CHAPTER 13

Money and Banking

A. Short-Answer, Essays, and Problems
1. What are the three functions that a commodity must fulfill to be useful as money? 2. Money is what money does. Explain. 3. Some go ernment bonds can be redeemed for currency or a chec! at ban!s. Why" then" isn#t it uni ersally agreed that go ernment bonds are part of the money supply? $. What is the difference between the M1 and M2 definitions of the money supply? %ew &. 'se the figures in the table below to answer the following (uestions. Small time deposits *arge time deposits Sa ing deposits" including money,mar!et deposit accounts Money,mar!et mutual funds /hec!able deposits /urrency 1a2 What is the alue of M1? 1b2 What is the alue of M2? 1c2 What is the alue of M3? +. 'se the figures in the table below to answer the following (uestions. Small time deposits *arge time deposits Sa ing deposits" including money,mar!et deposit accounts Money,mar!et mutual funds /hec!able deposits /urrency 1a2 What is the alue of M1? 1b2 What is the alue of M2? 1c2 What is the alue of M3? $ Billions 1"2+) 1"2.) 1"0&) -&) -.+ 3$) $ Billions 1)2$ 2)2+ 1-12 -.) &0&23

2).

Chapter 13 0. 'se the figures in the table below to answer the following (uestions. Small time deposits *arge time deposits Sa ing deposits" including money,mar!et deposit accounts Money,mar!et mutual funds /hec!able deposits /urrency 1a2 What is the alue of M1? 1b2 What is the alue of M2? 1c2 What is the alue of M3? -. 3ow is a commercial ban! different from a sa ings and loan association? .. 4re currency and chec!able deposits owned by the go ernment 1'.S. 5reasury2 and the 6ederal 7eser e 8an!" commercial ban!s" and other financial institutions part of the money supply? Explain. 1). Explain the difference between a money,mar!et deposit account and a money,mar!et mutual fund. %ew 11. 1/onsider 5his2 4re credit cards money? Explain. 12. Why is money considered to be debt? 13. 9iscuss three ma:or points about what gi es money its alue. %ew 1$. /omplete the following table showing the relationship between a percentage change in the price le el and the percentage change in the alue of money. /alculate the percentage change in the alue of money to one decimal place. Change in ri!e level a. rise by; -< 1+< 2$< b. fall by: -< 1+< 2$< Change in value o" money =====.===< =====.=== =====.=== =====.===< =====.=== =====.=== $ Billions 1"2&) 1"3)) 1"+2) .)& -3+ 32&

%ew 1&. 3ow do high rates of inflation affect the acceptability of a nation#s currency?

21)

Money and Banking %ew 1+. Explain what policies are used to stabili>e the alue of money. 10. What are the two reasons that people want to hold money? ?n other words" what are the two types of demand for money? 1-. Explain how the @9A and the interest rate are related to the transactions and asset demands for money. 1.. 5he total demand for money is e(ual to the transactions demand plus the asset demand for money. 1a2 4ssume that each dollar held for transactions purposes is spent on the a erage fi e times per year to buy final goods and ser ices. ?f the nominal @9A is B&))) billion 1B& trillion2" what is the transaction demand? 1b2 5he table below shows the asset demand at certain rates of interest. 'sing your answer to part 1a2" complete the table to show the total demand for money at arious rates of interest. #nterest rate %in &' 1) + $ Asset demand %billions' B $) -) 12) 1+) $otal demand %billions' B===== ===== ===== =====

1c2 ?f the money supply is B1)-) billion" what will be the e(uilibrium rate of interest? 1d2 ?f the money supply rises" will the e(uilibrium rate of interest rise or fall? 1e2 ?f @9A rises" will the e(uilibrium rate of interest rise or fall? 2). 5he total demand for money is e(ual to the transactions demand plus the asset demand for money. 1a2 4ssume that each dollar held for transactions purposes is spent on the a erage fi e times per year to buy final goods and ser ices. ?f the nominal @9A is B1)"))) billion 1B1) trillion2" what is the transaction demand? 1b2 5he table below shows the asset demand at certain rates of interest. 'sing your answer to part 1a2" complete the table to show the total demand for money at arious rates of interest. #nterest rate %in &' 1) + $ Asset demand %billions' B 3) +) .) 12) $otal demand %billions' B===== ===== ===== =====

1c2 ?f the money supply is B2")+) billion" what will be the e(uilibrium rate of interest? 1d2 ?f the money supply rises" will the e(uilibrium rate of interest rise or fall? 1e2 ?f @9A rises" will the e(uilibrium rate of interest rise or fall?

