Money Creation, Banks and the Federal Reserve
Homework Assignment:
1.
What are the three functions of money? Give an example for each.
Medium of exchange; buying goods at the mall
Unit of account; comparing prices at the mall
Store of value; saving, not going to the mall
2.
How do we measure the money supply?
M1; currency, traveler’s checks, demand deposits, other checkable deposits
M2; M1 plus savings deposits, small time deposits, money market mutual funds
M3, M2 plus large time deposits, repurchase agreements, Eurodollars, and
institution only money market mutual fund balances
3.
What are financial intermediaries? Why are they important?
Financial intermediaries transfer funds from savers to borrowers. They include:
banks, insurance companies, mutual funds finance companies, and investment
banks.
Financial intermediaries are important because they make the saving and lending
process more efficient. Financial intermediaries are a very important source of
financing for corporations.
4.
What is meant by the term “fractional reserve banking?”
A fraction of every dollar that is deposited in a checking account in the United
States must be held as required reserves at the Federal Reserve. The banks are
permitted to make loans with the rest.
5.
Why do banks hold required reserves? What about excess reserves?
Banks hold required reserves because they are required to by law. Banks hold
excess reserves as an insurance against unexpected deposit outflows.
6.
You take $100 you had kept under your pillow and deposit it in your bank
account. If this $100 stays in the banking system as reserves and if banks hold
reserves equal to 10 percent of deposits, by how much does the total amount of
deposits in the banking system increase? By how much does the money supply
increase? Why?
The $100 is a deposit on which the bank must hold required reserves of $10 (10%
of $100). The remaining $90 may be loaned out. The multiplier in this case is
1/0.10 = 10 so the maximum amount of deposits that can be created is $90 x 10 =
$900. The assumes that there are no currency drains and that banks do not hold
excess reserves.
8.
Assume that the banking system has total reserves of $100 billion. Assume also
that required reserves are 10 percent of checking deposits, and that banks hold
no excess reserves and households hold no currency.
a.
What is the numerical value of the money multiplier?
b.
The money multiplier is 10.
If the Fed raises required reserves to 20 percent of deposits, what is the
new money multiplier, the change in reserves, and the change in the
money supply.
The new money multiplier is 5.
9.
The economy of Country A contains 2,000 $1 bills.
a.
If people hold all money as currency, what is the quantity of money?
$2000
b.
If people hold all money as demand deposits and banks maintain 100
percent reserves, what is the quantity of money?
$2000
c.
If people hold equal amounts of currency and demand deposits and banks
maintain 100 percent reserves, what is the quantity of money?
$2000.
d.
If people hold all money as demand deposits and banks maintain a reserve
ratio of 10 percent, what is the quantity of money?
$18,000
e.
If people hold equal amounts of currency and demand deposits and banks
maintain a reserve ratio of 10 percent, what is the quantity of money?
Currency = $1000, bank deposits = $1000. The bank must hold $100 as
required reserves and may lend the rest. Change in deposits = $900 x 10 =
$9000. The total money supply equals currency plus deposits or $10,000.
10.
Suppose that the T-account for First National Bank is as follows:
Assets
Reserves
Loans
a.
b.
Liabilities
$100,000
$400,000
Deposits
$500,000
If the Fed requires banks to hold 5 percent of deposits as reserves, how
much in excess reserves does First National hold? Required reserves =
$25000 so excess reserves = $100,000 - $25,000 = $75,000.
Assume that all other banks hold only the required amount of reserves. If
First national decides to loan out its excess reserves, by how much would
the economy’s money supply increase? The multiplier is 1/0.05 = 20 so
the money supply would increase by $1,500,000.
11.
What is the Federal Reserve? What is its most important function?
The Federal Reserve is the central bank of the United States. It’s most important
function is the conduct of monetary policy.
12.
How is the Federal Reserve structured? What is the Federal Open Market
Committee (FOMC)? What does it do? Who is a member?
The Federal Reserve is comprised of twelve district banks and a Board of
Governors in Washington, D.C. The FOMC is comprised of the Board of
Governors and 5 District Bank presidents. The members of the FOMC meet
every 6 weeks and determine monetary policy.
13.
What are the tools used by the Federal Reserve to implement monetary policy?
a.
If the Fed wants to increase (decrease) the rate of growth in the money
supply with open market operations, what does it do?
It buys bonds on the open market when it wants to increase the rate of
growth in the money supply and sells bonds on the open market when it
wants to decrease the money supply.
b.
What is the discount rate? What happens to the money supply when the
Fed raises (lowers) the discount rate?
The discount rate is the interest rate the Fed charges banks when the banks
borrow from the Fed. If the Fed lowers the rate, banks may borrow more.
In this case, bank reserves will rise and the money supply will increase. If
the Fed raises the rate, banks may borrow less. In this case, bank reserves
will not rise and the money supply will grow more slowly.
c.
What are reserve requirements? What happens to the money supply when
the Fed raises (lowers) reserve requirements?
Banks are required by law to hold a fraction of every demand deposit in an
account at the Fed. If the Fed raises reserve requirements, banks have
fewer excess reserves and the money supply contracts. If the Fed lowers
reserve requirements, banks have more excess reserves the money supply
increases.
14.
Explain how expansionary (contractionary) open market operations lead to an
increase (a decrease) in GDP.
When the Fed buys on the open market (expansionary), excess bank reserves
increase. As the banks make loans, new deposits are created, and the growth rate
of the money supply rises.
When the Fed sells on the open market (contractionary), excess bank reserves
decrease. As the banks make fewer loans, fewer new deposits are created, and the
growth rate of the money supply decreases.
15.
What is meant by the expression “Inflation is always and everywhere a
monetary phenomenon.”
As the money supply increases, it stimulates aggregate demand for goods and
services. At some point, full employment of resources is reached and at that point
further stimulus results in rising prices only. The economy is not able to produce
more goods and services because all resources are employed. We, however, still
demand more goods and services an in doing so bid up prices. A rising price
level is the definition of inflation.