An increase in the price level increases the nominal demand for money but the quantity of real money demanded is independent of the price level.. An increase in the nominal interest rate
Trang 1A n s w e r s t o t h e R e v i e w Q u i z z e s
Page 222 (page 630 in Economics)
1 What makes something money? What functions does money perform? Why do you think packs of chewing gum don’t serve as money?
Money is anything that is generally acceptable as a means of payment Money has three functions: medium of exchange (money is accepted in exchange for goods and services), unit of account (prices are quoted in terms of money), and store of value (money can be held and exchanged for goods and services later) Packs of chewing gum do not function as money because they are not particularly good as
a store of value—gum deteriorates Additionally, packs of gum are not generally accepted in exchange for goods and services, so packs of gum are not a medium
of exchange
2 What are the problems that arise when a commodity is used as money?
Commodities are not used as money because of several problems Many
commodities are bulky And many commodities change in value over time Using
as money a commodity that changes in value would be awkward Prices would change simply because the commodity’s value changed Additionally, using a commodity as money has a higher opportunity cost than do currency and bank deposits because the commodity has alternative uses that must be foregone
3 What are the main components of money in the United States today?
The main components of money in the United States today are currency and deposits at banks and other depository institutions
4 What are the official measures of money? Are all the measures really money?
The official measures of money are M1 (the sum of currency, traveler’s checks, and checking deposits owned by individuals and businesses) and M2 (the sum of M1, savings deposits, time deposits, and money market mutual funds and other
deposits) All of the components of M1 are truly money because all the
components serve as a means of payment Some of the components of M2 are not truly money because they are not a means of payment (For instance, funds at money market mutual funds cannot be used as a means of payment for small purchases.) But all of these “non-money” assets are highly liquid so they are operationally similar to money
135
Trang 21 3 6
5 Why are checks and credit cards not money?
Checks and credit cards are not money because they are not a means of payment
A check is an order to transfer a deposit from one person to another The deposits are money but the checks are not A credit card is an ID card that lets a person take out a loan at the instant he or she buys something The loan still needs to be repaid with money so the credit card is not a means of payment, that is, it is not money
Page 226 (page 634 in Economics)
1 What are depository institutions?
Depository institutions are financial firms that take deposits from households and firms They then make loans available to other households and firms
2 What are the functions of depository institutions?
Depository institutions have four major economic functions: They create liquidity, pool risk, lower the cost of borrowing, and lower the cost of monitoring borrowers
3 How do depository institutions balance risk and return?
Banks earn a higher return by using the funds they acquire from their deposits to buy higher-yielding, riskier assets such as loans But these assets are risky If the loans fail, then the bank might not have sufficient funds to repay their depositors
If the bank undertakes too much risk, then its depositors might rush to withdraw their deposits, which would cause the bank to fail But if the bank forgoes all risky assets its profit will be much lower So the bank must balance its search for higher return against the risk earning the return entails
4 How do depository institutions create liquidity, pool risks, and lower the cost
of borrowing?
Liquidity is the property of being easily convertible into a means of payment without loss in value Depository institutions create liquidity when they offer
deposits that can be withdrawn as money at short (or no) notice and then use these deposits to make long-term loans
Depository institutions pool risk because they use funds obtained from many depositors to make loans to many borrowers As a result, if a borrower defaults, no one depositor bears the entire loss because the loss is spread over all depositors
By spreading the risk, depository institutions are pooling risk
Depository institutions lower the cost of borrowing because they specialize in borrowing For instance, a firm that wants to borrow a large sum of money need only visit one depository institution to arrange such a loan In the absence of depository institutions, the firm would need to undertake many transactions with many lenders, which would be a costly process
5 How have depository institutions made innovations that have influenced the composition of money?
Checking deposits at thrift institutions such as S&L’s savings banks, and credit unions are examples of deposits that were created by innovations in the 1980s and 1990s These deposits have become an increasingly large percentage of M1 Savings deposits have decreased as a percentage of M2, while time deposits and money market mutual funds have increased, and checking deposits at commercial banks have become a decreasing percentage of M1
Page 230 (page 638 in Economics)