211

Chapter 13 21. 'se the table below to answer the (uestions; #nterest rate %in &' 1$ 13 12 11 Asset demand %billions' B2)) 3)) $)) &))

1a2 ?f the transactions demand for money e(uals 1)< of nominal @9A" the nominal @9A is B+))) billion" and the supply of money is B.)) billion" what is the e(uilibrium interest rate? 1b2 ?f nominal @9A remains constant" and the money supply is increased from B.)) to B1))) billion" what will the e(uilibrium rate of interest be? 22. 'se the table below to answer the (uestions; #nterest rate %in &' 1$ 13 12 11 Asset demand %billions' B2)) 3)) $)) &))

1a2 ?f the transactions demand for money e(uals 1)< of nominal @9A" the nominal @9A is B&"))) billion" and the supply of money is B.)) billion" what is the e(uilibrium interest rate? 1b2 ?f nominal @9A remains constant" and the money supply is decreased from B.)) to B-)) billion" what will the e(uilibrium rate of interest be? 23. 'se the graph below to answer the following (uestions. Dt is the transactions demand for money" Dm is the total demand for money" and Sm is the supply of money.

1a2 What is the transactions demand for money in this mar!et? 1b2 What is the asset demand for money if the interest rate is $<? 1c2 ?f the money mar!et is in e(uilibrium at +<" describe the change that must occur for the e(uilibrium rate to change to $<. 1d2 ?f the money mar!et is in e(uilibrium at +< and the money supply has increased to Sm3" by how much has total demand for money changed?

212

Money and Banking 2$. 4naly>e what would happen to the e(uilibrium rate of interest in the money mar!et if the supply of money were increased while the demand schedule remained the same. 2&. Explain how the money mar!et responds to a shortage of money or to a surplus of money. 2+. 'se the table below for the next set of (uestions. /olumn 1 shows the interest rate" column 2 shows the demand for money" and columns 3C& show the supply of money. 4ll (uantities are in millions 1B2. %(' #nterest rate 1)< + $ 2 %)' -m B1"&)) 1"-)) 2"2)) 2"&)) 2"-)) %*' Sm( B2"2)) 2"2)) 2"2)) 2"2)) 2"2)) %+' Sm) %,' Sm*

B2"&)) B1"-)) 2"&)) 1"-)) 2"&)) 1"-)) 2"&)) 1"-)) 2"&)) 1"-))

1a2 @i en the demand for money" what will the e(uilibrium interest rate be for each of the different supply of money schedules? 1b2 4ssume the economy was in e(uilibrium at 9m and Sm1. ?f the 6E9 decides to change the money supply to Sm2 and the interest rate stays the same" how much of a shortage or surplus in the money supply will there be? 9escribe what will happen in the money mar!et and the bond mar!et to eliminate the surplus or shortage and restore a new e(uilibrium interest rate. 1c2 4ssume the economy was in e(uilibrium at 9m and Sm1. ?f the 6E9 decides to change the money supply to Sm3 and the interest rate stays the same" how much of a shortage or surplus in the money supply will there be? 9escribe what will happen in this money mar!et and the bond mar!et to eliminate the surplus or shortage of money and restore a new e(uilibrium interest rate. 20. 4nswer the next two (uestions using the following information; 5he price of a bond with no expiration date is B1))) and its fixed annual interest payment is B&)D bond annual rate of interest is &<. 1a2 ?f the price of this bond decreases by B2&) to B0&)" what will its effecti e interest rate be for the new buyer? 1b2 ?f the price of this bond increases to B12))" what will its effecti e interest rate be for the new buyer? %ew 2-. Suppose that a bond ha ing no expiration date has a face alue of B&"))) and pays a fixed amount of interest of B&)) annually. /ompute and enter in the spaces pro ided the effecti e interest rate 1to one decimal place2 that a bond buyer could recei e at the new bond price. Bond ri!e B 3"0&) $"2&) &"0&) +"&)) #nterest rate %&' ==== ==== ==== ====

