CHAPTER 16: IMPORTANT NOTES:

Assets = Liabilities

(2) A balance sheet, by definition, has to balance. That means, for the commercial banks, their An Asset of a commercial bank are (1) Reserves (2) Treasury bonds (3) Loans So Deposits = Reserves + Treasury Bonds + Loans A Liability of a commercial bank are its deposits

(1) M2 is ALWAYS bigger than M1 as M2 includes M1

(5) Money Multiplier:

(4) Reserve Ratio = (Total Reserve)*100/Deposits, where

(3) Reserve requirement (also known as Required Reserve Ratio, typically denoted by RRR) = Total Reserves = Required Reserves + Excess Reserves (Required Reserves)*100/Deposits

(a) If banks choose to keep ONLY required reserves (and no excess reserves), (b) If banks choose to keep BOTH required as well as excess reserves, money (c) Notice that the money multiplier is INVERSELY related to the reserve increase the reserve ratio, the money multiplier goes down. requirement, or the reserve ratio, so if the Fed increases the reserve multiplier = 1/ (Reserve Ratio) Reserve Ratio)

money multiplier = 1/(Reserve Requirement which is also called the Required

requirement, or commercial banks choose to keep more excess reserves that

(7) Sometimes, we just want to find out what will be the CHANGE in money supply if the Then

(6) Given a certain amount of deposits, Total Money Supply Possible = (Money Multiplier)* (Amount of the initial deposit) Federal Reserve Bank takes certain action (for example, Fed Purchases Treasury Bonds).

(8) Federal Reserve Bank typically controls money supply by doing one or all of these three things: commercial bank if a commercial bank chooses to borrow money from the Fed. to pay more interest when it borrows money from the Fed. This reduces the

due to the Feds action of purchasing treasury bonds from the public)

Change in Money Supply Possible = (Money Multiplier)* (Change in Deposits that take place

a. It can change the official discount rate this is the interest rate that Fed charges a

When Fed increases the official discount rate, it means that a commercial bank has

b. It can change the reserve requirement if Fed increases the reserve requirement, a opposite will happen if Fed reduces the reserve requirement. commercial bank has to hold more reserves for a given amount of deposits. More reserves mean fewer loans. This implies money supply will be lower. Just the

be lower. Just the opposite will happen if Fed reduces the official discount rate.

banks have less money, they can make fewer loans. This implies money supply will

incentive of the commercial bank to borrow money, and therefore, since commercial

c. It can buy or sell Treasury Bonds this is a very popular measure often used by the when a Fed buys back Treasury bonds from the public or the commercial banks.

This results in more money with the public or commercial banks which increase the

Fed. It is also known as Open Market Operations. An Open Market Purchase happens

deposits of the commercial banks. When deposits go up, a commercial bank can make more loans, so total money supply will go up. the commercial banks and to the public. When we or the commercial banks buy Treasury Bonds, we give money to the Fed. This implies that deposits go down.

The opposite policy is called Open Market Sale. Now the Fed sells Treasury Bonds to When deposits go down, it reduces the amount of loans a commercial bank can make and therefore, total money supply will also go down. Now let us do a few Numerical Examples to illustrate these points. Assignment 16-2: Qs 26. multiplier_________ If the Fed increases the reserve ratio from 4% to 10%, then the money Answer: First, note that Fed has increased the reserve ratio. Since the money should decrease. When reserve ratio is 4%, money multiplier = 1/(.04) = 25 Assignment 16-2: Qs 11. deposits?

multiplier is inversely related to the reserve ratio, it means that money mutplier When reserve ratio increases to 10%, money multiplier= 1/(0.1) = 10 Suppose the banking system currently has $300 billion in reserves; the reserve

requirement is 10%; and excess reserves amount to $3 billion. What is the level of

Answer: The commercial bank has $300 billion in total reserves out of which excess reserves is $3 billion. Required Reserves = Total Reserves Excess Reserves We know that reserve requirement = 10%. So 10% of Deposits = $297 billion, OR (0.1)*Deposits = $297 billion = $300 billion - $3 billion = $297 billion.

Then Deposits = $297 billion / (0.1) = $2970 billion Assignment 16-2: Question 6 and Question 7

The Monetary Policy of Tazi is controlled by the countrys central bank known as the Bank of Tazi. The local unit of currency is the taz. Aggregate banking statistics show that collectively the banks of Tazi hold 300 million tazes of required reserves, 75 million tazes of excess the bank. reserves, have issued 7,500 million tazes of deposits, and hold 225 million tazes of Tazian

Treasury bonds. Tazians prefer to use only demand deposits and so all money is on deposit at

6. Assume that banks desire to continue holding the same ratio of excess reserves to deposits. What Answer: Reserve Requirement = (Required Reserves)*100/Deposits Reserve Ratio = (Total Reserves)*100/Deposits is the reserve requirement and the reserve ratio for Tazian Banks? = $300 million *100/$7500 billion = 4%

the value of existing loans made by Tazian banks? Deposits = Reserves + Treasury Bonds + Loans

7. Assuming the only other thing Tazian banks have on their balance sheets is loans, what is

= ($300 million + $ 75 million)*100/$7500 million = 5%

Answer: We know that a balance sheet has to balance. THEN, Loans = Deposits Reserves Treasury Bonds = $ 6900 million

= $7500 million - $375 million - $225 million

Assignment 16-2 : Question 19

Answer: The number one clue here is that banks hold NO excess reserves. That means: Money Multiplier = 1/(Reserve requirement) = 1/.04 = 25

The reserve requirement is 4%, banks hold no excess reserves and people hold no currency. If the Fed sells $10,000 of bonds, what happens to the money supply?

supply decrease?

