Chapter 15 Homework Solutions

1.If the manager of the open market desk hears that a snowstorm is about to strike New York City,
making it difficult to present checks for payment there and so raising the float, what defensive open
market operations will the manager undertake?
1.The snowstorm would cause float to increase, which would increase the monetary base. To
counteract this effect, the manager will undertake a defensive open market sale.

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.

3. If the Treasury has just paid for a supercomputer and as a result its deposits with the Fed fall,what
defensive open market operations will the manager desk undertake?

As we saw in Chapter 15 when the Treasury's deposits at the Fed fall, the monetary base increases. To
counteract this increase, the manager would undertake an open market sale.

4. .If float decrease below its normal level, why might the manager of domestic operations consider it
more desirable to use repurchace agreement to affect the monetary base rather than an outright
purchase of bonds?

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5. Most open market operations are currently repurchase agreements. What does this tell us about the
likely volume of defensive open market operations relative to dynamic open market operation?

In suggest that defensive open market operations are far more common than dynamic operations
because repurchase agreements are used primarily to conduct defensive operations to counteract
temporary changes in the monetary base.

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 iff false. The Fed could affect the level of borrowed
reserves in two ways. First, they could directly limit the amount of
discount loans
id =aniff,2 individual bank can take out. Second, they could
reduce non-borrowed reserves to such a point that even with a fixed
iff,1
discount rate, borrowed reserves will rise, as outlined in the diagram
below:

RD
RS 2 RS 1

NBR2 R2 NBR1 = R1 R
(BR = 0)

BR = R2 – NBR2
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
iff
borrow directly from the Fed at the discount window.
RS
id
iff,2

iff,1

RD 2
RD1
NBR1 = R1
R

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:
iff

RS
id = iff,2

iff,1

RD 2
RD1
R1 = NBR R2 = NBR + BR
R

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.

15.Compare the use of open market operations, discounting, and changes in reserve requirements to

comtrol money supply on the following criteria: flexibility, reversibility, effectiveness, and speed of

implementation.
Open market operations are more flexible, reversible, and faster to implement than the other two tools.

Discount policy is more flexible, reversible, and faster to implement than changing reserve

requirement, but it is less effective than either of the other two tools.