Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System

presidents of the Federal Reserve Banks are chosen by each bank’s board of
directors.
5. If the Fed wants to increase the supply of money with open-market
operations, it purchases U.S. government bonds from the public on the open
market. The purchase increases the number of dollars in the hands of the
public, thus raising the money supply.
6. Banks do not hold 100% reserves because it is more profitable to use the
reserves to make loans, which earn interest, instead of leaving the money as
reserves. The amount of reserves banks hold is related to the amount of
money the banking system creates through the money multiplier. The smaller
the fraction of reserves banks hold, the larger the money multiplier, because
each dollar of reserves is used to create more money.
7. Bank B will show a larger change in bank capital. The decrease in assets will
render Bank B insolvent because its assets will fall below its liabilities, a
decrease in bank capital of 140%. Bank A will suffer a large decline in bank
capital (70%) but will remain solvent.
8. The discount rate is the interest rate on loans that the Federal Reserve makes
to banks. If the Fed raises the discount rate, banks will borrow less from the
Fed, so both banks' reserves and the money supply will be lower.
9. Reserve requirements are regulations on the minimum amount of reserves that
banks must hold against deposits. An increase in reserve requirements raises
the reserve ratio, lowers the money multiplier, and decreases the money
supply.
10. The Fed cannot control the money supply perfectly because: (1) the Fed does
not control the amount of money that households choose to hold as deposits
in banks; and (2) the Fed does not control the amount that bankers choose to
lend. The actions of households and banks affect the money supply in ways
the Fed cannot perfectly control or predict.

PROBLEMS AND APPLICATIONS

1.
a. A U.S. penny is considered money in the U.S. economy because it is
used as a medium of exchange to buy goods or services, it serves as a
unit of account because prices in stores are listed in terms of dollars
and cents, and it serves as a store of value for anyone who holds it over
time.
b. A Mexican peso is not considered money in the U.S. economy, because it
is not used as a medium of exchange, and prices are not given in terms
of pesos, so it is not a unit of account. It could serve as a store of value,
though.

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 Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System

c. A Picasso painting is not considered money, because you cannot

exchange it for goods or services, and prices are not given in terms of
Picasso paintings. It does, however, serve as a store of value.
d. A plastic credit card is similar to money, but represents deferred
payment rather than immediate payment. So credit cards do not fully
represent the medium of exchange function of money, nor are they
stores of value, because they represent short-term loans rather than
being an asset like currency.
2.
a. When the Fed buys bonds in open market operations, the money supply
increases.
b. When the Fed reduces the reserve requirement, the money supply
increases.
c. When the Fed increases the interest rate it pays on reserves, the money
supply decreases.
d. When Citibank repays a loan from the Fed, the money supply decreases.
e. When people decide to hold less currency, they likely deposit their
currency in a bank and the bank will lend portion of that money, so the
money supply increases.
f. When bankers decide to hold more reserves, the money supply
decreases.
g. When the FOMC increases its target for the federal funds rate, the
money supply decreases.
3. When your uncle repays a $100 loan from Tenth National Bank (TNB) by writing
a check from his TNB checking account, the result is a change in the assets
and liabilities of both your uncle and TNB, as shown in these T-accounts:

Your Uncle
Assets Liabilities
Before:
Checking Account $100 Loans $100
After:
Checking Account $0 Loans $0

Tenth National Bank

Assets Liabilities
Before:
Loans $100 Deposits $100
After:
Loans $0 Deposits $0

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to a publicly accessible website, in whole or in part.
 Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System

By paying off the loan, your uncle simply eliminated the outstanding loan
using the assets in his checking account. Your uncle's wealth has not
changed; they simply have fewer assets and fewer liabilities.
4.
a. Here is BSB's T-account:

Beleaguered State Bank

Assets Liabilities
Reserves $25 million Deposits $250 million
Loans $225 million

b. When BSB's largest depositor withdraws $10 million in cash and BSB
reduces its loans outstanding to maintain the same reserve ratio, its T-
account is now:

Beleaguered State Bank

Assets Liabilities
Reserves $24 million Deposits $240 million
Loans $216 million

c. Because BSB is cutting back on its loans, other banks will find
themselves short of reserves and they may also cut back on their loans
as well.
d. BSB may find it difficult to cut back on its loans immediately, because it
cannot force people to pay off loans. Instead, it can stop making new
loans. But for a time, it might find itself with more loans than it wants.
It could try to attract additional deposits to get additional reserves, or
borrow from another bank or from the Fed.
5. If you take $100 that you held as currency and put it into the banking system,
then the total amount of deposits in the banking system increases by $1,000,
because a reserve ratio of 10% means the money multiplier is 1/0.10 = 10. Thus,
the money supply increases by $900, because deposits increase by $1,000 but
currency declines by $100.
6.
a.
Happy Bank
Assets Liabilities
Reserves $100 Deposits $800
Loans $900 Bank Capital $200

b. The leverage ratio = $1,000/$200 = 5.

