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 

Note: Starting in May 2020, the Fed changed the definition of M1. Here's the revised definition:

"M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (3) other liquid deposits, consisting of other checkable deposits (or OCDs, which comprise negotiable order of withdrawal, or NOW, and automatic transfer service, or ATS, accounts at depository institutions, share draft accounts at credit unions, and demand deposits at thrift institutions) and savings deposits (including money market deposit accounts)."
https://www.federalreserve.gov/releases/h6/current/default.htm

Suppose the Fed buys $40 million worth government securities from Fultona Bank.

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.