer you provided in part C.

E. If the Federal Reserve Bank had purchased the U.S. government securities directly from Wilber National Bank instead of from Mr. X, what would the numerical effect have been on Wilber National Bank’s

 1) reserves:
 2) excess reserves:
 3) required reserves:

F. Under which economic situation (recession or inflation) would the Federal Reserve Bank buy (purchase) U.S. government securities. Briefly explain why.

G. Illustrate the resultant effect of the Federal Reserve Bank purchase on a carefully labeled aggregate demand, aggregate supply graph for the economy.

Solution to Problem 3

4.
The required reserve ratio (m) is 10%. Wilber National Bank currently has:
Reserves of $500, loans of $900, and demand deposits of $1,400.

A. Illustrate a carefully labeled T-Account (balance sheet) for Wilber National Bank:

B. What is the $ amount of additional loans Wilber National Bank may make? (Show how you determine your answer.)

C.  The Federal Reserve Bank then sells $100 of U.S. government securities on the open market to Mr. X who has his checking account at Wilber National Bank. After the check clears, indicate the exact resultant $ amount of Wilber National Bank’s: (Be certain to show how you determined your answers.)

 1) reserves:
 2) required reserves:
 3) excess reserves:

D. What is the $ amount of additional loans that Wilber National Bank may now make? Briefly explain.

E. If the Federal Reserve Bank had sold the $100 U.S. government security directly to Wilber National Bank instead of to Mr. X, what would have been the exact resultant $ amount of Wilber National Bank’s: (Be certain to show how you determined your answers.)

 1) reserves:
 2) required reserves:
 3) excess reserves:

F. Under which economic situation (recession or inflation) would the Federal Reserve Bank sell U.S. government securities. Explain why.

G. Illustrate the resultant effect of the Federal Reserve Bank sale on a carefully labeled aggregate demand, aggregate supply graph for the economy.

Solution to Problem 4

5.
The required reserve ratio (m) is 10%. Key Bank currently has: Reserves of $115 million, loans of $235 million, and demand deposits of $350 million.

A.  Illustrate a carefully labeled T-Account (balance sheet) for Key Bank.

B.  What is Key Bank’s level of excess reserves? (Be certain to show how you determined your answer).

C.  The Federal Reserve Bank then sells $20 million of U.S. government securities (bonds) directly to Key Bank. Show the new T-Account (balance sheet) for Key Bank.

D. After this Federal Reserve Bank action, what is Key Bank’s level of excess reserves? (Be certain to show how you determined your answer.)

E. What would be the effect of the Federal Reserve Bank sale in part C on interest rates charged on loans? Explain why.

F.  Under which economic situation (recession or inflation) would the Federal Reserve Bank sell U.S. government securities (bonds) on the open market? Explain why.

G.  Assume the federal government is considering changing the level of income taxes on households. Under the economic situation you indicated in part F, which one would be considered an appropriate fiscal (budget) policy: an increase in taxes or a decrease in taxes? Explain why.

Solution to Problem 5

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