Economics 102 Professor McClelland

Fall 2007

Problem Set # 6 -- Solutions

I.  a. The following is Nations Bank's completed balance sheet before Irene withdraws $14,000 in cash:

Nations Bank: Balance Sheet

Asset / Liabilities
Reserves / 22,000 / Demand Deposits:
Loans / 173,000 / of Irene / 19,000
Securities / 25,000 / of others / 201,000
Total / 220,000 / Total / 220,000

b. The impact of Irene's withdrawal of cash on Nations Bank's balance sheet:

Nations Bank: Balance Sheet

Asset / Liabilities
Reserves / 8,000 / Demand Deposits:
Loans / 173,000 / of Irene / 5,000
Securities / 25,000 / of others / 201,000
Total / 206,000 / Total / 206,000

c. Nations Bank's reserves fall short of the legal requirement by $12,600.

II.  a. The Bank of America's completed balance sheet before Sarah purchases the securities:

The Bank of America: Balance Sheet

Asset / Liabilities
Reserves / 56,000 / Demand Deposits:
Loans / 120,000 / of Sarah / 34,000
Securities / 384,000 / of others / 526,000
Total / 560,000 / Total / 560,000

b. Balance sheets of Nations Bank and the Bank of America when Sarah pays for those securities by giving Nations Bank a personal check on her deposit at the Bank of America, which Nations Bank turns over to the Bank of America in exchange for cash:

Nations Bank: Balance Sheet

Asset / Liabilities
Reserves / 20,600 / Demand Deposits:
Loans / 173,000 / of Irene / 5,000
Securities / 12,400 / of others / 201,000
Total / 206,000 / Total / 206,000

OVER

Economics 102 Professor McClelland

The Bank of America: Balance Sheet

Asset / Liabilities
Reserves / 43,400 / Demand Deposits:
Loans / 120,000 / of Sarah / 21,400
Securities / 384,000 / of others / 526,000
Total / 547,400 / Total / 547,400

III.  So far, the money supply decreases by (14,000 + 14,000 + 12,600) = $40,000, due only to the original sale of two bonds to Irene and to Paul as well as the subsequent sale of Nations Bank's securities to Sarah.

IV. a. If the Bank of America replenishes its shortage of reserves (caused by transactions described in II) by selling some of its securities, it must sell securities valuing $11,340.

b. The ultimate decrease in the money supply resulting from this initial sale of two bonds by the Federal Reserve will be (14,000 + 10 x 14,000) = $154,000.

c. Had Nations Bank begun with $14,000 of excess reserves, then it did not have fallen short of reserves and thus did not have to sell securities. In such a case, the ultimate decrease in the money supply resulting from those initial sale of two bonds by the Federal Reserve would have been (14,000 + 14,000) = $28,000.