Economic theory and practice

Economics of Government Bonds

If the Federal Reserve wishes to use an open market transaction to reduce the money supply, it must sell government bonds. To determine how many, we consider the following formula:

DD = (1/RRR) * ? Reserves

The desired change in demand deposits is $100 billion. The required reserve ratio is 5%. Therefore, we derive the following formula for the amount that the Federal Reserve needs to change reserves:

Reserves = ?DD/20

So $100 billion / 20 = $5 billion. Thus, if the Fed sells $5 billion in government bonds, the demand deposit multiplier will result in a decrease in the money supply by $100 billion.

11-9) a) if depositors become concerned about the safety of depositing institutions, they may begin to withdraw their deposits. This will reduce the money supply. Banks will see their deposits decrease and will need to call in loans to cover the shortfall.

A b) if the Fed reduces the RRR, the money supply will increase. A lower reserve requirement means that banks can lend out more of their deposits.

A c) if banks have a difficult time finding enough creditworthy borrowers, they will be unable to lend out their money. The result will be that banks hold their money, which will reduce the demand deposit creation, in effect lowering the money supply.

A d) the money supply will decrease if the Fed sells government bonds to the First National Bank.

12-3) the following reflects the amount and rate of return on the investment based the following formula:

Return = (500-P)/P

Price

Int Payment

Int Rate

As the price rises, the return on the bond diminishes. The bond that is priced today at $500 returns nothing to the holder for their time, but the bond that returns $125 over the year has a high rate of return.