Question

In the tables that follow, you will find consolidated balance sheets for the commercial banking system and the 12 Federal Reserve Banks. Use columns 1 through 3 to indicate how the balance sheets will read after each transaction a to c is completed. Do not cumulate your answers; that is, analyze each transaction separately, starting in each case from the numbers provided. All accounts are in billions of dollars.

	\(	Consolidated Balance Sheet: All commercial banks
1	2	3
Assets Reserve Securities Loans	33 60 60 150 3
Liabilities and net worth: Checkable deposits Loans from federal reserve banks

	\)	Consolidated Balance Sheet: The 12 Federal Reserve Banks
1	2	3
Assets Securities Loans to commercial banks	60 03 33
Liabilities and net worth: Reserves of commercial bank
Treasury deposits Federal reserve notes	3 27

a. A decline in the discount rate prompts commercial banks to borrow an additional \(1 billion from the Federal Reserve Banks. Show the new balance-sheet numbers in column 1 of each table.

b. The Federal Reserve Banks sell \)3 billion in securities to members of the public, who pay for the bonds with checks. Show the new balance-sheet numbers in column 2 of each table.

c. The Federal Reserve Banks buy $2 billion of securities from commercial banks. Show the new balance-sheet numbers in column 3 of each table.

d. Now review each of the previous three transactions, asking yourself these three questions: (1) What change, if any, took place in the money supply as a direct and immediate result of each transaction? (2) What increase or decrease in the commercial banks' reserves took place in each transaction? (3) Assuming a reserve ratio of 20 percent, what change in the money-creating potential of the commercial banking system occurred as a result of each transaction?

Short answer

The answers for a, b, and c can be obtained from the following table by referring to columns 1, 2, and, 3 respectively.

Assets	$	Consolidated Balance Sheet: The 12 Federal Reserve Banks
1	2	3
Reserve Securities Loans	33 60 60 150 3	34 60 60 150 4	36 60 60 153 3	33 58 60 150 1
Liabilities and net worth: Checkable deposits Loans from federal reserve banks

	$	Consolidated Balance Sheet: The 12 Federal Reserve Banks
1	2	3
Assets Securities Loans to commercial banks	60 03 33	60 04 34	57 03 33	62 03 35
Liabilities and net worth: Reserves of commercial bank
Treasury deposits Federal reserve notes	3 27	3 27	0 27	3 27

(d)

1. The money supply in the US economy increased.

2. The reserves of commercial banks became $34 billion, $36 billion, and then remained unchanged to $33 billion due to first, second, and third transactions respectively.

3. For 20% of the reserve

The new reserve of commercial banks due to the first transaction is $31.6 billion.

The new reserve of commercial banks due to the second transaction is $33.6 billion.

The reserves of commercial banks remain unchanged due to the third transaction, $30.6 billion.

Step-by-step solution

Step 1. The decline in the discount rate and changes in the balance sheet

The commercial bank borrows an additional $1 billion from the federal reserve banks due to a decline in the discount rate.

	$	Consolidated Balance Sheet: All commercial banks
1	2	3
Assets Reserve Securities Loans	33 60 60 150 3	34 60 60 150 4
Liabilities and net worth: Checkable deposits Loans from federal reserve banks

	$	Consolidated Balance Sheet: The 12 Federal Reserve Banks
1	2	3
Assets Securities Loans to commercial banks	60 03 33	60 04 34
Liabilities and net worth: Reserves of commercial bank
Treasury deposits Federal reserve notes	3 27	3 27

Thus, in the balance sheet of commercial banks, there is an increase in assets and liabilities & net worth as reserves change from $33 billion to $34 billion and loans from federal reserve banks rise from $3 billion to $4 billion, respectively.

Similarly, in the balance sheet of Federal Reserve Banks, there is an increase in assets and liabilities & net worth as loans to commercial bank changes from $3 billion to $4 billion and reserves of commercial bank changes from $3 billion to $4 billion, $33 billion to $34 billion, respectively.

Step 2. New balance sheet due to selling of securities worth $3 billion

For the commercial banks, the new balance sheet will show $36 billion in reserve and $153 billion

as checkable deposits.

This is shown in the following balance sheet.

	$	Consolidated Balance Sheet: All commercial banks
1	2	3
Assets Reserve Securities Loans	33 60 60 150 3		36 60 60 153 3
Liabilities and net worth: Checkable deposits Loans from federal reserve banks

The new balance sheet will show $57 billion as the securities and $0 billion as treasury deposits for the Federal Reserve Banks.

This is shown in the following balance sheet.

	$	Consolidated Balance Sheet: The 12 Federal Reserve Banks
1	2	3
Assets Securities Loans to commercial banks	60 03 33		57 03 33
Liabilities and net worth: Reserves of commercial bank
Treasury deposits Federal reserve notes	3 27		0 27

New balance sheet due to selling of securities worth $2 billion

The loans from federal reserve banks, thereby liabilities and net worth, will decline, and the securities will fall if commercial banks sell securities to federal reserve banks.

The new balance sheet will show $58 billion as securities and $1 as loans from Federal Reserve banks in the balance sheet below.

Assets	$	Consolidated Balance Sheet: All commercial banks
Reserve Securities Loans	33 60 60 150 3			33 58 60 150 1
Liabilities and net worth: Checkable deposits Loans from federal reserve banks

While the new balance sheet of Federal Reserve banks will show a net change in securities from $60billion to $ 62 billion and commercial bank reserves from $33 billion to $35 billion.

This is shown below.

	$	Consolidated Balance Sheet: The 12 Federal Reserve Banks
1	2	3
Assets Securities Loans to commercial banks	60 03 33			62 03 35
Liabilities and net worth: Reserves of commercial bank
Treasury deposits Federal reserve notes	3 27			3 27

Step 4. Effects of transactions

Part (1)

Due to borrowing of $1 billion by commercial banks, the money supply in the US economy increased by exactly $1 billion.

Part (2)

The reserves of commercial banks increased to $34 billion and $36 billion when there was a borrowing of worth $1 billion and selling of securities of $3 billion by the federal reserve banks, respectively. At the same time, commercial banks' reserves remained unchanged to $33 billion due to the selling of securities by commercial banks.

Part (3)

The net asset of commercial banks is $153 billion. For 20% of the reserve,

$$\begin{gathered} =\frac{20}{100}\times 153 \\ =30.6 \end{gathered}$$

The reserve is worth $30.6 billion.

For the borrowing of $1 billion, the reserve will be $31.6 billion

Due to the sale of securities of $3 billion, the commercial bank reserve will be $33.6 billion.

And due to the selling of securities of $2 billion by the commercial banks, the reserve will remain unchanged to $30.6 billion.