Homework 4

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ECON 2313 Principles of Macroeconomics Homework 4 Note : Please make sure your answer is clear for grading. To get full credit of short-answer (open end) questions, you need follow instructions of the question, and present correct and detailed (step-by-step) solution to the question. Part I. Multiple Choice Question (pick up only ONE correct answer). 1. The ability of banks to create money has its source in which of the following _____? A. the 100 percent reserve requirement B. the ability of the government to mint as much currency as it wishes C. the banks’ ability to issue currency (bank notes) of their own D. fractional-reserve banking (i.e. less than 100 percent reserve requirement) 2. Which of the following items is a liability to a bank _____? A. loans B. reserves C. deposits D. an interest-bearing asset owned by the bank 3. Suppose a bank has a 5 percent reserve ratio, $10,000 in deposits, and it loans out all it can, given the reserve ratio. Which of the following is correct _____? A. It has $500 in reserves and $9500 in loans. B. It has $50 in reserves and $9950 in loans. C. It has $555 in reserves and $9445 in loans. D. It has $550 in reserves and $9450 in loans. 4. When the Federal Reserve conducts open market sales, what effect does it have on the money Supply _____? A. It increases the money supply. B. It decreases the money supply. C. There is a gradual change to the money supply. D. There is no change to the money supply. 5. First National Bank has assets of $500,000 and liabilities of $400,000. First National Bank’s equality (net capital) is ____. A. $900,000. B. $500,000. D. $400,000. D. $100,000. 6. Other things being equal, when the Federal Reserve Bank cuts its discount rate, which of the following is likely to occur _____? A. Bank reserves tend to fall. B. Bank lending tends to fall. C. Total money supply tends to rise. D. Total money supply tends to fall. 1

Part II. Open End Questions Note: To get full credit, you need follow instructions of the question, and present correct and detailed (step-by-step) answer to the question. Question 1. Money Supply Calculation Suppose one economy starts with $1,000 as currency (cash) in the market. Calculate total money supply (M) in the following scenarios. (a) If all money is held as deposits (D) in banks. And banks have 100% of deposits as reserves (reserve ratio = 100%). Then how much is total money supply (M) in this case? M = D = $1,000 (b) If the reserve ratio (rr) now equals 25%. Still no currency is kept by consumers (all money as deposits). Without considering consumers’ decision, how much is the money multiplier (m) and total money supply (M) with the same initial deposit (D) $1,000 as above? M=1/0.25 M=4 M = D x m = $1,000 x 4 = $4,000. (c) Now we add consumers into the story. Suppose consumers hold equal amounts of currency and demand deposits (C = D). Banks still have 25% reserve ratio (rr). If we have the monetary base (B) is $1,200. Then, what is the value of money multiplier (m) and total money supply (M)? Note: Here you need consider consumers’ decision about cash% holding at hand (cr). C=0.5x1200=600 B=600+600=1200 M=1200x4=4800 Question 2 . Banking and Central Banks 2

(a) What are the three measurements of money stock commonly used? After reading the article “What’s behind the recent surge in the M1 money supply?”, use your language to explain why M1 has tremendously increased since April 2020 in the US. https://fredblog.stlouisfed.org/2021/01/whats-behind-the-recent-surge-in-the-m1-money-supply/ The three measurements of money stock commonly used are money base, m1 and m2. The reason for the surge in the M1 money supply is because the federal reserve stopped limits on transactions and withdrawals on savings and deposit accounts. (b) Use your language to describe what is the “Leverage” in banking businesses? And how to calculate the leverage ratio of a commercial bank? Leverage is a strategy used by investors in which they use borrowed money to increase potential ROI. To find the leverage ratio of a commercial bank, one must divide the banks capital by its consolidated assets. (c) From the table below, how much is the banks’ equity (its own capital)? How much is the leverage ratio of this bank? Table 1. A Bank’s Balance Sheet Assets Liabilities Reserves = $600 Deposits = $3,000 Asset 1 = $2,500 Debts = $2,600 Asset 2 = $2,900 Equity = ? 400/6000=0.07 The leverage ration is 0.07. (d) Suppose this bank’s total assets (all the three items in the 1 st row of the table above) falls by 10% of the original value, then how much will be the bank’s net capital (equity) now? Assets=5400 Capital=5400-5600=-200 The banks net capital will be -$200. 3

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Question 3 . Cryptocurrencies The article Wolla (2018) introduced some basic principles of cryptocurrencies and the impacts of digital currencies on money supply (as the link below). After reading this paper, use your language to explain the following questions. Note: your answer should be no more than 150 words for each question. (a) What is the major difference(s) between Bitcoin or other digital currencies and a payment system with a central authority? The major difference between Bitcoin and other digital currencies is that Bitcoin is decentralized, because of this bitcoin is not regulated by the government like other digital currencies. Another difference is that bitcoin is not affected by inflation due to the fact that bitcoin has a limited supply. (b) How the price of Bitcoin is determined in current market? What is the major driving force of price changes of Bitcoin and other cryptocurrencies? The price of bitcoin is determined like the price of most other things, through supply and demand. However, there is a cap on the supply of bitcoin. The major driving force on the price changes is the amount of bitcoin that has been “mined” as well as how trustworthy investors view the currency. (c) Should Bitcoin and other similar cryptocurrencies be considered as money (legal tenders) or financial investment? Why? I think it should be considered legal tender as long as it is backed in some way, and since bitcoin has a limited supply, it would fall in that category. It will help avoid inflation, which is a major problem with USD and other forms of currency. 4

# References: Wolla, S.A., 2018. Bitcoin: Money or Financial Investment?, Page One Economics. Federal Bank of St. Louis. https://research.stlouisfed.org/publications/page1-econ/2018/03/01/bitcoin-money-or-financial- investment 5

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