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Question-7 [13 marks] [6 marks] The tables below show the T-accounts for the SBP and the...

Question-7 [13 marks]

  1. [6 marks] The tables below show the T-accounts for the SBP and the entire private banking sector of Pakistan. Assume no one holds currency, and all purchases are made via debit cards or checks. Private banks do not hold excess reserves.

State Bank of Pakistan

ASSETS

LIABILITIES

Bonds Rs.15 million

Reserves Rs.15 million

Private Banking System

ASSETS

LIABILITIES

Reserves Rs. 15 mill

Bonds Rs. 32.5 mill

Loans Rs.12.5 mill

Demand Deposits Rs.60 million

  1. The State Bank makes an open market purchase of Rs.5 million worth of government bonds from the banking system. Show how this impacts the t-accounts before the banking system adjusts to the required reserve level. The State Bank T-account has been done for you.[3]
  2. Bank

ASSETS

LIABILITIES

Bonds 15 mill

+Rs.5 mill

Reserves 15 mill

+Rs.5 mill

= Rs. 20 mill

=Rs. 20 mill

Private banking sector

ASSETS

LIABILITIES

Reserves Rs.15 mill

Demand Deposits Rs. 60 mill

Bonds Rs.32.5 mill

Loans Rs.12.5

  1. After the Open Market Operations in part (a), does the banking system have excess reserves or insufficient reserves? [1]
  2. How much do total deposits increase by in the private banking sector? How much do loans increase by? [2]
  1. What is the new supply of money after the OMO and what would happen to the equilibrium market interest rate, ceteris paribus? [2]
  1. [7 marks]
  1. Consider the loanable funds market. The government runs a budget deficit and people simultaneously start to save more in light of COVID-19. What happens to the equilibrium interest rate and quantity? Show your answer with a diagram. List any assumptions you make. [3]
  2. What happens to this diagram when the government decides to finance its deficit by borrowing in the loanable funds market? Show the new equilibrium and repercussions on the real economy. [4]

Homework Answers

Answer #1

A)

B) Banking system has excess reserve as they have additional funds to lend as loans or to invest in bonds

C) reserve requirement ratio=15/60=0.25 or 25%

Increase in deposit=5/0.25=20 million

Increase in loans =5/0.25 -5=20-5=15 million

D) Money supply= curreny+ deposit

Initial Money supply=0+60=60 million

New deposit=60+20=80 million

New money supply=80 million.

Increase in money supply will lead to surplus of money at initial equilibrium interest rate, so as a result of Surplus , equilibrium interest rate will fall.

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