Suppose that commercial banks keep no excess reserves, and that as the money supply changes, people do not change the amount of cash in their pockets. The required reserve ratio is 0.25. The Federal Reserve System wishes to reduce the money supply by $800 million, through the use of open market operations.

a) What open-market operation will the Fed engage in?

b) Show how this operation will initially affect the balance sheet of a single commercial bank.

c) Trace the money contraction process through the balance sheets of two more commercial banks, carefully showing the change in the country’s money supply at each step.

d) Show the eventual consolidated balance sheet of the commercial banking system, resulting from this open market operation.

e) Suppose that as the money supply falls, people decide to hold less cash in their pockets. Explain why the reduction in the money supply will be greater

Answer rating: 100% (QA)

a We know that open market operation means that the monetory policy action for buying and selling of ... View the full answer