Question: The reserve requirement in Montopia is 10%. Freedom Bank has deposits of $14 million and keeps its reserves as low as possible. It has a net worth of $1 million. It has 6 million in government securities and allocates the remainder (of what is not kept as reserves) to loans. Bells Largo has deposits of $4 million, a net worth of $1 million, follows the same policy with reserves, has loaned out $2.5 million, and holds the remainder of its assets as government securities.
a. Write down each bank's balance sheet.
b. Suppose the Fed purchases $1.5 million worth of securities from Freedom Bank. What does Freedom Bank's new balance sheet look like?
c. Now, suppose that Freedom Bank adjusts its loans such that it is again holding the minimum allowed amount of currency in reserves. In order to do so, it loans money to Bells Largo. Show both banks' new balance sheets.
d. Illustrate the effect of the Fed's actions in the loanable funds model. What do you expect would happen to the interest rate in the economy?
e. Use the AS/AD model to illustrate the effect that this policy will therefore have on aggregate demand. What will be the effect on prices and unemployment?