213

Chapter 13

2.. Suppose that a bond ha ing no expiration date has a face alue of B1)"))) and pays a fixed amount of interest of B1))) annually. /ompute and enter in the spaces pro ided either the effecti e interest rate which a bond buyer could recei e at the new price or the bond price re(uired to recei e the interest rate shown. Bond ri!e B -"))) ====== 1)"))) 12"))) ====== #nterest rate %&' ====== 11.1 ====== ====== +.+0

3). Suppose that a bond ha ing no expiration date has a face alue of B1)"))) and pays a fixed amount of interest of B1))) annually. /ompute and enter in the spaces pro ided either the effecti e interest rate which a bond buyer could recei e at the new price or the bond price re(uired to recei e the interest rate shown. Bond ri!e B====== ."))) ====== ====== 1&"))) #nterest rate %&' 12.& ====== 1).) -.3 ======

%ew 31. 9escribe the three ma:or units of the 6ederal 7eser e System and their functions. 32. Who sits on the 6ederal Epen Mar!et /ommittee and what does this committee do? 33. What are the three ma:or characteristics of the twel e 6ederal 7eser e 8an!s? 3$. 5he 6ederal 7eser e 8an!s are ban!ers# ban!s. Explain. 3&. What are the se en functions of the 6ederal 7eser e System? Which one is most important? 3+. ?s the 6ederal 7eser e an independent institution? 30. Why did the '.S. /ongress establish the 6ederal 7eser e as an independent agency? 3-. /ite fi e recent de elopments that ha e affected money and ban!ing in the 'nited States. 3.. 1*ast Word2 Why is there a large amount of '.S. currency circulating abroad? What are the economic effects on the global economy?

21$

Money and Banking

B. Answers to Short-Answer, Essays, and Problems

1. What are the three functions that a commodity must fulfill to be useful as money? 5he commodity must ser e as a medium of exchangeD it must pro ide a unit of accountD and it must act as a store of alue" that is" it must retain its worth in terms of other goods and ser ices. Ftext; E pp. 232,233D M4 pp. 232,233G 2. Money is what money does. Explain. 5his refers to the idea that money 1at least paper money and chec!s2 has no intrinsic alue. ?t is aluable only in terms of its acceptability in exchange for goods and ser ices. ?n other words" it is aluable only in terms of what it does; act as a medium of exchange" a unit of account" and a store of alue. Ftext; E pp. 232,233D M4 pp. 232, 233G 3. Some go ernment bonds can be redeemed for currency or a chec! at ban!s. Why" then" isn#t it uni ersally agreed that go ernment bonds are part of the money supply? 5he (uestion literally answers itself. 5hese assets must be exchanged for currency or a chec! 1which is money by definition2 before they are generally acceptable in exchange for goods and ser ices. While they can be exchanged for currency or a chec!" bonds are one step remo ed from being spendable as money. Ftext; E pp. 232,233D M4 pp. 232, 233G $. What is the difference between the M1 and M2 definitions of the money supply? 8oth M1 and M2 are definitions of the economy#s money supply. M1 is the definition of the money supply with the highest degree of li(uidity" the money supply used mainly for transactions purposes. M1 consists of currency 1coins and paper money2 and chec!able deposits. M2 consists of e erything in M1 plus nonchec!able sa ings deposits" small time deposits" money,mar!et deposit accounts and money,mar!et mutual fund balances. M2 is a broader" but less li(uid" definition of the money supply. ?t includes e erything in M2 plus large time deposits 1B1))"))) or more2. M2 and M3 are considered near monies because they do not function directly as a medium of exchange" but can be con erted to currency or chec!able deposits. Ftext; E pp. 233,23&D M4 pp. 233,23&G %ew &. 'se the figures in the table below to answer the following (uestions. Small time deposits *arge time deposits Sa ing deposits" including money,mar!et deposit accounts Money,mar!et mutual funds /hec!able deposits /urrency 1a2 What is the alue of M1? 1b2 What is the alue of M2? 1c2 What is the alue of M3? 1a2 B&23 H B&0- I B11)1 billion 1b2 B11)1H B1-12 H B1)2$ H B-.) I B$-20 billion 1c2 B$-20 H 2)2+ I B+-&3 billion Ftext; E pp. 233,23&D M4 pp. 233,23&G 21& $ Billions 1)2$ 2)2+ 1-12 -.) &0&23

