CH 17

Chapter 17 - The Central Bank Balance Sheet and the Money Supply Process
Chapter 17
The Central Bank Balance Sheet
and the Money Supply Process
Conceptual and Analytical Problems
1. Follow the impact of a $100 cash withdrawal through the entire banking system,
assuming that the reserve requirement is 10 percent and that banks have no desire
to hold excess reserves. (LO3)
Answer: Deposits fall by $100 and reserves fall by $100. The bank (Bank A)
needs to increase its reserves by $90 in order to meet the required reserve ratio.
In order to do so, Bank A will sell $90 of securities to a customer of Bank B. The
deposit account of the person who purchased the securities will fall by $90, as
will the reserve balance of his bank, Bank B. Bank B now needs to increase its
reserves by $81 in order to meet the reserve requirements so it will sell $81 of
securities. This continues until deposits contract by $100/0.1 = $1,000.
2. Suppose a major bank needs to borrow $20 billion overnight that it cannot obtain
from private creditors. The Fed is willing to make a discount loan of $20 billion
provided that it will not alter interbank lending rates. How can it do so? (LO1)
Answer: The Fed can make the $20 billion loan to the problem bank if it
simultaneously sells $20 billion of securities to the rest of the banking system.
These two operations would keep the aggregate supply of reserves to the banking
system unchanged; the $20 billion rise in reserves offered to the problem bank is
offset by the $20 billion withdrawal of reserves from other banks, which pay for
the securities by drawing down their reserve accounts.
3. Compute the impact on the money multiplier of a fall in the currency-to-deposit

ratio from 10 percent to 8 percent when the reserve requirement is 10 percent of
deposits, and banks’ desired excess reserves are 3 percent of deposits. (LO3,
LO4)
Answer:
1  0 .1
 4.78
When desired currency holdings = 10% of deposits, m = 0.1  0.1  0.03
When desired currency holdings = 8% of deposits, m =

1  0.08
 5.14
0.08  0.1  0.03
17-1
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4. Does the Federal Reserve frequently purchase or sell gold or foreign exchange as
part of its efforts to change the money supply? (LO2)
Answer: No. Fed transactions in foreign exchange and gold are infrequent, and
are not used to alter the money supply. The Fed usually purchases and sells
foreign exchange only when it implements Treasury decisions to intervene in
currency markets. It typically offsets these actions with with a separate open
market operation. While the Fed holds gold, it rarely alters its gold holdings and it
does not adjust the value of these holdings in response to changes in the market
price of gold.
5. Consider an open market purchase by the Fed of $5 billion of Treasury bonds.

What is the impact of the purchase on the bank from which the Fed bought the
securities? Compute the impact on M1 assuming that: (1) the required reserve
ratio is 10 percent; (2) the bank does not wish to hold excess reserves; and (3) the
public does not wish to hold currency. (LO2, LO3)
Answer: The bank’s securities fall by $5 billion and its reserves rise by $5 billion.
Assuming that the required reserve ratio is 10 percent, banks do not want to hold
excess reserves, and the public does not wish to hold currency, the simple deposit
expansion multiplier will be 1/0.1=10, so the value of deposits (and M1) will rise
by $50 billion.
6. When you withdraw cash from your bank’s ATM, what happens to the size of the
Fed’s balance sheet? Is there any reason for the Fed to react to your action? (LO2)
Answer: The reserves held by your bank at the Fed decline, but there is a larger
volume of currency in the hands of the nonbank public. These changes are
offsetting, so there is no impact on the Fed’s total liabilities (or, equivalently, on
the size of its balance sheet). However, your action has raised the currency-to-
deposit ratio and can lead to a change in the money supply. The Fed may choose
to alter policy to offset the impact on the money supply if the withdrawal is large
enough.
7. *Why is currency circulating in the hands of the nonbank public considered a

liability of the central bank? (LO1)
Answer: Currency issued by the central bank is effectively an IOU to the holder
of the currency. The central bank is obliged to pay back the holder of the
currency. If the currency were backed by gold, for example, the central bank
17-2
would be obliged to exchange gold for currency. With fiat money, however, the
central bank is obliged only to exchange currency for more currency.
8. How did the financial crisis of 2007–2009 affect the size and composition of the
balance sheet of the Federal Reserve? (LO1)
Answer: Between December 2007 and December 2009, the assets on the Federal
Reserve’s balance sheet increased by 2.5 times, mostly in the form of securities.
The Fed also broadened the range of assets held to include riskier instruments
such as extraordinary loans to non-banks and long-term securities (including
mortgage-backed instruments and Treasury bonds). On the liability side of the
balance sheet, the liquidity crisis led to a surge in commercial bank deposits at the
Fed as banks held on to excess reserves. At times, the Treasury also increased its
deposits at the Fed to help the Fed limit the increase of bank reserves as its assets
rose.
9. Suppose the currency-to-deposit ratio is 0.25, the excess reserve-to-deposit ratio is

