Chapter 5--Money and Banking

Question 1

What are the three functions of money?

Answer 1

1) A medium of exchange
2) A store of value
3) A unit-of-account (that is, a useful measure for accounting purposes and displaying prices)

Question 2

What are the two types of money?

Answer 2

1) Fiat money, which has no intrinsic value. It’s status comes from the power of the state.
2) Commodity money, which is an intrinsically valuable good itself

Question 3

What is the M1 definition of the money supply?

Answer 3

M1: narrowly defined as currency, traveler’s checks, demand deposits, and other checkable deposits. The most common definition.

Question 4

What is the M2 definition of the money supply?

Answer 4

M2: broadly defined as everything in M1, plus savings deposits, small time deposits, money markets mutual funds, and other minor categories.

Question 5

How do commercial banks create the money supply?

Answer 5

By using a fractional-reserve banking system, in which it is assumed that normal ebb and flow of deposit accounts will not equal 100%, so the cash in the deposit accounts can be loaned out, rather than held in reserve.

Since money supply is defined as the sum of checkable deposits and money in circulation, checkable deposits that are borrowed against and put into other checkable deposits multiply the money supply.

Question 6

What is the reserve-deposit ratio?

Answer 6

The percentage of deposits that should be held in reserve by a bank for normal operations. Set by the Federal Reserve.

Question 7

How does the Federal Reserve alter the money supply?

Answer 7

1) Open market operations: By selling and purchasing government securities, which changes the amount of money in circulation (decreases and increases, respectively), changing bank reserves (most common method)
2) By changing the desired reserve-deposit ratio (increase in ratio decreases money supply, and vice versa)
3) Changing the discount rate (interest rate) the Federal Reserve charges banks for overnight loans. These loans are borrowed from the Federal Reserve when banks do not have enough reserves to meet reserve requirements. Increase in this rate discourages borrowing, which decreases the reserves in the banking system, and the money supply, and vice versa.

Question 8

How are the value of money and the price level related?

Answer 8

Inversely–as the price level increase, the value of money decreases.
If the Federal Reserve increases the monetary supply, it causes inflation, decreasing the value of money.
If the Federal Reserve decreases the monetary supply,it causes deflation, increasing the value of money