Chapter 12-The Financial Sector and the Economy
THE FINANCIAL SECTOR AND THE ECONOMY
PROBLEM SET
NAME: _______________________________________ DATE: ____ / ____ / ____
Give the best answer to each of the following questions.
1. Are bond prices with fixed coupon rates (periodic payments) and interest rates inversely
related, directly related, or unrelated? Explain why.
2. What are the three main motives behind why people hold money? What is the opportunity
cost of holding large quantities of cash?
3. State whether the following is a component of only M1, only M2, both, or neither.
a. Savings deposits
b. Available credit on a credit card.
c. Checking account balance accessible by an ATM card.
d. Cash in your pocket.
4. For each of the following hypothetical reserve requirements, calculate the money multiplier.
a. 10%
b. 25%
c. 75%
d. 0%
Chapter 12-The Financial Sector and the Economy
e. 100%
5. A single bank’s balance sheet is shown below. The reserve requirement is 20%.
Assets
Reserves $20,000
Loans $60,000
Total $105,000
Liabilities and Net Worth
Checking Deposits $75,000
Net Worth $30,000
Total $105,000
a. What is the amount the bank is required to keep as reserves?
b. What are excess reserves?
c. What is the money multiplier?
d. If this were the only bank in the financial sector, and it decided not to keep any excess
reserves, how much more money would be created in the economy? (Assume that people
hold no currency.)
6. Assume the reserve requirement is 20%. Banks lend all excess reserves, people hold no cash,
and banks meet their reserve requirements. Complete the first five rounds of the money
creation process and show the totals when the money creation process is complete.
Chapter 12-The Financial Sector and the Economy
Round
Bank
Gets
Bank Keeps
Bank Loans /
Person Borrows
1
5,000
1,000
4,000
2
4,000
800
3,200
3
______
______
______
4
______
______
______
5



______
______
______
Total
______
______
______
7. What are the three functions of money?
Chapter 12-The Financial Sector and the Economy
Answers to the Problem Set
The following are the correct answers to the problem set that follows on the next two
pages, along with the learning objective associated with each question. The problem set
is designed to be photocopied directly from this book and distributed for student use.
1. (LO4)
Bond prices and interest rates are inversely related. This is because when interest
rates go up, you can earn more on new bonds that pay higher interest rate. The
only way anyone will buy the old, lower-interest rate bonds is if their price falls.
2. (LO1, LO4)
The three motives are as follows: the need to hold money for spending is called
the transactions motive, the desire to hold money for unexpected expenses is
called the precautionary motive, and the speculative motive fuels the desire to
hold cash in order to avoid a sinking financial market. The opportunity cost for
holding large amounts of cash is the interest you would have earned if you had
invested it. When interest rates go up, the opportunity cost of holding cash
increases and the quantity of money demanded decreases.
3. (LO1)
a. M2; b. Neither; c. Both; d. Both
4. (LO2)
a. 10; b. 4; c. 1.33; d. infinity; e. 1
5. (LO2)
a. $15,000; b. $5,000; c. 5; d. $25,000
6. (LO2)
The completed table should look like the one below.
Bank
Bank Loans /
Round
Gets
Bank Keeps Person Borrows
1
$5000
$1,000
$4,000
2
$4000
$800
$3,200
3
$3,200
$640
$2,560
4
$2,560
$512
$2,048
5
$2,048
$409.60
$1638.40
$5,000
$20,000
Total $25,000
7. (LO1)
The three functions of money are: it serves as a medium of exchange; it serves as
a unit of account; and it serves as a store of wealth.