Chapter 29

Question 1

What money is and why it’s important

Answer 1

• without money, trade would require barter, the exchange of one good or service for another.
• problem: every transaction would require a double coincidence of wants -the unlikely occurrence that two people each have a good the other wants.
• most people would have to spend a lot of time searching for others to trade with - that is a huge waste of resources!
• this searching is unnecessary with money, which is an asset that people regularly use to buy goods and services from other people -> if you can buy stuff with a few slips of paper, you don’t need to spend hours to satisfy the “double coincidence of wants.

Question 2

Money has three functions what are they?

Answer 2

• Medium of exchange: an item buyers give to sellers when they want to purchase goods and services.
o we use money to pay for the stuff we buy. o money is unique - typically, sellers will not accept any of our other assets in payment for the stuff they sell.
• new alternative - Bitcoin.
o or maybe not? obstacle: the network effect. o unanswered question: does “cash money” have a future?

Question 3

What’s unit of account

Answer 3

• Unit of account: the yardstick people use to post prices and record debts.
o in the U.S., everything is measured in dollars. o what would happen if every store had its own way of measuring prices?
• Price Chopper sells one gallon of milk for 3 globules.
• Wegmans sells one gallon of milk for 5 tribbles.
• how would that work? What is the price of a gallon of milk?

Question 4

What’s store of value

Answer 4

• Store of value: an item people can use to transfer purchasing power from the present to the future.
o you don’t have to spend all your dollars when you get
them.
o you can hold them to spend later and they will buy roughly the same amount of stuff (after inflation!)

Question 5

What’s commodity money?

Answer 5

Commodity money -> something that has value beyond being a medium of exchange.
Examples: gold coins, cigarettes in POW camps, shells in Pacific islands.

Question 6

What’s fiat money?

Answer 6

Fiat money -> money without intrinsic value. Accepted as money by government decree.
Example: the U.S. dollar - the dollar is worth $1, not because it has any value, but because the US government says it is.

Question 7

What’s the money supply

Answer 7

• the money supply (or money stock): the quantity of money available in the economy
• what assets should be considered part of the money supply? Two candidates:
• currency: the paper bills and coins in the hands of the public > that is, not banks

Question 8

What are demand deposits?

Answer 8

Balances in bank accounts that depositors can access on demand by writing a check

Question 9

What is a central bank

Answer 9

• Central bank: an institution that oversees the banking system and regulates the money supply (through its monetary policy).
• Every country has one. o UK: Bank of England o Mexico: Banco de Mexico
• Germany: Deutsche Bundesbank
• Federal Reserve (the Fed): the central bank of the U.S.

Question 10

The Structure of the Fed

Answer 10

The Structure of the Fed - the US’s Central Bank
The Federal Reserve System consists of:
• Board of Governors (7 members), located in Washington, DC
• 12 regional Fed banks, located around the U.S.
• Federal Open Market Committee (FOMC), includes the Board of Governors and presidents of some of the regional Fed banks.
The FOMC decides monetary policy.

Question 11

What is one way the Fed can set monetary policy through the bank reserve system

Answer 11

One way the Fed can set monetary policy is through the bank reserve system
• in a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest to make loans.
• the Fed establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits.
• banks may hold more than this minimum amount if they choose.
• the reserve ratio, R
= fraction of deposits that banks hold as reserves = total reserves as a percentage of total deposits

Question 12

What is the money multiplier

Answer 12

The Money Multiplier
• Money multiplier: the amount of money the banking system generates for every dollar of reserves.
• the money multiplier equals 1/R.
• in our example,
• R= 10%
• money multiplier = 1/R = 10
• $100 of reserves creates $1,000 of money

Question 13

Bank balance sheet

Answer 13

• Assets: besides reserves and loans, banks also hold securities.
• Liabilities: besides deposits, banks also obtain funds from issuing debt and equity.
• Bank capital: the resources a bank obtains by issuing equity to its owners (can be calculated as bank assets minus bank liabilities
• Leverage: the use of borrowed funds to supplement existing funds for investment purposes

Question 14

What’s capital requirement?