Chapter 13 +. 'se the figures in the table below to answer the following (uestions. Small time deposits *arge time deposits Sa ing deposits" including money,mar!et deposit accounts Money,mar!et mutual funds /hec!able deposits /urrency 1a2 What is the alue of M1? 1b2 What is the alue of M2? 1c2 What is the alue of M3? 1a2 B-.+ H B3$) I B123+ billion 1b2 B123+ H B10&) H B12.) H B-&) I B&).+ billion 1c2 B&).+ H B12.) I B+3-+ billion Ftext; E pp. 233,23&D M4 pp. 233,23&G 0. 'se the figures in the table below to answer the following (uestions. Small time deposits *arge time deposits Sa ing deposits" including money,mar!et deposit accounts Money,mar!et mutual funds /hec!able deposits /urrency 1a2 What is the alue of M1? 1b2 What is the alue of M2? 1c2 What is the alue of M3? 1a2 B-3+ H B32& I B11+1 billion 1b2 B11+1 H B1+2) H B12&) H B.)& I B$.3+ billion 1c2 B$.3+ H B13)) I B+23+ billion Ftext; E pp. 233,23&D M4 pp. 233,23&G -. 3ow is a commercial ban! different from a sa ings and loan association? 4 commercial ban! differs from a sa ings and loan association primarily in the type of loans each is allowed to ma!e. Sa ings and loan associations were originally established to act as lending institutions for homebuyers. 5hus" most of their assets were mortgages. /ommercial ban!s" on the other hand" dealt with business loans and short,term consumer and installment loans. 8an!s were allowed to ha e chec!ing accounts whereas SJ*s were not. 5oday" the difference between the two institutions is blurred as SJ*s offer chec!able deposits and ma!e short,term consumer loans. 5hey still exist primarily to ma!e home mortgage loans. /ommercial ban!s are still the ma:or source of business short,term borrowed funds and offer commercial chec!ing accounts. While ban!s do ma!e some long,term home loans" they are still primarily associated with business lending and short,term consumer loans. Ftext; E p. 23$D M4 p. 23$G .. 4re currency and chec!able deposits owned by the go ernment 1'.S. 5reasury2 and the 6ederal 7eser e 8an!" commercial ban!s" and other financial institutions part of the money supply? Explain. $ Billions 1"2&) 1"3)) 1"+2) .)& -3+ 32& $ Billions 1"2+) 1"2.) 1"0&) -&) -.+ 3$)