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to a publicly accessible website, in whole or in part.
 Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System

c.

Happy Bank
Assets Liabilities
Reserves $100 Deposits $800
Loans $810 Bank Capital $110

d. Assets decline by 9%. The bank's capital declines by 45%. The reduction
in bank capital is larger than the reduction in assets because all of the
defaulted loans are covered by bank capital.
7. With a required reserve ratio of 10%, and if banks hold no excess reserves and
people do not increase their currency holdings, the money multiplier could be
as high as 1/0.10 = 10. Therefore, the maximum increase in the money supply
from a $10 million open-market purchase is $100 million. Alternatively, if all of
the new money is held as currency by the individual investors, the result would
be the smallest possible increase of $10 million.
8. The money supply will expand more if the Fed buys $2,000 worth of bonds.
Both deposits will lead to monetary expansion, but the Fed’s deposit is new
money. With a 5% reserve requirement, the multiplier is 20 (1/0.05). The $2,000
from the Fed will increase the money supply by $40,000 ($2,000 x 20). The
$2,000 from the cookie jar is already part of the money supply as currency.
When it is deposited the money supply increases by $38,000. Deposits
increase by $40,000 ($2,000 x 20) but currency decreases by $2,000.
9.
a. With a required reserve ratio of 10% and no excess reserves, the money
multiplier is 1/0.10 = 10. If the Fed sells $1 million of government bonds,
reserves will decline by $1 million and the money supply will contract by
10 × $1 million = $10 million.
b. Banks might wish to hold excess reserves if they need to hold the
reserves for their day-to-day operations, such as paying other banks for
customers' transactions, making change, cashing paychecks, and so on.
If banks increase excess reserves such that there is no overall change in
the total reserve ratio, then the money multiplier does not change and
there is no effect on the money supply.
10.
a. With banks holding only required reserves of 10%, the money multiplier
is 1/0.10 = 10. Because reserves are $100 billion, the money supply is 10 ×
$100 billion = $1,000 billion or $1 trillion.
b. If the required reserve ratio is raised to 20%, the money multiplier
declines to 1/0.20 = 5. With reserves of $100 billion, the money supply
would decline to $500 billion, a decline of $500 billion. Reserves would
be unchanged.

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 Instructor Manual: Mankiw, Principles of Economics, 10e, 9780357722718; Chapter 30: The Monetary System

11.
a. To expand the money supply, the Fed should buy bonds.
b. With a reserve requirement of 20%, the money multiplier is 1/0.20 = 5.
Therefore to expand the money supply by $40 million, the Fed should
buy $40 million/5 = $8 million worth of bonds.
12.
a. If people hold all money as currency, the quantity of money is $2,000.
b. If people hold all money as demand deposits at banks with 100%
reserves, the quantity of money is $2,000.
c. If people have $1,000 in currency and $1,000 in demand deposits, the
quantity of money is $2,000.
d. If banks have a reserve ratio of 10%, the money multiplier is 1/0.10 = 10.
So if people hold all money as demand deposits, the quantity of money
is 10 × $2,000 = $20,000.
e. If people hold equal amounts of currency (C) and demand deposits (D)
and the money multiplier for reserves is 10, then two equations must be
satisfied:

(1) C = D, so that people have equal amounts of currency and demand

deposits; and (2) 10 × ($2,000 – C) = D, so that the money multiplier (10)
times the number of dollar bills that are not being held by people
($2,000 – C) equals the amount of demand deposits (D). Using the first
equation in the second gives 10 × ($2,000 – D) = D, or $20,000 – 10D =
D, or $20,000 = 11 D, so D = $1,818.18. Then C = $1,818.18. The quantity of
money is C + D = $3,636.36.

ADDITIONAL ACTIVITIES AND ASSIGNMENTS

The following are activities and assignments developed by Cengage but not included
in the text, PPTs, or courseware (if courseware exists) – they are for you to use if you
wish.
I. [In-class demonstration] What Can Be Learned from a Dollar?: 5 minutes total.
Works in any class size. Topics include money and Federal Reserve.
A. Purpose: This activity introduces the role of the Federal Reserve in
controlling the money supply.
B. Instructions: Ask the class to take a dollar bill from wallets (or a $5,
$10, $20, or $100). Students without any currency can share with
someone who does. Ask the class to read the bill. After a minute, ask
them what they have learned.
C. Common Answers and Points for Discussion: Most students focus on
the statement “This note is legal tender for all debts, public and

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to a publicly accessible website, in whole or in part.