Econ 1250-A7-Ch14 1 Econ1250 In class A7 –Chapter 14 Q1

Econ 1250-A7-Ch14 1 Econ1250 In class A7 –Chapter 14 Q1. The reserve requirement is 20%, and Leroy withdraws $1000 from his chequing account. The bank does NOT want to hold excess reserves. a) What would be the immediate affect on the bank’s balance sheet after the deposit? b) How much of the $1000 deposit had the bank kept in reserves? c) By how much does the bank reduce loans based on the $1000 withdrawal? d) What is the maximum contraction in the money supply possible? e) By how much did the monetary base change? Q2. Open Market Operations a) Consider an open market purchase of $50 million by BoC. i) Show the effect of this Open market purchase on the balance sheets of both BoC and TD Canada Trust ii) What is the effect on the MB iii) If the desired reserve ratio is 15% what is the effect on the Money Supply?

Question One

1. The bank’s balance sheet account, also known as a T-account, consists of assets and liabilities. Assets and liabilities are interdependent in that they are limited to the availability of each other. For example, the value of assets in a bank depends on the available liabilities, such as demand deposits and equity. Therefore, in this scenario, a withdrawal of $1000 from Leroy’s chequing account would have an immediate effect on the bank’s liabilities, which would reduce by $1,000.
2. Bank reserves are the bank’s cash holdings held in the bank to cover cash withdrawals. In this scenario, the bank had kept $200 (20%*$1,000) in reserves.
3. A $1,000 withdrawal would reduce a bank’s loan because of the interdependency between liabilities and assets. For example, Leroy’s initial $1,000 deposit implies that the bank would hold $200 in the required reserves and create assets for the bank in loans worth $800. Therefore, a $1,000 withdrawal means that the bank must generate $1,000 in m1 cash from its assets to cover Leroy’s cash withdrawal. The transaction would reduce loans by 80%, the same portion of loans initially created by a deposit of $1,000, as illustrated in the T-account below.

Figure 1: The T-Account

1. The money supply contraction arises from a reduction in the amount of money that the bank can lend to the public. Therefore, the money supply’s maximum contraction is $800, which is the proportion of loans reduced by Leroy’s cash withdrawal.
2. The formula: Reserve (R) + liquid currency (C) is used to calculate the monetary base. Therefore, the monetary base changed by $200, which is the bank’s amount of money in hand.

Question Two: Open Market Operations

3. An open market operation (OMO) is a monetary action undertaken by the central bank to regulate money supply in an economy. An open market purchase by the BoC would increase the supply of money in the economy by increasing TD Canada Trust reserves and the amount available for lending to the public. This transaction would also significantly affect the balance sheet of both BoC and TD Canada Trust, as shown in figures 2 and 3.

Figure 2:

1. BoC original Balance Sheet (in millions)

1. The BoC conducts an open market purchase of $50 million

Figure 3: TD Canada Trust

1. TD Canada Trust original balance sheet

1. TD Canada Trust Balance Sheet after the open market purchase

• TD Canada Trust makes additional loans

Explanation

Figure 2(i) shows an assumption of the bonds and deposits in the BoC before the open market purchase; they are set at $100 million. When the BoC makes a purchase worth $50 million, the bonds increase by $50 million to $150 million, as shown in figure 2(ii). Figure 3 (i) shows an assumption of the reserve, deposits, and loans in TD Canada Trust before the open market purchase. After the purchase, the bank’s bonds reduce by $50 million to $30 million, increasing the amount of reserve in TD Canada Trust to $65 million, as shown in figure 3(ii). However, the commercial bank does not hold excess reserves; but it must have a 15 percent reserve to cover for withdrawals. Therefore, the excess reserve is converted to loans, as shown in figure 3(iii).

1. BoC’s open market purchase also increases the monetary base because of the significant rise in commercial banks reserve.
2. The money supply would increase significantly if the desired reserve ratio is 15 percent, as the TD Canada Trust would convert the excess reserve into loans available to consumers and businesses.

Part 2

1. A price ceiling is the maximum amount of money sellers can charge for goods and services. For example, the government may institute a price ceiling of $8 on oil, requiring the sellers to charge a maximum of $8 on the product. A price ceiling promotes the affordability of basic goods to all consumers. For example, the government may institute price ceilings on food and rent to make it affordable. Price ceilings may also control the margins generated by sellers.

Often, price ceilings are placed below the equilibrium price to affect prices. However, a price ceiling that is below the market equilibrium price may not be effective. For example, if the government sets a ceiling for flour at $15 per kilogram and the equilibrium price is $10, this cap may not have a real effect on the flour prices. Therefore, the economy would end up with a non-binding price ceiling.

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