ECMA06_Tutorial_9_Solution.doc
ECMA06_Tutorial_9_Solution.doc

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School
University of Toronto Scarborough
Department
Economics for Management Studies
Course
MGEA06H3
Professor
Iris Au
Semester
Summer

Description
ECMA06 Tutorial #9 Answer Key Question 1 Part (a) • Desired reserves: Desired reserves = reserve ratio (rr) ×demand deposits (DD) Desired reserves = 0.125 × $3600 = $450 • Excess reserves: Excess reserves = actual reserves held by chartered bank – desired reserves Excess reserves = $500 - $450 = $50 • The chartered bank holds excess reserves of $50. Part (b) Suppose the chartered bank keeps the level of excess reserves constant at $50 and the central bank purchases $25 of government bonds from the public (we called this open market purchase): The chartered bank’s balance sheet– Beginning Assets Liabilities Cash & reserves $500 Demand deposits $3600 Loans $4000 Equity $900 The chartered bank’s balance sheet– Final Assets Liabilities Cash & reserves $500+$25 = $525 Demand deposits $3600 + $25/0.125 = $3800 Loans $4000 + ($200 – $25) = $4175 Equity $900 • The chartered bank’s reserves increases by $25. • Loans made by the chartered bank rises by $175. • Demand deposits increases by $200. • Money supply increases by $200, as demand deposits increases by $200. FYI: How MS increases? • When the central bank purchases $25 of government bonds form the public, those who sell the bonds to the central bank will receive cheques form the central bank (a total amount of $25). • These bond sellers deposit their cheques to the chartered banks; demand deposits immediately increase by $25 and so does the reserves held by the chartered bank. • Given the reserve ratio is 12.5% and there are $25 new demand deposits, the chartered bank only needs to hold $3.125 ($25 × 0.125) as reserves to meet its target but the chartered bank finds its reserves increases by $25 and has additional excess reserves of $21.875 ⇒ the chartered bank gets rid of these additional excess reserves by making loans to the public ⇒ loans begin to increases. ECMA06 Tutorial #9 Answer Key 1 • The lent out money ends up being redeposited back in the chequing accounts (demand deposits), and the above process continues until the excess reserves of the chartered bank return to their previous level (i.e., $50) when the demand deposits increase by $200. Part (c) Suppose the chartered bank keeps the level of excess reserves constant at $50 and the central bank sells $30 of government bonds to the public (we called this open market sale): The chartered bank’s balance sheet– Beginning Assets Liabilities Cash & reserves $500 Demand deposits $3600 Loans $4000 Equity $900 The chartered bank’s balance sheet– Final Assets Liabilities Cash & reserves $500–$30 = $470 Demand deposits $3600 – $30/0.125 = $3360 Loans $4000 – ($240 – $30) = $3790 Equity $900 • The chartered bank’s reserves decreases by $30. • Loans made by the chartered bank falls by $210. • Demand deposits decreases by $240. • Money supply decreases by $240, as demand deposits decreases by $240. FYI: How MS decreases? • When the central bank sells $30 of government bonds to the public, those who buy the bonds from the central bank will write cheques to the central bank for the purchases (a total amount of $30). • These bond buyers write their cheques from their accounts at the chartered banks; demand deposits immediately decrease by $30 and so does the reserves held by the chartered bank. • Given the reserve ratio is 12.5% and demand deposits fall by $30, the chartered bank find that it only needs to reduce its reserves by $3.75 ($30 × 0.125) to meet its target but it finds its reserves actually falls by $30 (i.e., left with a reduction in its excess reserves) ⇒ the chartered bank tries to replenish its excess reserves to their previous level by calling back some of the loans it made to the public ⇒ of course, the loans are repaid out of chequing account (demand deposits), so reserves cannot rise. • The above process continues until the excess reserves of the chartered bank return to their previous level (i.e., $50) when the demand deposits decrease by $240. Part (d) Suppose the chartered bank cuts its excess reserves by half, i.e., excess reserves = $25: • Immediately after the decision to cut the excess reserves by half, the chartered bank finds itself has additional excess reserves of $25. • It will try to get rid of these additional excess reserves by making loans to the public, and this act will increase money supply. ECMA06 Tutorial #9 Answer Key
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