Ch 27

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© 2013 Pearson
The Monetary System
27
CHECKPOINTS
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Checkpoint 27.1
Problem 1
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Checkpoint 27.2
Problem 1
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Checkpoint 27.3
Problem 1
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Problem 2
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Problem 2
Problem 2
Problem 3
Problem 3
Problem 3
In the news
Problem 4
Problem 4
In the news
In the news
© 2013 Pearson
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Checkpoint 27.4
Problem 1
Problem 2
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Problem 3
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In the news
© 2013 Pearson
CHECKPOINT 27.1
Practice Problem 1
In the United States today, money includes which of the
following items?
Your Visa card
The quarters inside vending machines
U.S. dollar bills in your wallet
The check that you have just written to pay for your rent
The loan you took out last August to pay for your school
fees
© 2013 Pearson
CHECKPOINT 27.1
Solution
Money is defined as means of payment.
Only the quarters inside vending machines and U.S.
dollar bills in your wallet are money.
© 2013 Pearson
CHECKPOINT 27.1
Study Plan Problem
In the United States today, money includes
___________.
A. Your Visa card, the quarters inside vending machines,
and the U.S. dollar bills in your wallet.
B. The U.S. dollar bills in your wallet and your Visa card,
but not quarters inside vending machines.
C. The quarters inside public phones, the U.S. dollar bills
in your wallet, the check you wrote to pay the rent,
and the loan you took out to cover the school fees.
D. The U.S. dollar bills in your wallet and the quarters
inside vending machines, but not your Visa card.
© 2013 Pearson
CHECKPOINT 27.1
Practice Problem 2
In January 2011,
• Currency held by individuals and businesses was $920
billion
• Traveler’s checks were $5 billion
• Checkable deposits owned by individuals and businesses
were $926 billion
• Savings deposits were $5,378 billion
• Small time deposits were $905 billion
• Money market funds and other deposits were $705
billion.
Calculate M1 and M2 in January 2011.
© 2013 Pearson
CHECKPOINT 27.1
Solution
M1 is the sum of
Currency held by individuals and businesses, $920
billion,
Traveler’s checks, $5 billion, and
Checkable deposits owned by individuals and
businesses, $926 billion.
M1 = ($920 + $5 + $926 ) billion = $1,851 billion.
© 2013 Pearson
CHECKPOINT 27.1
M2 is the sum of
• M1, $1,851
• Savings deposits, $5,378 billion
• Small time deposits, $905 billion
• Money market funds and other deposits, $705 billion
M2 = ($1,851 + $5,378 + $905 + $705) billion
M2 = $8,839 billion.
© 2013 Pearson
CHECKPOINT 27.1
Practice Problem 3
In August 2011,
• M1 was $2,108 billion
• M2 was $9,545 billion
• Checkable deposits owned by individuals and businesses
were $1,127 billion
• Time deposits were $810 billion
• Money market funds and other deposits were $716 billion.
Calculate currency and traveler’s checks held by individuals
and businesses and calculate savings deposits.
© 2013 Pearson
CHECKPOINT 27.1
Solution
Currency and traveler’s checks equals M1 ($2,108 billion)
minus checkable deposits owned by individuals and
businesses ($1,127 billion).
Currency and traveler’s checks held by individuals and
businesses is $981 billion.
Saving deposits equals M2 ($9,545 billion) minus M1
($12,108 billion) minus time deposits ($810 billion) minus
money market funds and other deposits ($716 billion).
Saving deposits are $5,911 billion.
© 2013 Pearson
CHECKPOINT 27.1
In the news
The cell phone as wallet: Will the trend catch on?
In the next few years, you'll be able to pull out your cell
phone and wave it over a scanner to make a payment. The
convenience of whipping out your phone as a payment
mechanism is driving the transition.
Source: CTVNews.ca, September 24, 2011
As people use their cell phones to make payments, will
currency disappear?
How will the components of M1 change?
Will debit cards disappear?
© 2013 Pearson
CHECKPOINT 27.1
Solution
Most people will probably carry less currency, but it won’t
disappear because currency is used in the underground
economy.
Most of M1 will be checkable deposits.
Cell phones and debit cards will be perfect substitutes, so
debit cards will probably disappear.
© 2013 Pearson
CHECKPOINT 27.2
Practice Problem 1
What are the institutions that make up the U.S. banking
system?
© 2013 Pearson
CHECKPOINT 27.2
Solution
The institutions that make up the U.S. banking system are
• The Fed
• Commercial banks
• Thrift institutions
• Money market funds
© 2013 Pearson
CHECKPOINT 27.2
Study Plan Problem
The institutions that make up the U.S. banking
system are ______.
