Money and Banking

Question 1

What are the four functions of money?

Answer 1

1. Medium of exchange - instead of a barter system you exchange money
2. Store of value - the money will hold value into the future
3. Unit of account - gives a value to trade-offs
4. Standard of deferred payment - it will be accepted in the future to pay off purchases made today

Question 2

What is a commodity-backed currency?

Answer 2

Currencies with values backed by gold, silver, or other commodity physically held at a bank

Question 3

What is fiat money?

Answer 3

Fiat money has no intrinsic value. It is not backed by anything other than the universal faith and trust that the currency has value backed by legal decree from the government

Question 4

What are the two definitions of money supply?

Answer 4

M1 - very liquid - cash, checks, cashiers checks, coins, and currency in circulation

M2 - not very liquid, you can withdraw them to spend but require effort to get - money in savings accounts, CD’s, money market funds

Question 5

On a bank’s balance sheet, how does the T-account breakdown?

Answer 5

Left - Assets which is comprised of the current outstanding loans given, US government securities given, and the reserves on hand

Right - Liabilities and Net Worth
Liabilities = deposits made by customers
Net Worth = Assets - Liabilities

Question 6

How does a bank go bankrupt?

Answer 6

Defaults on loans lowers the overall assets on the balance sheet leading to a negative net worth.

In other words, people don’t pay their loans and the bank has no way to repay the deposits made by its customers

Question 7

What is the main driving factor of a bank going bankrupt, and what is a common term used to express this?

Answer 7

Asset-Liability Time Mismatch - a banks liabilities (customers deposits) can be withdrawn in the short term while the assets (loans to others) are repaid in the long run

commonly known as a bank run

Question 8

What is the main goal behind bank diversity in markets, what impact does the diversity have on overall net worth, and what is the major dark cloud over the banking industry?

Answer 8

Banks will diversify their loans across all markets with varying repayment schedules to fight the asset-liability time mismatch.

The diversity in markets helps keep a positive net worth when specific industries face economic trouble and defaults.

The major dark cloud over the banking industry is a widespread macroeconomic recession

Question 9

What is a money multiplier and what is the formula?

Answer 9

The money multiplier tells us how many times a loan will be multiplied and spent in the economy

money multiplier = 1 / reserve requirement

Question 10

What is a reserve requirement?

Answer 10

The percentage of money required to be on hand at a bank compared to overall deposits

Question 11

What is the two part structure to the federal reserve?

Answer 11

1 - Centralized - board of governors

2 - Decentralized - 12 reserve banks

Question 12

What is the federal open market comity, who makes up the fmoc, and what is its main function?

Answer 12

It brings together the board of governors and the 12 reserve banks into a comity that meets 8 times a year

It is made up of 12 voting members; the entire 7 board of governors, and 5 annually rotating presidents from the 12 reserve banks

Their main function is to analyze economic conditions and vote on monetary policies based on these conditions

Question 13

What is the board of governors, and who makes up the board of governors?

Answer 13

The board of governors oversees the entire federal reserve system.

It is made up of presidential electives who serve a 14-year term

Question 14

What are the three tools of the central bank’s monetary policies?

Answer 14

Open market operations - buying/selling treasury bonds

Changing reserve requirements

Changing the discount rate

Question 15

What is an open market operation?

Answer 15

When the central bank buys or sells US treasury bonds influencing the overall bank reserves at the current interest rate

Question 16

How does changing the reserve requirements affect money supply?

Answer 16

If the fed raises reserve requirements then banks will have less money to lend out

If the fed lowers reserve requirements then banks will have more money to lend

Question 17

What is the discount rate, and how does it affect the money supply and interest rates?

Answer 17

The discount rate is the interest rate that banks pay when they borrow money from the Federal Reserve

When the fed raises the discount rate, banks will reduce borrowing from the fed, reduce overall lending, leading to a decrease in the money supply and an increase in interest rates.

When the fed lowers the discount rate, banks will increase borrowing, increase overall lending, leading to an increase in money and a decrease in interest rates

Question 18

What is a loose/expansionary monetary policy?

What is a tight/contractionary policy?

Answer 18

A policy that lowers interest rates and stimulates borrowing

A policy that raises rates and reduces borrowing

Question 19

What happens to supply curves and demand curves of the financial market when there are changes in monetary policies?

Answer 19

With an expansionary policy the fed will lower the rate, causing a supply shift to the right, and a movement down along the demand curve to the higher quantity.

With a contractionary policy the fed will raise rates, causing a supply shift to the left, and a movement upwards along the demand curve to a lower quantity

Question 20

What two factors of aggregate demand are affected with contractionary and expansionary monetary policies?

Answer 20

First, consumer spending will increase/decrease depending on the direction of interest rates

Second, business investments will follow the demand of consumer spending

Question 21

If a country is producing over potential GDP and the market is seeing overwhelming inflationary pressures what type of monetary policy would be enacted, and what would happen to the AD curve, SRAS curve, and the overall price and money of the economy?

Answer 21

A contractionary monetary policy would be enacted. The fed would decrease the money supply in order to decrease consumer spending and make borrowing less attractive.

The SRAS curve would shift to the left and a movement up the AD curve to a higher equilibrium price and money supply

Question 22

What is the velocity of money and what is the formula?

Answer 22

How quickly money circulates through an economy

Velocity = Nominal GDP / Money Supply