Change in Money Supply = (Money Multiplier) * (Change in Deposits) $2,50,000 =25 * $10,000= $2,50,000

supply should decrease. If deposits decrease, then by how much does total money

Fed sells $10,000 of bonds. When Fed sells bonds, deposits decrease, so money

So, when Fed sells bonds worth $10,000, total money supply will decrease by Assignment 16-2 : Question 17

The banking system currently has $50 billion of reserves, none of which are excess. People hold only deposits and no currency, and the reserve requirement is 10 percent. If the Fed bonds, then by how much does the money supply change? a. It falls by $20 billion. b. It falls by $110 billion. c. It falls by $180 billion. d. None of the above is correct. Answer:

raises the reserve requirement to 12.5 percent and at the same time sells $10 billion worth of

Then Deposits = $50 billion/0.1 = $500 billion.

Initially, the Reserve requirement was 10% and the banks held $50 billion of

So, the banking system has $500 billion dollars in deposits.

reserves. That means, 10% of Deposits = Reserves, or 10% of Deposits = $50 billion

The banking system ONLY holds required reserves.

it sells $10 billion worth of bonds.

Notice that when reserve requirement goes up, money supply will go down. Also, (a) Let us first analyze the effect of increasing reserve requirement to 12.5%. $50 billion. reserves. by how much will money supply fall due to these two policy changes?

Now the Fed does two things- (a) it increases the reserve requirement to 12.5% (b)

when the Fed sells treasury bonds, money supply goes down. We have to figure out When the reserve requirement was 10%, the commercial banks had to keep

10% of its deposits in reserves. So reserves were 10% of $500 billion which is

have to keep 12.5% of $500 billion in reserves, or it has to keep $62.5 billion in So, the commercial banks have to keep an additional $12.5 billion in reserves Since loans of one bank are deposits of another bank, a reduction of loans by ($62.5 billion - $50 billion), which implies loans will decrease by $12.5 billion.

However, when reserve requirement increases to 12.5%, the commercial banks

shows you that deposits are going down).

Therefore, change in money supply due to this one action is: (Money Multiplier )* (Change in Deposits) multiplier).

$12.5 billion in turn means that change in deposits is -$12.5 billion (the - sign

Money Multiplier = 1/(0.125) = 8 (note that since our reserve requirement has changed to 12.5%, this is the value that we will use to calculate the money Hence, change in money supply = 8 * (-$12.5 billion) = -$100 billion

(b) There is one other policy change that happens in addition to the change in question is by how much?

So, when Fed increases reserve requirement to 12.5%, this action reduces money supply by $100 billion dollars.

reserve requirement, and that is the Fed sells treasury bonds worth $10 billion. Change in money supply = Money Multiplier * Change in deposits We calculated money multiplier to be 8 in step (a) above.

We know that when Fed sells treasury bonds, the money supply goes down. The

We also know that sale of treasury bonds means deposits go down, so change in deposits is $10 billion. Hence change in money supply = 8*(-$10 billion) = -$80 billion.

So, the TOTAL change in Money Supply = Change in Money supply when Fed dollars. increases reserve requirement + Change in Money supply when Fed sells

Hence money supply will GO DOWN (FALL) by $180 billion dollars

treasury bonds = $100 billion (step (a) ) + $80 billion (step (b) ) = $180 billion

One Important Concept for the Exam from Chapter 13 Take Note
and is a bonus for all of you who pay attention to my lectures and notes.

This concept that I am now going to discuss is relevant for Chapter 13. It is important for the exam Page 263 of the Customized edition of the Mankiw Book you have- It is the Top Box on Page 263). By definition, Price Earnings Ratio = Stock Price / (Retained Earnings per share + Dividends per There are two concepts called Price Earnings Ratio and Dividend Yield (Reference Chapter 13,

share)

Dividend Yield = (Dividends per share / Stock price)*100% SO, let us take a numerical example. Suppose the stock of XYZ Corporation is selling for $20. Its retained earnings are $5 per share and

dividends is $0.1 per share.

Price-Earnings ratio of XYZ Corporation = $20 /($5+$0.1) = $20/($5.1) = 3.9216 Dividend Yield of XYZ Corporation = ($0.1/$20)*100% = 0.5%

Real GDP per capita, Real GDP growth and Real GDP Chapter 12
Some of you have approached me about the difference in these concepts. Real GDP growth = (Real GDP in period (t) Real GDP in the previous period (t-1))*100%/Real GDP in previous period t-1 Real GDP per capita (this is also called Real GDP per person) = Real GDP / Population

Now let us take the numerical example from Practice Questions. Practice Question Number 23

previous period (t-1))*100%/Real GDP per capita in previous period t-1

Real GDP per capita growth = (Real GDP per capita in period (t) Real GDP per capita in the

real GDP in Florastan in 2010? a. 202,860 b. 198,059 d. 200,445

In 2009, the imaginary nation of Florastan had a population of 8,300 and real GDP of 190,900.

Florastan had 5% growth in real GDP per person. In 2010 it had a population of 8,400. What was

c. None of the above is correct. We know that Real GDP of Florastan in 2009 = 190,000 Population in 2009 = 8300

So, Real GDP per capita in Florastan in 2009 = Real GDP/Population = 190,900/8300=23 Florastan had a 5% growth in Real GDP per capita between 2009 and 2010. So, (Real GDP per capita in 2010 Real GDP per capita in 2009)*100%/Real GDP per capital in

2009 = 5%

Or, (Real GDP per capita in 2010 23)*100/23= 5 Population in Florastan in 2010 = 8400 Real GDP per person = 24.15

So, solving the above equation, Real GDP per capita in Florastan in 2010 = 24.15

So, Real GDP in Florastan in 2010 = Real GDP per capita in 2010 * Population in 2010 Hence, answer is (a). = 24.15*8400 = 202,860