Question

Assume the Fed sells a $10m T-bill to First National Bank. a. Show the T-accounts of the Fed and First National Bank. b. By how much will the monetary base change? c. If the reserve-deposit ratio is 15% and the currency-deposit ratio is 25%, calculate the eventual change in the money supply.

Answer 1

(a) The t accounts are as follows:

Federal's cash account

particulars	Amount (dr.)	particulars	Amount (cr.)
To Treasury bills	$ 10 millon
		bt balance carried down	$ 10 million

Federal's Treasury bill Account

Particular Amount (dr.) Particular Amount (cr.) By Cash $10 million To balance carried down $10 million
National Bank's cash Account

Particular Amount (dr.) Particular Amount (cr.) By Treasury bills $10 million To balance carried down $10 million
Natioanl bank's Treasury bill Account

particulars	Amount (dr.)	particulars	Amount (cr.)
To cash	$ 10 millon
		by balance carried down	$ 10 million

(b) The monetary base is money held by public in currency and by banks as reserves. As a bank has bought traesury bills by $10 million, the monetary base has been reduced by $10 million.

(c) The money supply has also changed. It has been decreased. If the reserve-deposit ratio is 15% and the currency-deposit ratio is 25%, the eventual change in the money supply is calculated below:

M = [(cr+1)/(cr+rr)]B

where M is the change in money supply, cr is currency deposit ratio, rr is reserve deposit ratio and B is changed money base.

M = [(0.25+1)/(0.25+0.15)] * $10 million = 3.125*$10 million = $31.25 million.