21+

Money and Banking %o. /urrency and chec!able deposits at these institutions are not counted. ?n the case of commercial ban!s and other financial institutions" if currency from an indi idual is deposited in a chec!ing account" and both the currency and chec!able deposit were then counted as part of the money supply" then it would be double counting. So" the money supply consists only of the currency and chec!able deposits held by indi iduals or businesses at financial institutions. 5he exclusion of currency and chec!able deposits held by go ernment is more arbitrary" but permits economists to focus on the money supply in the pri ate sector of the economy. Ftext; E p. 23$D M4 p. 23$G 1). Explain the difference between a money,mar!et deposit account and a money,mar!et mutual fund. 4 money mar!et mutual fund is offered through a financial in estment company and in estors buy shares in the fund. Such funds in est in short,term 1less than one year2 credit instruments such as 5reasury bills and short,term certificates of deposit that are !nown as money,mar!et instruments. 5he money,mar!et deposit account is a type of sa ings account offered by ban!s and thrifts that pool indi idual deposits to buy a ariety of short,term securities. 5hese accounts ha e minimum balance re(uirements and limit how often money can be withdrawn. 8ecause they are ban! accounts" howe er" they are insured by the rele ant deposit insurance fund. Ftext; E p. 23&D M4 p. 23&G %ew 11. 1/onsider 5his2 4re credit cards money? Explain. /redit cards represent the ability to get an instant loan that can be exchanged for goods or ser ices. 4t some point" howe er" that loan must be paid with money 1chec!s or currency2. So credit card transactions are short,term loans that must be repaid with money. Ftext; E p. 23+D M4 p. 23+G 12. Why is money considered to be debt? 5he ma:or parts of the money supply are currency and chec!able deposits. 5hese items are debts" or promises to pay. Aaper money is the circulating debt of the 6ederal 7eser e ban!s. /hec!able deposits are debts of commercial ban!s and thrifts. %either the currency nor chec!able deposits ha e any intrinsic alue. 5hey are simply circulating paper to which people must attach alue. Ftext; E p. 23+D M4 p. 23+G 13. 9iscuss three ma:or points about what gi es money its alue. 6irst" currency and demand deposits 1M1 definition2 are considered money because these items are accepted as payment for goods and ser ices. Money must be acceptable to ser e its function as a medium of exchange. Second" the go ernment mandates through law that paper money be accepted as payment for debts. While chec!s are not mandated by law as money" go ernment agencies do bac! demand deposits at ban!s with deposit insurance that helps to maintain the acceptability of this form of money. 5hird" money is relati ely scarce. 5here is a reasonably constant demand for money for transactions purposes and future uses. 5he supply of money will determine the alue or Kpurchasing powerL of each unit of money. 5he supply of money is controlled by monetary institutions 1the 6ederal 7eser e System2 that attempt to maintain a reasonably stable purchasing power for money. Ftext; E pp. 23+,230D M4 pp. 23+,230G %ew 1$. /omplete the following table showing the relationship between a percentage change in the price le el and the percentage change in the alue of money. /alculate the percentage change in the alue of money to one decimal place.

210

Chapter 13 Change in value o" money =====.===< =====.=== =====.=== =====.===< =====.=== =====.=== Change in value o" money C0.$< C13.0< C1..$< H-.0< H1..)< H31.&<

Change in ri!e level a. rise by; -< 1+< 2$< b. fall by: -< 1+< 2$<

Change in ri!e level a. rise by; -< 1+< 2$< b. fall by: -< 1+< 2$< Ftext; E p. 230D M4 p. 230G

%ew 1&. 3ow do high rates of inflation affect the acceptability of a nation#s currency? 3igh rates of inflation reduce the purchasing power of a nation#s currency. 6rom the time the currency is recei ed to the time that it is spent" fewer goods and ser ices can be bought with that currency. 8usinesses and wor!ers may not want to hold currency that loses alue (uic!ly because of high inflation. 5hey may loo! for alternati e currencies to hold or other assets that do not lose alue. 5hese actions reduce the economic efficiency pro ided by the institution of money. ?t is also difficult for consumers to e aluate prices as a reflection of the alue of a product as the prices are changing rapidly. Ftext; E pp. 230,23-D M4 pp. 230,23-G %ew 1+. Explain what policies are used to stabili>e the alue of money. Monetary policy is used to regulate the money supply in the economy. ?f too much money is a ailable for the gi en le el of production of goods and ser ices" this situation can lead to inflation and reduce the alue of money. 6iscal policy can also be used to help maintain the alue of money. 5he '.S. go ernment needs to be prudent in its spending and taxing actions 1fiscal policy2 so that it does not reduce the alue of money by running large deficits when the economy is at full,employment. Ftext; E pp. 23-, 23.D M4 pp. 23-,23.G 10. What are the two reasons that people want to hold money? ?n other words" what are the two types of demand for money? Aeople want to hold money for transactions purposes and as a form of li(uid assets. 5hus" economists tal! about a transactions demand for money and an asset demand for money. Ftext; E pp. 23-,2$)D M4 pp. 23-,2$)G

