Economics problem questions – money and banking

Problem 1 (25 points) On the web site of the Federal Reserve Bank of St. Louis, find and plot data on the M1 money multiplier for the past ten years. Explain why the multiplier fell sharply with the onset of the financial crisis of 2007-2009.

Problem 2 (25 points) Suppose that currency in circulation is $600 billion, the amount of

checkable deposits is $900 billion, and excess reserves are $15 billion. 

         a. Calculate the money supply, the currency deposit ratio, the excess reserve ratio, and the money multiplier. 

         b. Suppose the central bank conducts an unusually large open market purchase of bonds held by banks of $1400 billion due to a sharp contraction in the economy. Assuming the ratios you calculated in part a are the same, what do you predict will be the effect on the money supply? 

         c. Suppose the central bank conducts the same open market purchase as in part b, except that banks choose to hold all of these proceeds as excess reserves rather than loan them out, due to fear of a financial crisis. Assuming that currency and deposits remain the same, what happens to the amount of excess reserves, the excess reserve ratio, the money supply, and the money multiplier? 

         d. Following the financial crisis in 2008, the Federal Reserve began injecting the banking system with massive amounts of liquidity, and at the same time, very little lending occurred. As a result, the M1 money multiplier was below 1 for most of the time from October 2008 through 2011. How does this relate to your answer to part c?

Problem 3 (25 points) Using the supply and demand analysis of the market for reserves, indicate what happens to the federal funds rate, borrowed reserves, and nonborrowed reserves, holding everything else constant, under the following situations.  

a. The economy is surprisingly strong, leading to an increase in the amount of checkable deposits. 

b. Banks expect an unusually large increase in withdrawals from checking deposit accounts in the future. 

c. The Fed raises the target federal funds rate. 

d. The Fed raises the interest rate on reserves above the current equilibrium federal funds rate. 

e. The Fed reduces reserve requirements. 

f. The Fed reduces reserve requirements, and sterilizes this by conducting an open market sale of securities.

Problem 4 (25 points) Watson Thrift Association reports an average asset duration of 7 years, an average liability duration of 3.25 years. In its latest financial report, the association recorded total assets of $1.8 billion and total liabilities of $1.5 billion. 

a. What is the Net Worth (NW)? 

b. If interest rates began at 6 percent and then suddenly climbed to 7.5 percent, what change (in percentage terms) will this have on the Watson Thrift’s Net Worth if market interest rates change as anticipated? What is the new NW?

c. What if interest rates decline from 6 to 5 percent? What is the new NW?

d. Explain your findings.