The Fed plays a number of important roles in the U.S. economy. Among the things

Question

The Fed plays a number of important roles in the U.S. economy. Among the things it does is conduct research on the nation's economy and regulate banks.

a. The Fed also acts as a bank for banks. What are the three activities the Fed undertakes when it acts as a bank for banks? Hint: What are the activities the Fed does for banks that are similar to the activities a bank does for its customers? (3 points)

b. The Fed also controls the money supply. List and explain the three tools the Fed uses to control the money supply. (6 points)

In exchange for his many years of hard work and devotion, National Corp Inc. gives Dave $100,000 in T-bonds. Dave sells these bonds to the Fed, and the Fed deposits the money in Dave's bank account.

c. By how much does the money supply change as a result of this deposit into Dave's account from the Fed? Explain. (3 points)

d. A bank's actual reserve ratio is the percentage of total deposits a bank actually holds on to. It is made up of the percentage they are required to hold on to, known as the required reserve ratio, plus any extra they choose to hold on to.

e. Suppose Dave's bank has an actual reserve ratio of 12%, and his bank makes a loan to Darlene based on the funds from Dave's deposit. How much does the money supply increase as a result of this second step? (3 points)

f. Darlene uses the money to buy a very expensive pair of soccer cleats from Arthur. Arthur deposits this money in his bank account. His bank holds onto 12% of the deposit and lends the rest out. How much does the money supply increase as a result of this step? (4 points)

g. In total, by what amount does the original $100,000 that the Fed released into circulation end up increasing the money supply if every bank holds 12% of its deposits? (4 points)

h. This example shows the increase in the money supply caused by an increase in bank deposits. Explain why this activity by banks is called money creation. (5 points)

Explanation / Answer

a.
The activities the Fed does for banks that are similar to the activities a bank does for its customers are
1.It provides loans to banks
2.Processing checks
3.Distribute coins and currency

b.
Three tools used by the fed to control money sup ply are
1.Open market operations
By conducting open market operations by purchasing or selling of the government securities money supply is changed by the FEd.When the Fed purchases government securitites it increases the money supply in the economy and vice-versa.
2.Discount rates
A discount rate is a rate at which a bank borrows from the Fed.If discount rates are increased the cost of borrowing goes up and hence money supply in the economy falls.The reverse also holds true.

3.Reserve requirements:By making changes in the required reserve ratio the Fed is able to change the money supply.When reserve requiremnets go up the amount of money supply decreases in the economy and vice-versa.

c.Since Dave sells his T-bills in exchange for money.The money so recieved is deposited in his bank.Assuming the bank has already kept its minimum reserves and the reserve requirement hasn't chnged,a multiplier of 5 the amount of money supply in the economy is increased by 5*100000=500000.
This is because of the fractional reserve banking system.A bank keeps certain amount of money with itself and loans out the rest of the money.Since most loans are usually just transfer of numbers and not the physical money, each bank actually lends out more money than it actually has.

d.A bank's actual reserve ratio is the percentage of total deposits a bank actually holds on to. It is made up of the percentage they are required to hold on to, known as the required reserve ratio, plus any extra they choose to hold on to.

e.
multiplier=1 / RRR
= 100/12
=25/3
increase in money supply=100000*25/3
=833333.33

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