21-

Money and Banking

1-. Explain how the @9A and the interest rate are related to the transactions and asset demands for money. 5he transactions demand for money is belie ed to ha e a direct relationship with @9A and the le el of income" but is thought to be largely independent of interest,rate fluctuations. 5he asset demand for money is belie ed to be largely independent of the le el of @9A" but is in ersely related to the interest rate. Ftext; E pp. 23-,2$)D M4 pp. 23-,2$)G 1.. 5he total demand for money is e(ual to the transactions demand plus the asset demand for money. 1a2 4ssume that each dollar held for transactions purposes is spent on the a erage fi e times per year to buy final goods and ser ices. ?f the nominal @9A is B&))) billion 1B& trillion2" what is the transaction demand? 1b2 5he table below shows the asset demand at certain rates of interest. 'sing your answer to part 1a2" complete the table to show the total demand for money at arious rates of interest. #nterest rate %in &' 1) + $ Asset demand %billions' B $) -) 12) 1+) $otal demand %billions' B===== ===== ===== =====

1c2 ?f the money supply is B1)-) billion" what will be the e(uilibrium rate of interest? 1d2 ?f the money supply rises" will the e(uilibrium rate of interest rise or fall? 1e2 ?f @9A rises" will the e(uilibrium rate of interest rise or fall? #nterest rate %in &' 1) + $ Asset demand %billions' B $) -) 12) 1+) $otal demand %billions' B1")$) 1")-) 1"12) 1"1+)

1a2 B&))) billion M & I B1))) billion 1b2 See table above. 1c2 Where money supply is e(ual to total demand at -<. 1d2 ?f the money supply increases" the rate will fall. 1e2 5he rate will rise because transactions demand" hence total demand" will rise and intersect supply at a new higher rate of interest. Ftext; E pp. 23-,2$)D M4 pp. 23-,2$)G 2). 5he total demand for money is e(ual to the transactions demand plus the asset demand for money. 1a2 4ssume that each dollar held for transactions purposes is spent on the a erage fi e times per year to buy final goods and ser ices. ?f the nominal @9A is B1)"))) billion 1B1) trillion2" what is the transaction demand? 1b2 5he table below shows the asset demand at certain rates of interest. 'sing your answer to part 1a2" complete the table to show the total demand for money at arious rates of interest.

21.

Chapter 13 #nterest rate %in &' 1) + $ Asset demand %billions' B 3) +) .) 12) $otal demand %billions' B===== ===== ===== =====

1c2 ?f the money supply is B2")+) billion" what will be the e(uilibrium rate of interest? 1d2 ?f the money supply rises" will the e(uilibrium rate of interest rise or fall? 1e2 ?f @9A rises" will the e(uilibrium rate of interest rise or fall? #nterest rate %in &' 1) + $ Asset demand %billions' B 3) +) .) 12) $otal demand %billions' B2")3) 2")+) 2").) 2"12)

1a2 B1)"))) billion M & I B2))) billion 1b2 See table above. 1c2 Where money supply is e(ual to total demand at -<. 1d2 ?f the money supply increases" the rate will fall. 1e2 5he rate will rise because transactions demand" hence total demand" will rise and intersect supply at a new higher rate of interest. Ftext; E pp. 23-,2$1D M4 pp. 23-,2$1G 21. 'se the table below to answer the (uestions; #nterest rate %in &' 1$ 13 12 11 Asset demand %billions' B2)) 3)) $)) &))

