#4 The Monetary System

Question 1

Money

Answer 1

Stock of assets (something that is worth something) that can be readily used to make transactions

Question 2

Money functions

Answer 2

1. Medium of exchange (used to buy stuff)
2. Store of value (transfers purchasing power from present to future)
3. Unit of account (common unit by which everyone measures prices/values)

Question 3

Money types

Answer 3

1. Fiat money —> no intrinsic value, paper currency
2. Commodity money —> has intrinsic value, Gold, cigarettes

Question 4

Money supply

Answer 4

Quantity of money available in the economy

Question 5

Monetary policy

Answer 5

Control over money supply

It’s conducted by central bank (FED)

Question 6

Open market operations

Answer 6

To control money supply, Fed uses purchases and sale of government bonds

Question 7

Money supply measures

Answer 7

C - currency

M1 - currency + demand deposits + travelers checks + other checkable deposits

M2 - M1 + retail monetary market mutual fund balances + saving deposits + {……}

Question 8

Money supply =

Answer 8

Currency + demand (checking account deposits)

M = C + D

Question 9

Reserved
R

Answer 9

Portion of deposits that banks haven’t lent

Question 10

100% reserve banking

Answer 10

Banks hold all deposits as reserves

No impact on money supply

Question 11

Fractional reserve banking

Answer 11

Banks hold fraction of deposits as reserves

Creates money, not wealth —- loan = debt

Question 12

Total money supply =

Answer 12

( 1 / rr ) 1000$

rr —> ratio of reserves to deposits

Question 13

Bank capital

Answer 13

Resources bank’s owners have put into the bank

Difference between banks assets and liabilities

Question 14

Leverage

Answer 14

Use of borrowed money to supplement existing funds for purposes of investment

Question 15

Leverage ratio

Answer 15

Assets / Capital

Question 16

What being highly leveraged does to banks?

Answer 16

Makes them vulnerable

Question 17

Capital requirement

Answer 17

1. Main amount of capital mandated by regulators
2. Intended to {…..} that banks will be able to pay off depositors
3. {…..}

Question 18

A model of money supply

Exogenous variables

Answer 18

1. Monetary base,
   B = C + R,
   controlled by central bank
2. Reserve-Deposit ratio,
   rr = R / D,
   depends on regulations, bank policies
3. Currency-Deposit ratio,
   cr = C / D,
   depends on households, preferences

Question 19

M =?

Answer 19

M = mB

m = cr + 1 / cr + rr

Question 20

M = cr + 1 / cr + rr

Answer 20

• if rr < 1, then m > 1
• if mon.base changes by 🔺B, then 🔺M = m🔺B
• m is the money multiplier, the increase in the money supply, resulting from a 1$ increase in monetary base

Question 21

Money multiplier
m

Answer 21

The increase in the money supply, resulting from a 1$ increase in monetary base

Question 22

The Fed can change monetary base by using

Answer 22

• open market operations
~» To increase the base, Fed buying gov.bonds with new $

• the discount rate - interest rate Fed charges on loans to banks
~» To increase the base, Fed could lower the discount rate, encouraging banks to borrow more reserves

Question 23

The Fed can change the Reserve-Deposit ratio by using

Answer 23

• Reserve requirements Fed regulations impose a minimum Reserve-Deposit ratio
~» to reduce reserved ratio, could reduce reserve requirements

• Interest on reserves Fed pays interest on bank reserves deposited with the Fed
~» to reduce reserved ratio, could lower interest rate on reserves

Question 24

Excess reserves

Answer 24

Reserves above the reserve requirement banks hold often

m = mB

m = cr + 1 / cr + rr

Question 25

Households can change…

Answer 25

cr, causing m and M to change

Question 26

Banks changing…

Answer 26

Excess reserves causing rr, m and M change