1 What is the central bank of the United States and what functions does it perform?
136
Trang 3The Federal Reserve System is the central bank of the United States The Federal Reserve conducts the nation’s monetary policy and regulates the nation’s
depository institutions The Fed provides banking services to commercial banks
2 What is the monetary base and how does it relate to the Fed’s balance sheet?
The monetary base is the sum of Federal Reserve notes, coins, and depository institutions’ deposits at the Fed Aside from coins, the rest of the monetary base consists of Federal Reserve liabilities Federal Reserve notes and depository
institutions’ deposits are liabilities of the Federal Reserve
3 What are the Fed’s three policy tools?
The Federal Reserve has three policy tools: required reserve ratio, last resort loans, and open market operations
4 What is the Federal Open Market Committee and what are its main functions?
The Federal Open market Committee (FOMC) is the main policy-making group within the Federal Reserve System It decides upon the nation’s monetary policy as conducted through open market operations The FOMC meets approximately once every six weeks
137
Trang 45 How does an open market operation change the monetary base?
The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Federal Reserve, that is, banks’ reserves When the Federal Reserve conducts an open market operation, it either buys securities and pays for them with newly created reserves or it sells securities and is paid with reserves held by banks In both cases the monetary base changes In the first case, when the Fed buys securities, the monetary base increases In the second case, when the Fed sells securities, the monetary base decreases
Page 232 (page 640 in Economics)
1 How do banks create money?
Banks within the banking system create money by creating deposits, which are part of the nation’s money Banks create deposits by making loans because part or all of the loans they make will be deposited in another bank For instance, a
student given a loan may purchase books at the local bookstore The bookstore will then deposit the proceeds into its bank as part of the bookstore’s checking
account Thus the loan has created new deposits at the bookstore’s bank
2 What limits the quantity of money that the banking system can create?
The quantity of money that the banking system can create is limited by: the
monetary base, desired reserves, and desired currency holdings
3 A bank manager tells you that she doesn’t create money She just lends the money that people deposit Explain why she’s wrong
Though the manager does not see the entire process, nonetheless the loans the manager makes create more deposits and more money Point out to the manager that when she makes a loan, the deposits at her bank initially increase And, when the loan is spent, the recipient selling the goods or services that have been
purchased will deposit part or all of the proceeds in his or her bank When the recipient makes this deposit, the total amount of the nation’s deposits increase and, because deposits are part of the nation’s money, the quantity of money also increases However, actions of other economic agents also affect the creation of money For example, if people decide to hold less currency and more deposits, the immediate effect on the quantity of money is nil But over time the quantity of money increases because banks gain more (excess) reserves, which are then loaned and then deposited, thereby creating additional deposits and increasing the quantity of money
Page 237 (page 645 in Economics)
1 What are the main influences on the quantity of real money that people and businesses plan to hold?
The quantity of real money demanded depends on four factors: the price level, the nominal interest rate, real GDP, and financial innovation An increase in the price level increases the nominal demand for money but the quantity of real money demanded is independent of the price level An increase in the nominal interest rate decreases the quantity of real money demanded, because the nominal
interest rate is the opportunity cost of holding money An increase in real GDP increases the demand for real money, because more real GDP implies more
transactions and an increase in the demand for money to finance the transactions And, financial innovations that make it less costly to get by with less money on hand decrease the demand for money
Trang 52 Show the effects of a change in the nominal interest rate and a change in real GDP using the demand for money curve