1a2 ?f the transactions demand for money e(uals 1)< of nominal @9A" the nominal @9A is B+))) billion" and the supply of money is B.)) billion" what is the e(uilibrium interest rate? 1b2 ?f nominal @9A remains constant" and the money supply is increased from B.)) to B1))) billion" what will the e(uilibrium rate of interest be? 1a2 5ransactions demand will be B+)) billion" so the asset demand must be B3)) billion because at e(uilibrium total demand e(uals supply of B.)) billion. When asset demand is B3)) billion" the interest rate is 13<. 1b2 7ate will be 12< because that is where demand I supply. Ftext; E pp. 23-,2$)D M4 pp. 23-,2$)G 22. 'se the table below to answer the (uestions; #nterest rate %in &' 1$ 13 12 11 Asset demand %billions' B2)) 3)) $)) &))

22)

Money and Banking 1a2 ?f the transactions demand for money e(uals 1)< of nominal @9A" the nominal @9A is B&"))) billion" and the supply of money is B.)) billion" what is the e(uilibrium interest rate? 1b2 ?f nominal @9A remains constant" and the money supply is decreased from B.)) to B-)) billion" what will the e(uilibrium rate of interest be? 1a2 5ransactions demand will be B&)) billion" so the asset demand must be B$)) billion because at e(uilibrium total demand e(uals supply of B.)) billion. When asset demand is B$)) billion" the interest rate is 12<. 1b2 7ate will be 13< because that is where demand I supply. Ftext; E pp. 23-,2$1D M4 pp. 23-,2$1G 23. 'se the graph below to answer the following (uestions. Dt is the transactions demand for money" Dm is the total demand for money" and Sm is the supply of money.

1a2 What is the transactions demand for money in this mar!et? 1b2 What is the asset demand for money if the interest rate is $<? 1c2 ?f the money mar!et is in e(uilibrium at +<" describe the change that must occur for the e(uilibrium rate to change to $<. 1d2 ?f the money mar!et is in e(uilibrium at +< and the money supply has increased to Sm3" by how much has total demand for money changed? 1a2 B12& 1b2 B32& C 12& I B2)) 1c2 En the abo e graph" the money supply must increase to 32&. 4lthough not indicated on the diagram" a decrease in demand could achie e the same effect assuming the supply remained at 2&)" demand would ha e to shift leftward until it intersected supply at 2&) and $<. 1d2 B0& Ftext; E pp. 23-,2$1D M4 pp. 23-,2$1G 2$. 4naly>e what would happen to the e(uilibrium rate of interest in the money mar!et if the supply of money were increased while the demand schedule remained the same. 8ecause the (uantity of money demanded is in ersely related to the interest rate" an increase in the supply of money would result in a higher e(uilibrium (uantity of money being demanded at a lower e(uilibrium rate of interest. Ftext; E pp. 23-,2$1D M4 pp. 23-,2$1G 2&. Explain how the money mar!et responds to a shortage of money or to a surplus of money. ?n the money mar!et" the demand for money and the supply of money determine the interest rate. @raphically" the demand for money is a downsloping line and the supply

221

Chapter 13 of money is a ertical line" and their intersection determines the interest rate. 9ise(uilibrium in this mar!et 1a shortage or a surplus of money2 is corrected by changes in bond prices and their in erse relationship with interest rates. ?f there is a shortage of money" bonds will be sold. 5he increase in supply of bonds will dri e down bond prices causing interest rates to rise until the shortage is eliminated. ?f there is a surplus of money" bonds will be bought. 5he increased demand for bonds will dri e up bond prices causing interest rates to fall until the surplus is eliminated. Ftext; E pp. 2$),2$1D M4 pp. 2$),2$1G 2+. 'se the table below for the next set of (uestions. /olumn 1 shows the interest rate" column 2 shows the demand for money" and columns 3C& show the supply of money. 4ll (uantities are in millions 1B2. %(' #nterest rate 1)< + $ 2 %)' -m B1"&)) 1"-)) 2"2)) 2"&)) 2"-)) %*' Sm( B2"2)) 2"2)) 2"2)) 2"2)) 2"2)) %+' Sm) %,' Sm*