Answer 14

A government regulation that specifies a minimum amount of capital, intended to ensure banks will be able to pay off depositors and debts

Question 15

Leverage and the financial crisis

Answer 15

Leverage and the Financial Crisis
• in the financial crisis of 2008-2009, banks suffered losses on mortgage loans and mortgage-backed securities due to widespread defaults.
• many banks became insolvent: In the U.S.: o 27 banks failed during 2000-2007. o 166 during 2008-2009
o the federal government had to step in and bail out depositors.
• many other banks found themselves with too little capital.
o they responded by reducing lending o this caused a credit crunch.

Question 16

What is the govs response to the crunch

Answer 16

° to ease the credit crunch, the Federal Reserve and US Treasury injected hundreds of billions of dollars’ worth of capital into the banking system.
• this unusual policy temporàrily made U.S. taxpayers part-owners of many banks.
•the policy succeeded in recapitalizing the banking system and helped restore lending to normal levels in 2009.
o it also helped ease the crisis and make it shorter than it would have been without government intervention

Question 17

The Fed’s Tools of Monetary Control

Answer 17

• recall that money supply = money multiplier × bank reserves
o and that money multiplier = 1/R
•the Fed can change the money supply by changing:
o bank reserves, or o the money multiplier.

Question 18

The Fed can influence reserves (and interest rates) by buying and selling gov’t bonds

Answer 18

• Open-Market Operations (OMOs): the purchase and sale of
U.S. government bonds by the Fed.
o if the Fed buys a goveriment bond from a bank, it pays for the bond by depositing new reserves in that bank’s reserve account.
o it injects cash (money) into the system -> M1 increases o with more reserves, the bank can make more loans, increasing the money supply.

Question 19

The Fed can simply alter the Reserve Ratio

Answer 19

• recall: reserve ratio = reserves/deposits o this inversely affects the money multiplier > as the reserve ratio increases, the money multiplier decreases.
• the Fed sets reserve requirements: regulations on the minimum amount of reserves banks must hold against deposits.

Question 20

The Fed can also simply alter the Reserve Ratio

Answer 20

•reducing the reserve requirement lowers the reserve ratio and increases the money multiplier.
• in plain English, if the Fed reduces the reserve requirement, banks don’t have to hold as much of their assets in reserve.
•and so, they can loan out more money!

Question 21

The Fed can also influence reserves by making loans to banks

Answer 21

•the Fed can make loans to banks, increasing their reserves. o traditional method: adjusting the discount rate-the interest rate on loans the Fed makes to banks to influence the amount banks borrow.
o the lower the rate, the more banks will borrow. o the more banks borrow, the more reserves they have for funding new loans and increasing the money supply.

Question 22

What are the problems of controlling the Money supply

Answer 22

• if households hold more of their money as currency:
o banks have fewer reserves, o banks make fewer loans, and o money supply falls.
• if banks hold more reserves than required, they make fewer loans, and money supply falls.
• the Fed is pretty good at predicting household and bank behavior and so can fairly precisely control the money supply.

Question 23

Bank Runs and the Money Supply

Answer 23

• a run on banks: When people suspect their banks are in trouble, they may “run” to the bank to withdraw their funds, holding more currency and less deposits.
• under fractional-reserve banking, banks don’t keep enough cash to pay off ALL depositors, hence banks may have to close.
• as a strategy against this, if banks perceive they are at risk of a bank run, they may:
o make fewer loans, and
o hold more reserves to satisfy depositors.
• these events:
o increase R,
oreverse the process of money creation, and o cause money supply to fall.

Question 24

The Federal Funds Rate

Answer 24

• on any given day, banks with insufficient reserves can borrow from banks with excess reserves.
• the interest rate on these loans is the federal funds rate.
• the federal funds rate is the rates that commercial banks charge each other for short term loans.
• the FOMC uses OMOs to target the fed funds rate.
• changes in the fed funds rate cause changes in other rates and have a big impact on the economy.
© 2023 by Ken Bulko