Question

a) Show the changes to the balance sheets for commercial banks when the Federal Reserve buys $50 million in us Treasury Bills. If the public holds a fixed amount of currency (so that all loans create an equal amount of deposits in the banking system , the minimum reserve requirement is 5%, by how much will checkable bank deposits in commercial banks change? b) Now suppose that the Fed raises the discount rate significantly. How would you expect this to affect the balance sheet of local banks? Is this likely to decrease or increase M1?

Answer 1

1)The deposits in the commercial banks will increase by $50 million sort of like a check and balance since the bank’s assets and liabilities will both increase by that amount.

The money supply will change by $1,000 million ($50 mn / 5%) because buying the $50 million in treasury bills will put them over the amount of reserves the banks carry over in excess.

Balance sheet

Assets	Liabilities
Treasury Bills = -$50 million
Reserves =+50 million	Checkable deposits=+1000 million
Loans = +1,000 million

2)

• The discount rate is the interest rate the central bank charges commercial banks that need to borrow additional reserves.
• It is an administered interest rate set by the Fed, not a market rate; therefore, much of its importance stems from the signal the Fed is sending to the financial markets (if it's low, the Fed wants to encourage spending and vice versa).
• As a result, short-term market interest rates tend to follow its movement. If the Fed wants to give banks more reserves, it can reduce the interest rate it charges, thereby tempting banks to borrow more.
• Alternatively, it can soak up reserves by raising its rate and persuading the banks to reduce borrowing.

THUS IF FED INCREASES THE DISCOUNT RATE , IT RAISES THE PRICE OF BORROWING AND THE MONEY SUPPLY DROPS
IN ESSENCE M1 DECREASES.