Unless otherwise noted, assume that the required reserve ratio is 8%, banks do n

Question

Unless otherwise noted, assume that the required reserve ratio is 8%, banks do not hold any excess reserves, and the nonbank public’s holdings of currency never changes.

(a) Suppose the Fed extends a discount loan to First National Bank in the amount of $2 million. What happens to checkable deposits in the entire banking system as well as the M1 money supply as a result of the discount loan?

(b) Suppose the Fed sells $2.4 million in securities to First National Bank. The Fed receives payment for these securities by debiting First National Bank’s reserve balances held at the Fed. What happens to checkable deposits in the entire banking system as well as the M1 money supply as a result of this open-market sale?

(c) Suppose that you decide to hold $100 less cash than usual and therefore deposit $100 more cash in your checking account at First National Bank. What effect will this have on checkable deposits in the entire banking system as well as the M1 money supply?

Explanation / Answer

Let's define the terms used in the question first:

M1 money supply can be defined as physical money present in the economy it is coins, paper notes(fiat money) and checkable amount as well as demand deposits. It is the most liquid part of the money supply available.  

The discount loan is the loans on which the banks don't have to pay any interest amount instead it is given as principle amount subtracted by the interest amount and the bank have to pay the original amount.

a) In the first situation, Fed has extended a discounted loan of $2 million to the first national bank. The scenario doesn't mention any discount rate so we assume its 10%. The M1 is the economy will be increased by $1.8 million and so will the checkable deposit in the bank. Because it's the discounted loan the Fed has given only $1.8 million at a discount rate of 10%(assumed) and the First national bank has to return full $2 million.

b) The First national bank has to maintain a reserve balance of 8% all the time with the Fed. The federal bank has sold securities worth $2.4 million to the First national bank, this will reduce the liquidity of we should say M1 by $2.4 and the checkable deposit by the same amount. The first national bank has to maintain the reserve, so they will deposit more $2.4 million after the fed has debited from their previous reserves.

c) If I deposit $100 more in the bank and spend less, it will increase the checkable deposits in the bank but will not have any effect on the M1. M1 already contains all demand deposits and currency with the bank. If I had made a time deposit with the First bank this will have reduced the M1 by $100, but with saving deposits, M1 remains the same.   

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