A. the Fed and money market funds
B. thrift institutions, the Fed, money market funds, and
commercial banks
C. New York Stock Exchange, the Fed, and banks
D. the New York Stock Exchange and the U.S. Treasury
E. the Fed and commercial banks
© 2013 Pearson
CHECKPOINT 27.2
Practice Problem 2
What is a bank’s balancing act?
© 2013 Pearson
CHECKPOINT 27.2
Solution
A bank makes a profit by borrowing from depositors at a
low interest rate and lending at a higher interest rate.
The bank must hold enough reserves to meet depositors’
withdrawals.
The bank’s balancing act is to balance the risk of loans
(profits for stockholders) against the security for
depositors.
© 2013 Pearson
CHECKPOINT 27.2
Study Plan Problem
What is a bank’s balancing act? A bank must
balance _______ against _____.
A. security for depositors; profit for stockholders
B. high-risk loans; lending to business and home buyers
C. lending to business and home buyers; profit for
stockholders
D. cash assets; securities
E. long-term loans; long-term deposits
© 2013 Pearson
CHECKPOINT 27.2
Practice Problem 3
A bank has the deposits and
assets set out in the table.
Calculate the bank’s
• Total deposits
• Deposits that are part of M1
• Deposits that are part of M2
The bank’s deposits and assets
$320 in checkable deposits
$896 in savings deposits
$840 in small time deposits
$990 in loans to businesses
$400 in outstanding credit card
balances
$634 in government securities
$2 in currency
$30 in its reserve account at the
Fed.
© 2013 Pearson
CHECKPOINT 27.2
Solution
The bank’s deposits and assets
$320 in checkable deposits
Total deposits are
$320 + $896 + $840 = $2,056.
$896 in savings deposits
$840 in small time deposits
$990 in loans to businesses
$400 in outstanding credit card
balances
$634 in government securities
$2 in currency
$30 in its reserve account at the
Fed.
© 2013 Pearson
CHECKPOINT 27.2
Deposits that are part of M1
are checkable deposits,
$320.
The bank’s deposits and assets
$320 in checkable deposits
$896 in savings deposits
$840 in small time deposits
$990 in loans to businesses
$400 in outstanding credit card
balances
$634 in government securities
$2 in currency
$30 in its reserve account at the
Fed.
© 2013 Pearson
CHECKPOINT 27.2
Deposits that are part of M2
are checkable deposits,
savings deposits, and small
time deposits.
Deposits that are part of M2
total $2,056.
The bank’s deposits and assets
$320 in checkable deposits
$896 in savings deposits
$840 in small time deposits
$990 in loans to businesses
$400 in outstanding credit card
balances
$634 in government securities
$2 in currency
$30 in its reserve account at the
Fed.
© 2013 Pearson
CHECKPOINT 27.2
Practice Problem 4
A bank has the deposits and
assets set out in the table.
Calculate the bank’s
• Loans
• Securities
• Reserves
The bank’s deposits and assets
$320 in checkable deposits
$896 in savings deposits
$840 in small time deposits
$990 in loans to businesses
$400 in outstanding credit card
balances
$634 in government securities
$2 in currency
$30 in its reserve account at the
Fed.
© 2013 Pearson
CHECKPOINT 27.2
Solution
Loans are loans to
businesses and outstanding
credit card balances.
Loans equal
$990 + $400 = $1,390.
The bank’s deposits and assets
$320 in checkable deposits
$896 in savings deposits
$840 in small time deposits
$990 in loans to businesses
$400 in outstanding credit card
balances
$634 in government securities
$2 in currency
$30 in its reserve account at the
Fed.
© 2013 Pearson
CHECKPOINT 27.2
Securities are $634.
The bank’s deposits and assets
$320 in checkable deposits
$896 in savings deposits
$840 in small time deposits
$990 in loans to businesses
$400 in outstanding credit card
balances
$634 in government securities
$2 in currency
$30 in its reserve account at the
Fed.
© 2013 Pearson
CHECKPOINT 27.2
The bank’s reserves are its
reserve account at the Fed
and the bank’s currency in
its vaults and ATMS.
Reserves are
$30 + $2 = $32.
The bank’s deposits and assets
$320 in checkable deposits
$896 in savings deposits
$840 in small time deposits
$990 in loans to businesses
$400 in outstanding credit card
balances
$634 in government securities
$2 in currency
$30 in its reserve account at the
Fed.
© 2013 Pearson
CHECKPOINT 27.2
In the news
Regulators close Georgia bank in 95th failure for the
year
Regulators shut down Atlanta-based Georgian Bank. On
July 24, 2009, Georgian Bank has $2 billion in assets and
$2 billion in deposits. By 29 September, 2009, Georgian
Bank had lost about $2 billion in home loans and other
assets.
