Fabozzi Solutions Manual
Chapter 7
Central Banks
7.1
The primary role of a central bank is to maintain the stability of the currency and money supply
for a country or a group of countries.
7.2
A central bank should be independent of the government so that decisions of the central bank
will not be influenced for short-term political purposes, such as pursuing a monetary policy to
expand the economy but at the expense of inflation.
7.3
The Federal Open Market Committee decides on the general issues of changing the rate of
growth in the money supply by open market sales or purchase of securities. The trading desk of
the Federal Reserve Bank of New York implements policy through open market operations. The
desk transacts, in large volume, with large securities firms or commercial banks that are dealers,
or market makers, in Treasury securities. A bank borrowing from the Fed is said to use the
discount window, and these loans are backed by the bank’s collateral. The rate of interest on
these loans is the discount rate, set at a certain level by the Fed’s Board of Governors.
7.4
The Board of Governors consists of seven members who are appointed by the president and
approved by the Congress. These governors have 14-year appointments (with one appointment
ending every two years), and one governor is the board’s chair, a position of great influence on
the world economy.
7.5
a) This means that a bank must hold or “reserve” some portion of the funds that savers
deposit in a form approved by the Fed. Because of this, a bank may lend to borrowers
only a fraction of what it takes in as deposits.
b) A bank has excess reserves if its reserves amount to more than the Fed requires. A bank’s
total reserves equal its required reserves plus any excess reserves.
7.6
The ratio of mandatory reserves to deposits that banks must have is the required reserve ratio. In
the Depository Institutions Deregulation and Monetary Control Act of 1980, Congress assumed
much of the responsibility of setting that ratio, establishing new rules requiring all depository
institutions to apply it, including commercial banks, thrifts of various types, and credit unions.
The Act forced the Fed from then on to set required reserve ratios for different accounts to an
amount within a set range of allowed percentages and only under certain conditions.
7.7
A bank must maintain the required reserves as either currency on hand (that is, cash in the bank)
or deposits in the Federal Reserve itself.
7.8
a) The Fed’s most powerful instrument is its authority to conduct open market operations,
which means that the Fed may buy and sell, in open debt markets, government securities
for its own account.
b) The Federal Open Market Committee decides on open market policy and the trading desk
of the Federal Reserve Bank of New York implements the policy.
c) The immediate effect is a change in the amount of reserves in the banking system.
7.9
In a repurchase agreement, the Fed buys a particular amount of securities from a seller that
agrees to repurchase the same number of securities for a higher price at some future time, usually
a few weeks. In a matched sale, the Fed sells securities and makes a commitment to buy them
back at a higher price later.
7.10
The discount rate is the interest rate on loans to banks who borrow from the Fed. The rate is set
by the Fed’s Board of Governors.
7.11
Monetary base is defined as currency in circulation (or coins and Federal Reserve notes held by
the public) plus the total reserves in the banking system. M1 measures the amount of the medium
of exchange in the economy. M2 is defined as M1 plus all dollars held in time and savings
accounts at banks and thrift institutions, plus all dollars invested in retail money market mutual
funds, plus some additional accounts.
7.12
The money multiplier is determined by the complex interactions between the Fed, banks, savers,
and borrowers. The Fed sets reserve requirements for banks. Banks then choose to hold onto
reserves from the deposited money at or above the minimum reserve requirement, the remainder
of which is loaned out at a rate which exceeds that of demand deposits. For any one bank, the
remainder equals deposits less required reserves, which can be expressed as deposits times
(1− required reserve ratio). The borrower can also affect the money multiplier by holding wealth
through cash rather than deposits, in which case the deposit would require a set reserve
requirement.
7.13
Given the assumptions, a $100 million injection would increase M1 by a maximum of $1 billion
with a money multiplier of 10.
7.14
The money multiplier in this case is 3.57. This multiplier is reduced because households and
banks do not deposit or lend, respectively, all that they can, and these drains from the money
creation process reduce the multiplier effect of any increase in reserves.
7.15
Three widely accepted goals of monetary policy are stability in prices, high employment, and
economic growth.
7.16
The Fed’s policy necessarily represents trade-offs among its various goals, which have different
levels of relative importance at different times, depending on the state of the economy. In other
words, the Fed, like any monetary policymaker, has numerous goals, but at any given time, it
focuses on the goal that is most in danger of not being achieved.
7.17
The Fed can set discount rates, but it cannot force banks to accept loans. Total reserves cannot be
controlled because depository institutions determine the demand for loans, which can not be
completely influenced by different discount rates.
7.18
The Fed cannot be certain how much impact any change in reserves will have on short-term
rates. Without knowledge of what the rate will be for a given change in reserves, the Fed cannot
simultaneously determine both the rate and the level of reserves.
7.19
Using monetary policy to stabilize the economy may lead to increased inflation which can
accelerate if left unchecked.
7.20
The Fed can impact the level of activity in the stock market in a number of ways. When the Fed
changes interest rates, the stock market is immediately and directly affected. The Fed can also
impact the stock market indirectly by increasing the money supply, which can lead to increased
investment and higher stock prices. While the Fed’s goals are not directly related to the stock
market, stock market performance is an important component of systematic risk to the banking
system and is monitored alongside several related economic factors.