FIN350 – Slides 8

Solutions to Problems

1. The Fed buys $1b in Japanese yen denominated bonds from a US FX dealer. What is the
impact on the US monetary base?

The US monetary base increases by $1b. On the asset side of the Fed’s balance sheet, FX
reserves increase by $1b. On the liability side, bank reserves increase by $1b because the Fed
increased reserves to pay for the FX purchase, and the monetary base increases.

2. In an effort to diversify their foreign reserves, the People’s Bank of China has decided to
enter into a transaction with a US FX dealer to sell some of their dollar foreign exchange
reserves and purchase Euros. What is the impact on the US monetary base? On the Chinese
monetary base?

The US monetary base increases. The PBOC sells dollars to buy euro from a US FX dealer.
This transaction moves dollars into the US banking system. US banking assets increase by the
increase in dollar reserves, and their inventory of euros decline by the equivalent amount.
There is no change to the Chinese MB since neither dollars nor euros are part of their MB. The
balance sheets of the Fed, PBOC and the ECB are unaffected.

3. Assume the money multiplier (m) = 2.00. If the Fed sells $1 million of bonds and banks
reduce their borrowings from the Fed by $1 million, calculate the impact on the monetary
base. Calculate the impact on the money supply.

The Fed sale leads to a decline in the MB of $1m, and the bank reduction in borrowing from the
Fed leads to another decline in the MB of $1m. The MB declines by $2m. Using M = MB x m,
M will decline by $4 million.

4. The Fed buys $100 million of bonds from the public. What will happen to the money
supply?

The Fed’s purchase of $100 million of bonds raises the monetary base and leads to a rise in the
money supply.

5. During the Great Depression years from 1930–1933, both the currency ratio c and the
excess reserves ratio e rose dramatically. What effect did these factors have on the money
multiplier?

Both of these factors worked to reduce the money multiplier. The money supply declined
dramatically, while the monetary base grew modestly, if at all.

1
6. Consider an open market purchase by the Fed of $3 billion of Treasury bonds from a bank.
What is the impact of the purchase on the bank’s balance sheet? What is the impact of the
purchase on the Fed’s balance sheet?

On the asset side of the bank’s balance sheet, securities fall by $3 billion and its reserves rise by
$3 billion. On the Fed’s balance sheet, assets rise by $3 billion in securities and liabilities rise by
$3 billion in reserves.

7. 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?

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.

8. In which of the following cases will the size of the central bank’s balance sheet change?

a. The Federal Reserve conducts an open market purchase of $100 million 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.

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.

9. If the Fed sells $1 million of bonds, and the money multiplier is 1.3, predict what will
happen to the money supply.

The Fed’s sale of $1 million of bonds shrinks the monetary base by $1 million. The decline in
the monetary base and a money multiplier of 1.3 leads to a decline in the money supply of $1.3
million.

2
3