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Use T-accounts to show the effect of open market sales on the balance sheets of the Federal Reserve and the banking system. Do total reserves increase or decrease?

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Econ 331: Money and Financial Institutions

For all questions, the process of how you arrive at an answer is as important as the answer itself. For full credit, you are therefore required to show all steps and work, clearly label graphs, and fully explain any answers that ask for an explanation.

You can type your answers or write them by hand and scan them using the camera on your phone/tablet. In either case, submit the file as a single pdf document. If you type your answers, it is important to save as a pdf before submitting – equations often get jumbled between computers.

1. Discount loans:

a. Say that the Fed makes a $25 million discount loan to a distressed bank. What do the T- accounts of the Fed and the banking sector look like?

b. Why doesn’t this transaction yield a change in the size of the monetary base? Explain.

2. Use the supply and demand framework for the market for reserves to show what happens to the federal funds rate in the following situations:

a. The Fed lowers the target federal funds rate.

b. The Fed reduces reserve requirements.

3. In the years leading up to the Covid crisis, the Fed had been slowly raising interest rates. Let’s use the tools we’ve developed to analyze this contractionary monetary policy.

a. Use T-accounts to show the effect of open market sales on the balance sheets of the Federal Reserve and the banking system. Do total reserves increase or decrease?

b. Use the graphical supply and demand framework for the market for reserves to show the effect of these open market sales on the federal funds rate.

c. The Fed has concurrently increased the interest on excess reserves (IOER). In fact, the current federal funds rate is equal to IOER (~2.20%).

i. Why does IOER act as a floor on the federal funds rate? (1 sentence).

ii. Use the graphical supply and demand framework for the market for reserves to show how an increase in IOER can raise the federal funds rate.

4. Modern-day bank runs [Extra credit!]

Consider a bank with assets of 100, capital of 20, and checkable deposits of 80.

a. Set up the bank’s balance sheet.

b. Suppose the perceived value of the bank’s assets falls by 10. What is the new value of capital?

c. Suppose the deposits are insured by the government. Despite the decline in the value of bank capital, is there any immediate reason for depositors to withdraw their funds from the

bank? Would your answer change if the perceived value of the bank’s assets fell by 15? 20? Explain.

Now consider a different sort of bank, still with assets of 100 and capital of 20, but now with short- term credit (borrowings) of 80. Short-term credit must be repaid or rolled over (borrowed again) when it comes due.

d. Set up this bank’s balance sheet.

e. Suppose the perceived value of the bank’s assets falls. If lenders are nervous about the solvency of the bank, will they be willing to continue to provide short-term credit to the bank at low interest rates?

f. Assuming that the bank cannot raise additional capital, how can it raise the funds necessary to repay its debt coming due? If many banks are in this position at the same time, what will happen to the value of the assets at these banks? How will this affect the willingness of lenders to provide short-term credit.
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