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Commercial Banks and Money Supply

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1. The fundamental explanation of why commercial banks can create money lies in:
A)fractional reserves.
B)The Federal Reserve or other central banks.
C)Private ownership.
D)The consumption function.
E)Maintaining a marginal propensity to consume less than 1.

2. A reduction in reserve requirements of member banks tends to counter a recession by:
A)Raising interest rates.
B)Reducing excess reserves.
C)Increasing excess reserves.
D)Decreasing outstanding loans.
E)Decreasing aggregate demand.

3. By purchasing government securities in the open market, the Federal Reserve authorities hope ultimately to accomplish:
A)An increase in bank reserves larger than the original purchases by the appropriate multiple.
B)An increase in bank reserves by the amount of the original purchase.
C)A decrease in bank reserves.
D)An equal increase in bank reserves and Federal Reserve notes.
E)An increase in Federal Reserve notes larger than the original purchases by
Appropriate multiple.

4. If the Fed has correctly interpreted economic conditions, a contraction in the money-supply could:
A)reduce aggregate demand.
B)increase unemployment.
C)reduce output.
D)lower inflation.
E)any one of the above, depending upon circumstance.

5. Raising the discount rate, if effective, tends to:
A)expand the money supply and lower interest rates.
B)expand the money supply and raise interest rates.
C)contract the money supply and raise interest rates.
D)contract the money supply and lower interest rates.
E)Do none of the above.

6.During a period of high inflation:
A)Borrowers are better off because they can pay off their loans with currency that is worth less.
B)Borrowers are worse off because they have to pay off their loans with currency that is worth more.
C)Lenders are worse off because they cannot find anyone who wants a loan.
D)Lenders are worse off because they are repaid with currency that is worth more.
E)None of the above.

7. If banks hold a 20 percent reserve ratio, an initial increase in deposits of $20 will lead to an eventual:
A)Increase in the money supply of $400.
B)Increase in the money supply of $80.
C)Increase in the money supply of $100.
D)Increase in loans of $100.
E)Increase in loans of $400.

8. The real rate of interest:
A)Equals the nominal rate plus the rate of inflation.
B)Equals the rate of inflation minus the nominal rate.
C)Equals the nominal rate minus the rate of inflation.
D)Tends to increase when inflation rises.
E)None of the above.

9. In recent years, probably the most important mechanism of the Federal Reserve System's monetary control has been:
A)The discount rate.
B)Legal reserve requirements.
C)Open-market operations involving government securities.
D)Moral suasion.
E)Consumer credit and margin requirements.

10. A discretionary fiscal action involves

A)Changes in tax revenues that result from changes to tax rates
B)Payment of unemployment insurance
C)A Congressionally mandated change in the level of government spending
D)Payment of social security benefits to retirees
E)All of the above

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Solution Preview

1. The fundamental explanation of why commercial banks can create money lies in:
A)fractional reserves.
B)The Federal Reserve or other central banks.
C)Private ownership.
D)The consumption function.
E)Maintaining a marginal propensity to consume less than 1.

Answer: A) fractional reserves

The requirement of fractional reserve creates money. Under the fractional reserve the banks keep a fraction of their deposits ( reserve requirement ) and can lend out the rest. This process of lending money and the borrower again depositing the borrowed money in another bank which is again lent out after keeping a fraction as reserve ( which is carried forward by the second borrower and so on ) creates money.

2. A reduction in reserve requirements of member banks tends to counter a recession by:
A)Raising interest rates.
B)Reducing excess reserves.
C)Increasing excess reserves.
D)Decreasing outstanding loans.
E)Decreasing aggregate demand.

Answer: B) Reducing excess reserves.

When reserve requirements are reduced more money is available for borrowers. Thus money supply is increased, interest rate goes down , as a result more investment may takes place which can counter recession .

3. By purchasing government securities in the open market, the Federal Reserve authorities Hope ultimately to accomplish:
A)An increase in bank reserves larger than the original purchases by the appropriate multiple.
B)An increase in bank reserves by the amount of the original purchase.
C)A decrease in bank reserves.
D)An equal increase in bank reserves and ...

Solution Summary

Answers to 10 Multiple Choice questions on commercial banks and money supply.

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Macroeconomics

1. Key Question
In the table on page 289 you will find consolidated balance sheets for the commercial banking system and the 12 Federal Reserve Banks. Use columns 1 through 3 to indicate how the balance sheets would read after each of transactions a to c is completed. Do not cumulate your answers; that is, analyze each transaction separately, starting in each case from the figures provided. All accounts are in billions of dollars.
1. Â A decline in the discount rate prompts commercial banks to borrow an additional $1 billion from the Federal Reserve Banks. Show the new balance-sheet figures in column 1 of each table.
Consolidated Balance Sheet: All Commercial Banks
(1) (2) (3)
Assets:
Reserves $33 ______ ______ ______
Securities 60 ______ ______ ______
Loans 60 ______ ______ ______
Liabilities and net worth:
Checkable deposits $150 ______ ______ ______
Loans from the Federal
Reserve Banks 3 ______ ______ ______

Consolidated Balance Sheet: The 12 Federal Reserve Banks
(1) (2) (3)
Assets:
Securities $60 ______ ______ ______
Loans to commercial banks 3 ______ ______ ______
Liabilities and net worth:
Reserves of commercial banks $33 ______ ______ ______
Treasury deposits 3 ______ ______ ______
Federal Reserve Notes 27 ______ ______ ______
3. The Federal Reserve Banks sell $3 billion in securities to members of the public, who pay for the bonds with checks. Show the new balance-sheet figures in column 2 of each table.
4. The Federal Reserve Banks buy $2 billion of securities from commercial banks. Show the new balance-sheet figures in column 3 of each table.
5. Now review each of the above three transactions, asking yourself these three questions: (1) What change, if any, took place in the money supply as a direct and immediate result of each transaction? (2) What increase or decrease in the commercial banks' reserves took place in each transaction? (3) Assuming a reserve ratio of 20 percent, what change in the money-creating potential of the commercial banking system occurred as a result of each transaction?

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