Tutorial assignment: week 8 2022
Answer guide
1. Suppose that, as a result of increased uncertainty about the reliability of the electronic
payments network, there is a sudden surge in the demand for currency by households. As
a result, households withdraw a total of $250m from their bank accounts.
(a) Show the effect that this has on the balance sheets of the commercial banks and the
central bank.
Commercial banks
Assets ($m) Liabilities ($m)
Reserves -250 Deposits -250
Central Bank
Assets ($m) Liabilities ($m)
Bank reserves -250
Currency +250
(b) If the central bank took no offsetting action, what effect might this have on the level of
interest rates.
Interest rates would rise. This situation is essentially the same as in our earlier theoretical
analysis of what happens in a simple economy when there is an increase in the demand for
money and the money supply is fixed.
Now that we have introduced commercial banks into the analysis we can identify two
mechanisms that would push up the level of interest rates in this situation. First, since banks are
now short of desired reserves, they will compete harder in the interbank borrowing/lending
market for a share of the available reserves. Banks will be more reluctant to lend in this market
and willing to pay more to borrow. Second, banks would compete harder to attract deposits, as
this would be a way for individual banks to rebuild reserves. Higher interest rates on deposits
would in turn help to attract some of the lost deposits back into the system, since the
opportunity cost of holding currency would go up.
(c) What action can the central bank take to offset this effect?
If the central bank didn’t want interest rates to rise they could use open market operations to
restore the level of bank reserves to its original level. They could do this by buying securities
from the banks. This is illustrated below (the effects of the securities transactions are shown in
brackets):
Commercial banks
Assets ($m) Liabilities ($m)
Reserves -250 (+250 )= 0 Deposits -250
Securities (-250)
, Central Bank
Assets ($m) Liabilities ($m)
Securities (+250) Bank reserves -250 (+ 250) = 0
Currency +250
2. Suppose that the government decides to borrow $15bn in order to prepare for a possible
large increase in its future spending. It issues bonds of that value which are then
purchased by commercial banks. For the time being, the government leaves these funds
on deposit with the central bank.
(a) Show the effect of this action on the balance sheets of the central bank and the
commercial banks. Hence, what is the effect on the monetary base?
Central Bank
Assets ($b) Liabilities ($b)
Bank reserves -15
Government deposits +15
Commercial banks
Assets ($b) Liabilities ($b)
Securities +15
Reserves -15
The assets of the central bank are unchanged. Government deposits at the CB will increase by $15bn
as a result of the sale of bonds. Bank reserves fall because the banks have to make payments of that
amount into the government’s deposit account at the CB.
(b) What is the effect on the broad money supply?
Direct effect: There is no direct effect on the broad money supply because the investors who are
buying the bonds are banks. Bank reserves are not a component of broad money and there is no
direct transaction involving bank depositors.
Indirect effect: The reduction in bank reserves is likely to result in a contraction in bank lending and
hence deposits of the commercial banks. That is, the reverse of the deposit creation process
illustrated in lectures. The eventual effect on broad money would be a multiple of the original $15bn
given by the money multiplier.
(c) If the government now spends the $15bn by making stimulus payments into household
bank accounts, show how this affects the balance sheets of the central bank and the
commercial banks.
Answer guide
1. Suppose that, as a result of increased uncertainty about the reliability of the electronic
payments network, there is a sudden surge in the demand for currency by households. As
a result, households withdraw a total of $250m from their bank accounts.
(a) Show the effect that this has on the balance sheets of the commercial banks and the
central bank.
Commercial banks
Assets ($m) Liabilities ($m)
Reserves -250 Deposits -250
Central Bank
Assets ($m) Liabilities ($m)
Bank reserves -250
Currency +250
(b) If the central bank took no offsetting action, what effect might this have on the level of
interest rates.
Interest rates would rise. This situation is essentially the same as in our earlier theoretical
analysis of what happens in a simple economy when there is an increase in the demand for
money and the money supply is fixed.
Now that we have introduced commercial banks into the analysis we can identify two
mechanisms that would push up the level of interest rates in this situation. First, since banks are
now short of desired reserves, they will compete harder in the interbank borrowing/lending
market for a share of the available reserves. Banks will be more reluctant to lend in this market
and willing to pay more to borrow. Second, banks would compete harder to attract deposits, as
this would be a way for individual banks to rebuild reserves. Higher interest rates on deposits
would in turn help to attract some of the lost deposits back into the system, since the
opportunity cost of holding currency would go up.
(c) What action can the central bank take to offset this effect?
If the central bank didn’t want interest rates to rise they could use open market operations to
restore the level of bank reserves to its original level. They could do this by buying securities
from the banks. This is illustrated below (the effects of the securities transactions are shown in
brackets):
Commercial banks
Assets ($m) Liabilities ($m)
Reserves -250 (+250 )= 0 Deposits -250
Securities (-250)
, Central Bank
Assets ($m) Liabilities ($m)
Securities (+250) Bank reserves -250 (+ 250) = 0
Currency +250
2. Suppose that the government decides to borrow $15bn in order to prepare for a possible
large increase in its future spending. It issues bonds of that value which are then
purchased by commercial banks. For the time being, the government leaves these funds
on deposit with the central bank.
(a) Show the effect of this action on the balance sheets of the central bank and the
commercial banks. Hence, what is the effect on the monetary base?
Central Bank
Assets ($b) Liabilities ($b)
Bank reserves -15
Government deposits +15
Commercial banks
Assets ($b) Liabilities ($b)
Securities +15
Reserves -15
The assets of the central bank are unchanged. Government deposits at the CB will increase by $15bn
as a result of the sale of bonds. Bank reserves fall because the banks have to make payments of that
amount into the government’s deposit account at the CB.
(b) What is the effect on the broad money supply?
Direct effect: There is no direct effect on the broad money supply because the investors who are
buying the bonds are banks. Bank reserves are not a component of broad money and there is no
direct transaction involving bank depositors.
Indirect effect: The reduction in bank reserves is likely to result in a contraction in bank lending and
hence deposits of the commercial banks. That is, the reverse of the deposit creation process
illustrated in lectures. The eventual effect on broad money would be a multiple of the original $15bn
given by the money multiplier.
(c) If the government now spends the $15bn by making stimulus payments into household
bank accounts, show how this affects the balance sheets of the central bank and the
commercial banks.
