Answers to Exercises

1. a. District banks are located in Boston, New York, Philadelphia, Richmond, Atlanta, Dallas, St. Louis, Kansas City, Cleveland, Chicago, Minneapolis, and San Francisco.
b. Answer varies according to student.

2. The Federal Reserve provides three basic services to banks: (a) It provides banks with currency; (b) it is the banker's bank in the sense that it holds bank reserves; and (c) it clears checks. The Federal Reserve also provides a service to the system as a whole by acting as its supervisor.

3. The money supply curve is vertical because the quantity of money is set by the Fed. The money demand curve is downward-sloping because the interest rate is the opportunity cost of holding money.

4. When the Fed decreases the supply of money, there is an excess demand for money at the original interest rate, i₁. People want to hold fewer bonds and more money. As the demand for bonds is reduced, the price of bonds falls and the interest rate increases from i₁ to i₂.

5. When the Fed reduces the money supply, the rate of interest increases. Thus, it becomes more expensive for business firms to finance investments. For consumers, large durable-goods purchases are more difficult to finance. Hence, aggregate demand is reduced from AD₁ to AD₂ and real GDP falls from Y₁ to Y₂.

6. The quantity theory of money is understood best by first recognizing that the basic identity MV = PQ. MV (quantity and velocity of money) is another way of writing aggregate spending. PQ (price level and real income or real gross national product) represents nominal income. Therefore, all the equation tells us is that aggregate spending on nominal output equals the value of nominal output. If we assume that the velocity of money is constant, we see that changes in the money supply are directly related to nominal income.

7. a. The reserve requirement is the proportion of total deposits that banks must hold in reserve. The discount rate is the interest rate that the Fed charges banks for discount loans. When the Fed buys or sells government securities in financial markets, it is conducting open market operations.
b. To increase the money supply, the Fed could reduce the reserve requirement, which would lead to a larger multiplier and to more excess reserves in the banking system. The Fed could also lower the discount rate, which would lead to an increase in discount loans and thus would increase excess reserves in the banking system. Finally, the Fed could buy securities on the open market, which would add reserves to the banking system in exchange for the securities purchased.

8. a. With a reserve requirement at 10 percent, the bank must hold $200,000 in reserves against $2,000,000. This leaves $20,000 in excess reserves that can be loaned by First Bank. Based on the 10 percent reserve requirement the multiplier is: 1/.1 = 10. Hence, the money supply can increase by: 10 ( $20,000) = $200,000
b. If the reserve requirement were lowered to 5 percent, First Bank would have $120,000 in excess reserves and the multiplier would be 1/.05 = 20; the money supply could be expanded by $2,400,000.

9. This question is open ended and has no unique answer.

10.

If the Fed were targeting the exchange rate at 135 yen to the dollar and market forces (a decrease in U.S. demand for Japanese goods) caused the supply of dollars to fall from S₁ to S₂, the dollar would strengthen to 150 yen to the dollar. To achieve its target the Fed would be required to exchange dollars for yen (sell dollars), thus shifting the supply curve for dollars back to S₁.

11. We demand money for transaction, precautionary, and speculative purposes. The amount of money we hold is mostly determined by income but interest rates also play a role.

12. Current yield = annual interest rate/bond price. When bond prices change, the denominator changes so the value of the ratio changes (the numerator is constant). Another way to think about this is to consider the price of a bond to be the value today (the present value) of a stream of payments to be made in the future. A(n) decline (increase) in the bond's price means the present value of these future payments has declined (increased) which is the same as claiming these future payments are becoming more (less) heavily discounted. The interest rate is this rate of discount.

13. a. Interest rates fall.
b. Money demand is unchanged, but the quantity of money demanded increases.
c. Investment increases.
d. Aggregate demand increases.
e. The equilibrium level of real GDP rises.

14. The governors of the Federal Reserve System are appointed for fourteen-year terms, with one position coming up for reappointment every two years, which should put their decision-making above politics. Since presidents choose governors who share their political and economic philosophy, it is likely that politics does affect the governors' decisions.

15. a. 5 ( $1,000) = $5,000

b. Excess reserves = $1,400. The money supply can increase by 5 ($1,400) = $7,000.

Answers to Study Guide Homework

1. Federal Reserve; accepts deposits from and makes loans to financial institutions, acts as a banker for the federal government, supervises the banking system, and controls the money supply.

2. Federal Open Market Committee (FOMC)

The seven governors of the Federal Reserve, and five of the twelve regional Federal Reserve Bank presidents, always including the president of the New York Fed

Economic growth with stable prices

3. Reserve requirement, discount rate, open market operations. Open market operations are the most important tool.

4. Transactions demand, speculative demand, precautionary demand.

5. a. Decrease the money supply.
b. Selling bonds moves money from the economy into the Fed.
c. Price of bonds would decrease. At higher interest rates, the same dollar amount of interest is generated by a smaller number of dollars invested.
d. Aggregate demand would shift to the left, as higher interest rates decrease investment.
e. Real GDP would decrease (unless the economy remained in the vertical region of the AS curve).
f. The price level would decrease (unless the economy started in the horizontal region of the AS curve).

Answers to Internet Exercise

This exercise will allow students to access and read the latest minutes of a FOMC meeting. By doing so, students will be able to determine current FOMC policy by reading the most recent directive. Students will also be able to follow the political process and reasoning used by the committee members in determining such directives, particularly if there are dissenting members.

Answers will vary depending on the latest available minutes.