Source: USA Today, September 30, 2009
Explain how Georgian Bank’s balancing act failed.
© 2013 Pearson
CHECKPOINT 27.2
Solution
In July, Georgian Bank’s $2 billion of assets (home loans
and securities) balanced its deposits of $2 billion.
The bank expected to make a profit on its assets that
exceeded the interest it paid to depositors.
The financial crisis increased the risk on all financial assets.
The bank was now holding assets that were more risky
than it had planned to hold.
© 2013 Pearson
CHECKPOINT 27.2
As people defaulted on their home loans and the value of
securities fell, the value of Georgian Bank’s assets crashed
to about minus $2 billion.
With fewer assets than deposits, regulators had no choice
other than close the bank and sell its assets and deposits.
The bank failed to balance risk against profit.
© 2013 Pearson
CHECKPOINT 27.3
Practice Problem 1
What is the Fed and what is the FOMC?
© 2013 Pearson
CHECKPOINT 27.3
Solution
The Federal Reserve (Fed) is the central bank in the
United States.
The central bank in the United States is a public
authority that provides banking services to banks and
the U.S. government and that regulates the quantity of
money and the banking system.
The FOMC is the Federal Open Market Committee.
The FOMC is the Fed’s main policy-making committee.
© 2013 Pearson
CHECKPOINT 27.3
Study Plan Problem
The Fed is _______and the FOMC is _______.
A. the U.S. central bank; the New York Federal Reserve
B. a federation of commercial banks; its management
committee
C. the U.S. central bank; the Fed’s main policy-making
committee
D. the world’s central bank; the Fed’s chairman and the
U.S. president
© 2013 Pearson
CHECKPOINT 27.3
Practice Problem 2
Who is the Fed’s chief executive?
What are the Fed’s main policy tools?
© 2013 Pearson
CHECKPOINT 27.3
Solution
The Fed’s chief executive is the Chairman of the Board
of Governors, currently Ben Bernanke.
The Fed’s main policy tools are required reserve ratios,
the discount rate, and open market operations.
© 2013 Pearson
CHECKPOINT 27.3
Study Plan Problem
What are the Fed’s main policy tools?
A. Discount rate, interest rates, and open market
operations
B. Open market operations and required reserve ratios
C. The monetary base and the discount rate
D. Required reserve ratios, discount rate, and open
market operations
E. The monetary base and open market operations
© 2013 Pearson
CHECKPOINT 27.3
Practice Problem 3
What is the monetary base?
© 2013 Pearson
CHECKPOINT 27.3
Solution
The monetary base is the sum of
• Coins
• Federal Reserve notes (dollar bills)
• Banks’ reserves at the Fed
© 2013 Pearson
CHECKPOINT 27.3
Study Plan Problem
The monetary base is ______.
A. the sum of U.S. government securities and loans made
by the Fed to commercial banks
B. excess reserves held by the commercial banks
C. the sum of gold and U.S. currency held by U.S. citizens
but not U.S. currency held foreigners
D. money held by the regional federal reserve banks
E. the sum of coins, Federal reserve notes, and banks’
reserves at the Fed
© 2013 Pearson
CHECKPOINT 27.3
Practice Problem 4
Suppose that at the end of December 2009,
• The monetary base in the United States was $700
billion.
• Federal Reserve notes were $650 billion.
• Banks’ reserves at the Fed were $20 billion.
Calculate the quantity of coins.
© 2013 Pearson
CHECKPOINT 27.3
Solution
The monetary base is the sum of coins, Federal Reserve
notes, banks’ reserves at the Fed.
Quantity of coins = Monetary base – Federal Reserve
notes – Banks’ reserves at the Fed.
At the end of December 2009, the monetary base was $700
billion, Federal Reserve notes were $650 billion, and banks’
reserves at the Fed were $20 billion.
Quantity of coins = $700 billion – $650 billion – $20 billion
= $30 billion.
© 2013 Pearson
CHECKPOINT 27.3
In the news
Risky assets: Counting to a trillion
Prior to the September 15, 2008, … the Fed held less than
$1 trillion in assets, most of which were in U.S. government
securities. By mid-December, 2008, the Fed’s balance sheet
had more than doubled to over $2.3 trillion. Much of the
increase was in mortgage-backed securities. The massive
expansion began when the Fed rolled out its lending
program—sending banks cash in exchange for risky assets.
Source: CNNMoney, September 29, 2009
What are the Fed’s policy tools and which policy tool did the
Fed use to increase its assets to $2.3 trillion in 2008?
