1) In the economy of Panicia, the monetary base is $1,000. People hold a third of their money in form of currency (and thus two-thirds as bank deposits). Banks hold a third of their deposits in reserve.
a) What are the reserve-deposit ratio, the currency-deposit ratio, the money multiplier, and the money supply?
b) One day, fear about the banking system strikes the population, and people now want to hold half their money in the form of currency. If the central bank does nothing, what is the new money supply?
c) If, in the face of this panic, the central bank wants to conduct an open-market operation to keep the money supply at its original level, does it buy or sell government bonds? Calculate, in dollars, how much the central bank needs to transact.
2) To increase tax revenue, the U.S. government in 1932 imposed a 2-cent tax on checks written on bank account deposits. (In today’s dollars, this tax would amount to about 34 cents per check)
a) How do you think the check tax affected the currency-deposit ratio? Explain.
b) Use the model of the money supply under fractional-reserve banking to discuss how this tax affected the money supply.
c) Many economists believe that a falling money supply was in part responsible for the severity of the Great Depression of the 1930s. From this perspective, was the check tax a good policy to implement in the middle of the Great Depression?
3) Give an example of a balance sheet with a leverage ratio of 20. If the value of the bank’s assets rises by 2 percent, what happens to the value of the owners’ equity in this bank? How large a decline in value of bank assets would it take to reduce this bank’s capital to zero?