0.05, and the required reserve ratio is 0.10. Which will have a larger impact on the
money multiplier: a rise of 0.05 in the currency ratio or in the excess reserveratio?
(LO4)
Answer: Initially, the money multiplier is
1  0.25
 3.13
m = 0.25  0.10  0.05
If the currency-to-deposit ratio rises to 0.30, the multiplier falls to
1  0.30
 2.89
m = 0.30  0.10  0.05
If, instead, the excess reserve-to-deposit ratio rises, the multiplier will be
1  0.25
 2.78
m = 0.25  0.10  0.10
So, the multiplier falls by more with the increase in the excess reserve-to-deposit
ratio.
10. Is the money multiplier model still useful for policymakers in the United States?
If not, why not? (LO4)
17-3
Answer: Since the financial crisis began in 2007, the model has been of limited
use for policymakers. The reason is that the ratios to deposits of currency and
excess reserves--the terms in the multiplier that are beyond the control of the
central bank–have become unstable. Consequently, the central bank can no longer
predict accurately the level of the money supply when it provides a specific
amount of monetary base.
11. Based on Figure 17.10, explain why the multipliers fell sharply with the onset of
the financial crisis of 2007–2009. Why did they remain at this lower level after
the crisis ended? (LO4)
Answer: The money multipliers plummeted during the financial crisis as banks
hoarded excess reserves in the face of the liquidity crisis. Confronted with the
possibility of not being able to roll over debts or sell securities when necessary,
banks were willing to forego the extra profits from lending out these reserves,
especially given the prevailing low interest rates. When the Federal Reserve
began paying interest on reserves in 2008, the opportunity cost of holding excess
reserves fell, so banks continued to hold these excess reserves even as the crisis
receded. Consequently, the multiplier remained low.
12. The U.S. Treasury maintains accounts at commercial banks. What would be the
consequences for the money supply if the Treasury shifted funds from one of
those banks to the Fed? (LO2)
Answer: The balance sheet for the bank would reflect a decrease in reserves and a
decrease in deposits. The decrease in reserves would also appear on the Fed’s
balance sheet; however, it would be offset by an increase in the government’s
account. The response of the banking system to the decline in bank reserves
would be a decline in the quantity of money.
17-4
13. *Explain how an incomplete understanding at the Federal Reserve of the

relationship between the central bank’s balance sheet and the money supply
contributed to the Great Depression. How did the Fed’s behavior during the
financial crisis of 2007–2009 illustrate that it had learned a valuable lesson from
the Great Depression? (LO4)
Answer: During the Great Depression, the central bank was increasing the
monetary base at a significant rate. Conditions in the economy and the banking
system, however, meant that the money multiplier was declining, so the overall
impact was a fall in the quantity of money. This contributed to the contraction of
the economy. In contrast, when a similar decline in the money multiplier (due to a
surge in demand for excess reserves) emerged during the financial crisis of 2007–
2009, the Fed rapidly expanded the supply of reserves, preventing a collapse of
the money supply like that seen in the 1930s.
14. Suppose you examine the central bank’s balance sheet and observe that since the
previous day, reserves had fallen by $100 million. In addition, on the asset side of
the central bank’s balance sheet, securities had fallen by $100 million. What
activity did the central bank carry out earlier in the day to lead to these changes in
the balance sheet? Do you think the central bank was aiming to increase,
decrease, or maintain the size of the money supply? (LO2, LO3, LO4)
Answer: The central bank conducted an open market sale of $100 million with a
commercial bank. The sale of the securities would involve $100 million of
securities being removed from the central bank’s balance sheet. The commercial
bank would have paid for the securities from its reserve account, thus leading to a
fall of $100 million in reserves on the central bank balance sheet.
It is most likely that the central bank was aiming to decrease the money supply.
An open market sale reduces reserves on the central bank’s balance sheet and so
reduces the monetary base. Assuming the money multiplier remains unchanged,
this would decrease the money supply.
15. Suppose you observe a fall in reserves of $100 million on the central bank’s
balance sheet as well as a fall of $100 million in securities held by the central
bank. Do you think the size of the banking system’s balance sheet would be
affected immediately by these changes to the central bank’s balance sheet?
Explain your answer. (LO2)
Answer: No. Reserves and securities both appear on the asset side of the balance
sheet of the banking system, so their offsetting changes would affect the
composition but not the size of its balance sheet. Over time, the banking system
may try to shrink its assets and liabilities in response to the decline of reserves.
17-5
16. Do you think the Federal Reserve successfully carried out its role as lender of last
resort in the wake of the terrorist attacks on September 11, 2001? Why or why
not? (LO2)
Answer: Yes. The Fed successfully acted as lender of last resort and prevented
the financial system from collapsing in the wake of the attacks. The system was
threatened by the inability to collect checks in the absence of civilian flights. The
Fed stepped in and provided huge amounts of liquidity to enable banks to meet
their commitments.
17. *In carrying out open market operations, the Federal Reserve usually buys and
sells U.S. Treasury securities. Suppose the U.S. government paid off all its debt.
Could the Federal Reserve continue to carry out open market operations? (LO2)
Answer: In theory, yes. In the absence of Treasury securities, the Federal Reserve
would have to switch to other assets to carry out its open market operations. If
these alternative assets traded in deep, highly active markets, the Fed could avoid
imposing market distortions when conducting open market operations.
18. In which of the following cases will the size of the central bank’s balance sheet
change? (LO2)
a. The Federal Reserve conducts an open market purchase of $100 million of
U.S. Treasury securities.
b. A commercial bank borrows $100 million from the Federal Reserve.
c. The amount of cash in the vaults of commercial banks falls by $100
million due to withdrawals by the public.
Answer: The size of the central bank’s balance sheet will rise in cases (a) and (b).
On the liability side in both these cases, reserves rise by $100 million. On the
asset side, securities rise by $100 million in case (a) while loans rise by $100 in
case (b). In case (c), the composition of liabilities changes, with a shift from
reserves to currency, but the overall size of the balance sheet remains unchanged.
19. *You read a story reporting a major scandal about the Federal Deposit Insurance
Corporation that is likely to undermine the public’s confidence in the banking
system. What impact, if any, do you think this scandal might have on the
relationship between the monetary base and the money supply? (LO4)
Answer: The scandal is likely to increase the public’s desire to hold currency as
the safety of their deposits comes into question; the currency-to-deposit ratio is
likely to rise. In addition, banks are likely to hold a higher level of excess reserves
17-6
in anticipation of the public’s reaction, thus increasing the excess reserve-to-

