Question

5. The money supply contraction process

Dismiss All

Please Wait . . .

Please Wait...

Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 5%. Clancy, a client of First Main Street Bank, purchases $200,000 of Treasury bills in an open market sale undertaken by the Fed. Upon receipt of Clancy's check, the Fed subtracts $200,000 from First Main Street Bank’s Federal Reserve account, thereby extinguishing the money.

Complete the following table to reflect any changes in First Main Street Bank's balance sheet (before the bank makes any new loans).

First Main Street Bank's Balance Sheet
Assets		Liabilities
selector 1    Building and Furniture Checkable Deposits Loans Net Worth Reserves	selector 2    $200,000 -$200,000 $1,000,000 -$1,000,000	selector 3    Building and Furniture Checkable Deposits Loans Net Worth Reserves	selector 4    $200,000 -$200,000 $1,000,000 -$1,000,000

Points:

Close Explanation

Explanation:

Because the required reserve ratio is 5%, the $200,000 withdrawal selector 1

• decreases
• increases

First Main Street Bank's required reserves by selector 2

• $50,000
• $200,000
• $20,000
• $10,000

. In order to maintain the required reserve ratio, First Main Street Bank now must selector 3

• decrease
• increase

its reserves by selector 4

• $180,000
• $0
• $200,000
• $190,000

. One possible way to do this is to selector 5

• increase
• decrease

its outstanding loans.

Points:

Close Explanation

Explanation:

Now suppose Becky repays her loan of $190,000 to First Main Street Bank by writing a check issued by Second Republic Bank. First Main Street Bank uses funds from a loan repayment to increase its reserves instead of making new loans. Second Republic Bank then replenishes its reserves by using the funds from loan repayments by Alex, who writes a check issued by Third Fidelity Bank. Third Fidelity Bank then uses a loan repayment from Eileen to replenish its reserves instead of making new loans.

Fill in the following table to show the effect of this ongoing chain of events at each of the banks, including the initial withdrawal at the beginning of the question. Enter each answer to the nearest dollar.

Bank	Decrease in Checkable Deposits	Decrease in Required Reserves	Decrease in Loans
	(Dollars)	(Dollars)	(Dollars)
First Main Street Bank
Second Republic Bank
Third Fidelity Bank

Points:

Close Explanation

Explanation:

Assume this process continues, with each successive loan being repaid using a checking account and banks using repayments to replenish their reserves without issuing any new loans. Under these assumptions, the initial destruction of $200,000 by the Fed results in an overall decrease of selector 1

• $10,000
• $3,800,000
• $400,000
• $4,000,000

in checkable deposits.

Answer 1

Table-1

Bank	Decrease in Checkable Deposits	Decrease in Required Reserves	Decrease in Loans
	(Dollars)	(Dollars)	(Dollars)
First Main Street Bank	-200000	-10000	-190000
Second Republic Bank	-190000	-9500	-180500
Third Fidelity Bank	-180500	-9025	-171475