An increase in the nominal interest rate decreases the quantity of real money
demanded The slope of the demand for money curve shows how the quantity of
real money demanded depends on the nominal interest rate As illustrated in
Figure 8.1, a decrease in the nominal interest rate results in a movement
downward along the demand for money curve
A change in real GDP changes the demand for money An increase in real GDP
increases the demand for money and shifts the demand for curve for real money
rightward from MD0 to MD1, as shown in Figure 8.2
3 How is money market equilibrium determined in the short run?
Trang 6In the short run, the nominal interest rate adjusts to restore equilibrium to the money market When the quantity of money demanded equals the quantity
supplied, the nominal interest rate is at its equilibrium level
4 How does a change in the quantity of money change the interest rate in the short run?
In the short run an increase in the quantity of money lowers the interest rate and a decrease in the quantity of money raises the interest rate Suppose the Federal Reserve increases the quantity of money At the initial interest rate people hold more money than the quantity they demand To restore the amount of money they hold to equality with the quantity demanded, people use the surplus in the
loanable funds market to buy bonds The price of a bond rises which means that the interest rate on the bond falls When the Federal Reserve decreases the
quantity of money, the reverse occurs: At the initial interest rate people have less money than the quantity they demand so they sell bonds in the loanable funds market to acquire more money Selling bonds lowers their price which raises the interest rate
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Trang 75 How does a change in the quantity of money change the interest rate in the
long run?
In the long run a change in the quantity of money does not change the interest
rate For example, suppose the Federal Reserve increases the quantity of money
(the effects from a decrease in the quantity of money are the reverse of an
increase) In the short run the nominal interest rate and the real interest rate fall Both households and firms increase their demand for goods The resulting
shortages force prices higher and therefore the price level rises As the price level rises, the quantity of real money decreases, which raises the nominal interest rate and real interest rate The rise in the interest rate decreases the demand for
goods Eventually the price level rises so that the quantity of real money equals
the initial amount At this point, the nominal interest rate and real interest rate
have risen to equal their initial values so there is no long-run effect on the interest rate from a change in the quantity of money
Page 239 (page 647 in Economics)
1 What is the quantity theory of money?
The quantity theory of money is the proposition that in the long run an increase in the quantity of money creates an equal percentage increase in the price level
2 How is the velocity of circulation calculated?
The velocity of circulation is the average number of times a dollar of money is
used annually to buy the goods and services that make up GDP The velocity of
circulation equals (nominal) GDP divided by the quantity of money
3 What is the equation of exchange?
The equation of exchange is the formula that MV = PY, where M is the quantity of
money, V is the velocity of circulation, P is the price level, and Y is real GDP The
equation of exchange is always true by definition because the velocity of
circulation is defined as PY/M.
4 Does the quantity theory correctly predict the effects of money growth on
inflation?
The long-run historical and international evidence on the relationship between
money growth and the inflation rate support the quantity theory The data suggest
a marked tendency for nations with high money growth rates to have high inflation rates
Trang 8A n s w e r s t o t h e S t u d y P l a n P r o b l e m s a n d
A p p l i c a t i o n s
1 Money in the United States today includes which of the following items?
• Cash in Citibank’s cash machines
Money includes currency outside the banks Currency inside cash machines is not money
• U.S dollar bills in your wallet
The dollar bills inside your wallet are money
• Your Visa card
The Visa card is not money
• Your loan to pay for school fees
The loan is not money
2 In June 2013, currency held by individuals and businesses was $1,124 billion; traveler’s checks were $4 billion; checkable deposits owned by individuals and businesses were $1,042 billion; savings deposits were $6,884 billion; time deposits were $583 billion; and money market funds and other deposits were
$647 billion Calculate M1 and M2 in June 2011
M1 consists of currency and traveler’s checks plus checking deposits owned by individuals and businesses In June, 2011 M1 equaled $1,124 billion + $4 billion +
$1,042, or $2,170 billion
M2 consists of M1 plus time deposits, savings deposits, and money market mutual funds and other deposits In June, 2011 M2 equaled $2,170 + $583 billion + $6,884 billion + $647 billion, or $10,284 billion
3 Europe’s Banks Must Be Forced to Recapitalize
E.U banks must hold more capital Where private funding is not forthcoming, recapitalization must be imposed by E.U governments
Source: Financial Times, November 24, 2011
What is the “capital” referred to in the news clip? How might the requirement
to hold more capital make banks safer?
