Answers to the questions in Quiz 10:

1. A bank has $10,000 in deposits, $3,200 in excess reserves, and $6,000 in loans. Find both
the reserve ratio (RR) and the required reserve ratio (RRR). Show your calculations.

Answer.
 Total reserves = $10,000 – $6,000 = $4,000.
 Reserve ratio (RR)=(total reserves ÷ deposits)×100 =(4,000 ÷ 10,000)×100 = 40%.
 Required reserves = $10,000 – $3,200 – $6,000 = $800.
 Required reserve ratio (RRR) =
(required reserves ÷ deposits)×100 = (800 ÷ 10,000)×100 = 8%.

2. Explain how the central bank implements an expansionary and a contractionary monetary
policy using the requirement reserves.

Answer.

 The central bank reduces the reserve requirement ratio (RRR). As such, there is
more money available to commercial banks to loan out. In this case, money supply
increases. We call this an expansionary monetary policy.
 The central bank increases the reserve requirement ratio (RRR). As such, there is
less money available to commercial banks to loan out. In this case, money supply
decreases. We call this a contractionary monetary policy.

3. List the 3 functions of money.

Answer. Money has 3 functions:

 Money serves as a medium of exchange because it is used to purchase goods and
services.
 Money serves as a unit of account because it is used as the yardstick to post prices
and record debt.
 Money serves as a store of value because it is used to transfer purchasing power
from the present to the future.

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4. What is the definition of liquidity?

Answer.

 Definition of liquidity: the ease with which an asset can be converted into cash
quickly at little cost.

 As such, the narrow definition of money (M1) is more liquid than the broad
definition of money (M2).

5. If the reserve ratio is 100 percent, depositing $500 of paper money in a bank will increase
the money supply by how much? Show your calculations.

Answer. Reserve ratio (RR) = 100% means that money multiplier (MM) = 1. This means
that the $500 deposit does not multiply and therefore money supply stays the same.

6. Explain (i) how commercial banks react when the central bank increases the discount rate,
and (ii) what happens to the reserve ratio, money multiplier, and money supply.

Answer.
 When the central bank increases the discount rate, the cost of borrowing (from the
central bank) for the commercial banks increases.
 Thus, commercial banks tend to keep more excess reserves (so that they don’t
have to go to the central bank to borrow money at a high rate).
 This increases the reserve ratio, reduces the money multiplier, and reduces the
money supply.

7. Explain how the central bank implements an expansionary and a contractionary monetary
policy using the open market operation.

Answer.
 The central bank buys back government bonds from the public in exchange for
money (which can be printed). In this case, money supply increases. We call this an
expansionary monetary policy.
 The central bank sells government bonds to the public in exchange for money. In
this case, money supply decreases. We call this a contractionary monetary policy.

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8. Give 2 reasons why the central bank cannot 100% control money supply.

Answer. The central bank controls money supply to a very large extent but not completely.
This is because money supply is influenced:

 by the behavior of the public in holding currency, and

 by the behavior of commercial banks in holding excess reserves.

9. Write out the formula that defines the narrow definition of money.

Answer. The narrow definition of money (M1) is currency in circulation (CC) plus
demand deposits (DD). That is,

M1 = CC + DD

10. List the three tools available to the central bank to control money supply. Which tool is
most often used?

Answer. By implementing monetary policy, the central bank controls money supply
using the following three tools:
 the open market operation (OMO), which is most often used.
 the requirement reserve ratio (RRR), and
 the discount rate.