deposit ratio. The changes in both these ratios would reduce the money multiplier,
thus reducing the stock of money for a given monetary base.
20. Use your knowledge of the money multiplier to explain why the massive increase
in bank reserves that began in the 2007-2009 financial crisis has not resulted in
uncontrolled inflation. (LO4)
Answer: While the increase in reserves expanded the monetary base, this did not
translate into a massive increase in the money supply because the money
multiplier plunged. The two most important causes of the decline in the money
multiplier were: (1) impairment of the banking system during the crisis boosted
banks’ demand for excess reserves; and (2) the payment of interest on excess
reserves reduced the opportunity cost of holding them. The increase in the excess
reserve ratio depressed the money multiplier, limiting the impact of the reserve
increase on the money supply. Even after the crisis, the low opportunity cost of
holding reserves has supported banks’ demand for them, so the multiplier has
remained low.
21. Explain the distinction between the “zero lower bound” and the “effective lower
bound” on nominal interest rates. If interest rates were pushed below the effective
lower bound, what would be the likely impact on the money multiplier and the
supply of bank credit? (LO3, LO4)
Answer: If there were no transactions costs associated with using cash, its zero
rate of return would impose a zero lower bound on nominal interest rates.
However, on occasion, nominal rates have declined somewhat below zero in
several countries. This is possible because of the costs associated with storing,
transferring and insuring cash. The effective lower bound can be defined as the
zero lower bound minus those costs.
If nominal rates were pushed below the effective lower bound, we would expect
depositors to withdraw funds from the banking system in favor of holding cash.
This would increase the cash/deposit ratio, which would reduce the money
multiplier. As a result, trying to push the interest rate below the effective
lower bound would be contractionary because it would diminish the supply of bank
credit.
22. Assuming normal financial and economic conditions, what are the main
advantages of a central bank maintaining low-risk, short-term assets on its balance
sheet? (LO2)
17-7
Answer: A key advantage is that this minimizes liquidity and maturity risk. If the
assets are predominantly Government issued and so free of credit risk, this would
lead to a virtually riskless portfolio. By holding such a minimal-risk portfolio, the
central bank distorts relative asset prices as little as possible and maintains its
ability to respond to crises when they arise.
17-8

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Chapter 17 - The Central Bank Balance Sheet and the Money Supply Process

3. Compute the impact on the money multiplier of a fall in the currency-to-deposit

When desired currency holdings = 8% of deposits, m =

5. Consider an open market purchase by the Fed of $5 billion of Treasury bonds.

7. *Why is currency circulating in the hands of the nonbank public considered a

9. Suppose the currency-to-deposit ratio is 0.25, the excess reserve-to-deposit ratio is

Answer: Initially, the money multiplier is

If the currency-to-deposit ratio rises to 0.30, the multiplier falls to

13. *Explain how an incomplete understanding at the Federal Reserve of the

in anticipation of the public’s reaction, thus increasing the excess reserve-to-

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