The “capital” means owners’ capital; that is, funds the owners have invested in the bank
When loans or other assets go bad, the bank incurs a loss and the bank’s capital decreases If enough losses are incurred, the bank’s capital might be totally
dissipated, in which case the bank fails because the bank has no further cushion to absorb more losses The requirement to hold more capital makes the possibility of failure less likely
4 The FOMC sells $20 million securities to Wells Fargo Enter the transactions that take place to show the changes in the following balance sheets
The first balance sheet to the right
shows the balance sheet of the
Federal Reserve Bank of New York
The Fed’s assets decrease by $20
million because the Fed now has $20
million less securities The Fed’s
liabilities also decrease by $20 million
because Wells Fargo pays for its purchases
using the reserves that it has on deposit at
the Fed
The second balance sheet to the right shows
Federal Reserve Bank of New York Assets
(millions)
Liabilities (millions) Securities
−$20
Wells Fargo reserve deposit −$20
Wells Fargo Assets (millions)
Liabilities (millions) Securities
+$20 Reserve deposit
−$20
1 0 4 C H A P T E R 8
Trang 9the balance sheet of Wells Fargo Bank Wells Fargo gains assets in the form of
securities of $20 million Simultaneously it also losses reserve deposit assets of
$20 million because it pays for the government securities using its reserve
deposits at the Fed
Trang 105 In the economy of Nocoin, bank deposits are $300 billion, bank reserves are
$15 billion of which two thirds are deposits with the central bank Households and firms hold $30 billion in bank notes There are no coins Calculate
a The monetary base and the quantity of money
The monetary base is $45 billion The monetary base is the sum of the central bank’s notes, banks’ deposits at the central bank, and coins held by households, firms, and banks There are $30 billion in notes held by households and firms, banks’ deposits at the central bank are $10 billion (2/3 of $15 billion), the banks hold other reserves of $5 billion (which are notes), and there are no coins The monetary base is $45 billion
The quantity of money is $330 billion In Nocoin, deposits are $300 billion and currency is $30 billion, so the quantity of money is $330 billion
b The banks’ desired reserve ratio and the currency drain ratio (as
percentages)
The banks’ reserve ratio is 5 percent The banks’ reserve ratio is the percent of deposits that is held as reserves In Nocoin, deposits are $300 billion and reserves are $15 billion, so the reserve ratio equals ($15 billion/$300 billion) × 100, which is
5 percent
The currency drain is 10 percent The currency drain is the ratio of currency to deposits In Nocoin, currency is $30 billion and deposits are $300 billion, so the currency drain equals ($30 billion/$300 billion) 100, which is 10 percent
6 China Cuts Banks’ Reserve Ratios
The People’s Bank of China announces it will cut the required reserve ratio
Source: Financial Times, February 19, 2012
Explain how lowering the required reserve ratio will impact banks’ money creation process
Lowering the required reserve ratio decreases banks’ desired reserves When banks’ desired reserves decrease they will make more loans so the quantity of money in China increases (The Mathematical Note shows that an decrease in the desired reserve ratio increases the money multiplier.)
7 The spreadsheet provides data about the
demand for money in Minland Columns A
and B show the demand for money schedule
when real GDP (Y0) is $10 billion and Columns
A and C show the demand for money
schedule when real GDP (Y1) is $20 billion
The quantity of money is $3 billion What is
the interest rate when real GDP is $10 billion?
Explain what happens in the money market in
the short run if real GDP increases to $20
billion
When real GDP is $10 billion, the equilibrium nominal interest rate is 6 percent because that is the interest rate that sets the quantity of money demanded equal
to $3 billion If real GDP increases to $20, the quantity of money demanded
exceeds the quantity supplied, so people want to hold more money than is
available They try to increase the amount of money held by selling bonds The prices of bonds fall, and the interest rate rises to its new equilibrium of 5 percent
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