Question

4. The money supply contraction process

Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 20%. Raphael, a client of First Main Street Bank, purchases $1,500,000 of Treasury bills in an open market sale undertaken by the Fed. Upon receipt of Raphael's check, the Fed subtracts $1,500,000 from First Main Street Bank’s Federal Reserve account, thereby extinguishing the money.

Complete the following table to reflect any changes in First Main Street Bank's balance sheet (before the bank makes any new loans).

First Main Street Bank's Balance Sheet
Assets		Liabilities
(Building and furniture, checkable deposits, loans, net worth, reserves)	($1,500,000, -$1,500,000, $30,000,0000, -$30,000,000)	(Building and furniture, checkable deposits, loans, net worth, reserves)	($1,500,000, -$1,500,000, $30,000,0000, -$30,000,000)

Because the required reserve ratio is 20%, the $1,500,000 withdrawal ( decreases, increases) First Main Street Bank's required reserves by ( $600,000,$300,000, $1,500,000) . In order to maintain the required reserve ratio, First Main Street Bank now must (increase, decrease) its reserves by ($1,200,000,$0, $900,000, $1,500,000) . One possible way to do this is to (increase, decrease)  its outstanding loans.

Now suppose Megan repays her loan of $1,200,000 to First Main Street Bank by writing a check issued by Second Republic Bank. First Main Street Bank uses funds from a loan repayment to increase its reserves instead of making new loans. Second Republic Bank then replenishes its reserves by using the funds from loan repayments by Larry, who writes a check issued by Third Fidelity Bank. Third Fidelity Bank then uses a loan repayment from Susan to replenish its reserves instead of making new loans.

Fill in the following table to show the effect of this ongoing chain of events at each of the banks, including the initial withdrawal at the beginning of the question. Enter each answer to the nearest dollar.

Bank	Decrease in Checkable Deposits	Decrease in Required Reserves	Decrease in Loans
	(Dollars)	(Dollars)	(Dollars)
First Main Street Bank
Second Republic Bank
Third Fidelity Bank

Assume this process continues, with each successive loan being repaid using a checking account and banks using repayments to replenish their reserves without issuing any new loans. Under these assumptions, the initial destruction of $1,500,000 by the Fed results in an overall decrease of ( $750,000, $300,000, $6,000,000, $7,500,000) in checkable deposits.

Answer 1

(1) After the open market sale:

Assets	$	Liabilities	$
Reserves	-1,500,000	Checkable deposits	-1,500,000

(2) Because the required reserve ratio is 20%, the $1,500,000 withdrawal decreases First Main Street Bank's required reserves by $300,000 (= $1,500,000 x 20%). In order to maintain the required reserve ratio, First Main Street Bank now must increase its reserves by $1,500,000 (= Decrease in reserves = Decrease in checkable deposits). One possible way to do this is to decrease its outstanding loans.

(3) After initial withdrawal:

(5) Initial destruction of $1,500,000 by the Fed results in an overall decrease of $7,500,000 (= $1,500,000 / 0.2) in checkable deposits.