© 2013 Pearson
CHECKPOINT 27.3
Solution
The Fed’s policy tools are the required reserve ratio,
discount rate, open market operations, and extraordinary
crisis measures.
The Fed used an extraordinary crisis measure called credit
easing.
The Fed’s lending program took banks’ own risky assets to
increase their reserve deposits at the Fed.
© 2013 Pearson
CHECKPOINT 27.4
Practice Problem 1
How do banks create new deposits by making loans?
What factors limit the amount of deposits and loans that
banks can create?
© 2013 Pearson
CHECKPOINT 27.4
Solution
Banks can make loans when they have excess
reserves—reserves in excess of those required.
When a bank makes a loan, it creates a new deposit
for the person who receives the loan.
The bank uses its excess reserves to create new
deposits.
The amount of loans that the bank can make, and
therefore the amount of new deposits that it can
create, is limited by the monetary base, the desired
reserve ratio, and the currency drain ratio.
© 2013 Pearson
CHECKPOINT 27.4
Practice Problem 2
If the Fed makes an open market sale of $1 million of
securities, who can buy the securities to the Fed?
What initial changes occur in the economy if the Fed sells
to a bank?
© 2013 Pearson
CHECKPOINT 27.4
Solution
The Fed sells securities to banks or the public, but not the
government.
The initial change is an decrease in the monetary base of
$1 million.
Ownership of the securities passes from the Fed to the
bank and the Fed’s assets decrease by $1 million.
The bank pays for the securities by decreasing its
reserves at the Fed by $1 million.
© 2013 Pearson
CHECKPOINT 27.4
The Fed’s liabilities decrease by $1 million.
The bank’s assets are the same, but their composition has
changed.
The bank has $1 million less in reserves and $1 million
more in securities.
© 2013 Pearson
CHECKPOINT 27.4
Study Plan Problem
If the Fed makes an open market purchase of $1
million of securities, who can sell the securities to the
Fed?
A.
B.
C.
D.
E.
The government or the public
Only the public
The banks or the government
The banks or the public
The banks, the public, or the government
© 2013 Pearson
CHECKPOINT 27.4
Study Plan Problem
When the Fed makes an open market purchase from a
bank, the monetary base _____. The bank’s deposit
with the Fed _____. The bank’s total assets _____,
reserves ______ and securities _____.
A. decreases; decreases; are the same; decrease;
increase
B. increases; increases; decrease; increase; decrease
C. increases; increases; increase; decrease; increase
D. increases; increases; are the same; increase;
decrease
E. decreases; decreases; decrease; decrease; increase
© 2013 Pearson
CHECKPOINT 27.4
Practice Problem 3
If the Fed makes an open market sale of $1 million of
securities, what is the process by which the quantity of
money changes?
What factors determine how much the quantity of money
changes?
© 2013 Pearson
CHECKPOINT 27.4
Solution
When the Fed sells securities to a bank, the bank’s
reserves decrease by $1 million, but its deposits do not
change, so the bank is short of reserves.
The bank calls in loans and deposits decrease by the
same amount.
The desired reserve ratio and the currency drain ratio
determine the decrease in the quantity of money.
The larger the desired reserve ratio or the currency drain
ratio, the smaller is the decrease in the quantity of money.
© 2013 Pearson
CHECKPOINT 27.4
Study Plan Problem
If the Fed makes an open market sale , the larger the
______, the smaller is the decrease in the quantity of
money.
A. open market sale or the currency drain ratio
B. currency drain ratio or smaller the desired reserve ratio
C. desired reserve ratio or the smaller the currency drain
ratio
D. open market sale or the smaller the desired reserve
ratio and the currency drain ratio
E. the desired reserve ratio or the currency drain ratio
© 2013 Pearson
CHECKPOINT 27.4
In the news
Fed doubles monetary base
During the fourth quarter of 2008, the Fed doubled the
monetary base, but the quantity of money (M2) increased by
only 5 percent.
Source: Federal Reserve
Why did the quantity of M2 not increase by much more than
5 percent?
What would have happened to the quantity of M2 if the Fed
had kept the monetary base constant?
© 2013 Pearson
CHECKPOINT 27.4
Solution
The quantity of M2 equals the money multiplier,
(1 + C/D) divided by (R/D + C/D), multiplied by the
monetary base.
(R/D is the banks’ desired reserve ratio and C/D is the
currency drain ratio).
The quantity of M2 didn’t increase by more because the
banks increased their desired reserve ratio, R/D, which
decreased the money multiplier.
If the Fed had not increased the monetary base, the
quantity of M2 would have decreased because the money
multiplier decreased.
© 2013 Pearson
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