Exercise Set 13
BANKS AND MONEY CREATION

I. Objectives

1. To analyze the assets and liabilities of commercial banks
2. To explain how the Fed can effect changes in money supply through the banking system
   

II. Data

The balance sheet of Fultona Bank is shown in Fig. 1.

Fig. 1 Fultona Bank's Balance Sheet

Assets	Liabilities
Loans: $250 m	Checking deposits: $200 m
Govt. securities: $100 m
Reserves: $20 m	Net worth: $170 m

Given: The required reserve ratio is 10%.

Suppose the Federal Reserve buys a certain amount of government securities from Fultona Bank. 

• Select a value for the amount of government securities bought by the Fed. 
• Compute Fultona's resulting excess reserves. 
• What is the maximum amount of new loans that Fultona can now make? 
• And, finally, what is the maximum possible increase in money supply in the economy?

Click on Gimme Creation! to confirm.

Govt securities bought by the Fed from Fultona:

Excess reserves:

Max new loan that Fultona can make:

Max increase in M1:

III. Questions 

1. Sketch the revised balance sheet for Fultona Bank. Compute Fultona's excess reserves.
2. What is the maximum amount of new loans that Fultona can make? Will Fultona Bank make loans of this amount? Explain.
3. Describe the steps by which money will expand in the economy.
4. A narrow measure of money supply in the economy is M1. How is M1 defined?
5. What is the maximum possible increase in money supply (M1) as a result of the Fed's action?
   
6. Consider the original balance sheet for Fultona Bank (Fig. 1). Suppose the Fed lowers the required reserve ratio from 10% to 8%. 
1. How will this affect Fultona Bank's balance sheet? 
2. What is the consequent change in M1--will it increase or decrease? Explain.
7. Suppose the Fed wishes to reduce money supply in the economy. Which of the following will do the trick?
1. An open market operation in which the Fed buys government securities from commercial banks.
2. The Fed raises the required reserve ratio.
3. The Fed raises the discount rate.