B2"&)) B1"-)) 2"&)) 1"-)) 2"&)) 1"-)) 2"&)) 1"-)) 2"&)) 1"-))

1a2 @i en the demand for money" what will the e(uilibrium interest rate be for each of the different supply of money schedules? 1b2 4ssume the economy was in e(uilibrium at 9m and Sm1. ?f the 6E9 decides to change the money supply to Sm2 and the interest rate stays the same" how much of a shortage or surplus in the money supply will there be? 9escribe what will happen in the money mar!et and the bond mar!et to eliminate the surplus or shortage and restore a new e(uilibrium interest rate. 1c2 4ssume the economy was in e(uilibrium at 9m and Sm1. ?f the 6E9 decides to change the money supply to Sm3 and the interest rate stays the same" how much of a shortage or surplus in the money supply will there be? 9escribe what will happen in this money mar!et and the bond mar!et to eliminate the surplus or shortage of money and restore a new e(uilibrium interest rate. 1a2 9m and Sm1; +<D 9m and Sm2; $<D 9m and Sm3; -<. 1b2 5here will be a surplus of B3)) million. Aeople will now try to get rid of money by buying more bonds. 5he collecti e attempt to buy bonds increases the demand for bonds relati e to the supply and dri es up their price. 8ond prices will rise and interest rates will fall until a new higher e(uilibrium interest rate is established at -<. 1c2 5here will be a shortage of B3)) million. Aeople will attempt to ma!e up for this shortage by selling some of the financial assets they own such as bonds. 5he collecti e attempt to sell bonds increases their supply relati e to the demand and dri es down their price. 8ond prices will fall and interest rates will rise until a new higher e(uilibrium interest rate is established at -<. Ftext; E pp. 2$),2$1D M4 pp. 2$),2$1G 20. 4nswer the next two (uestions using the following information; 5he price of a bond with no expiration date is B1))) and its fixed annual interest payment is B&)D bond annual rate of interest is &<. 1a2 ?f the price of this bond decreases by B2&) to B0&)" what will its effecti e interest rate be for the new buyer? 1b2 ?f the price of this bond increases to B12))" what will its effecti e interest rate be for the new buyer?

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Money and Banking 1a2 B&)MB0&) I 1M1& I +.+0< 1b2 B&)MB12)) I 1M2$ I $.10< Ftext; E pp. 2$),2$1D M4 pp. 2$),2$1G %ew 2-. Suppose that a bond ha ing no expiration date has a face alue of B&"))) and pays a fixed amount of interest of B&)) annually. /ompute and enter in the spaces pro ided the effecti e interest rate 1to one decimal place2 that a bond buyer could recei e at the new bond price. Bond ri!e B 3"0&) $"2&) &"0&) +"&)) Bond ri!e B 3"0&) $"2&) &"0&) +"&)) #nterest rate %&' ==== ==== ==== ==== #nterest rate %&' 13.3 11.-.0 0.0

Ftext; E pp. 2&3,2&$D M4 pp. 2&3,2&$G 2.. Suppose that a bond ha ing no expiration date has a face alue of B1)"))) and pays a fixed amount of interest of B1))) annually. /ompute and enter in the spaces pro ided either the effecti e interest rate which a bond buyer could recei e at the new price or the bond price 1rounded to the nearest B1)))2 re(uired to recei e the interest rate shown. Bond ri!e B -"))) ====== 1)"))) 12"))) ====== Bond ri!e B -"))) ."))) 1)"))) 12"))) 1&"))) #nterest rate %&' ====== 11.1 ====== ====== +.+0 #nterest rate %&' 12.& 11.1 1).) -.3 +.+0

Ftext; E pp. 2$),2$1D M4 pp. 2$),2$1G 3). Suppose that a bond ha ing no expiration date has a face alue of B1)"))) and pays a fixed amount of interest of B1))) annually. /ompute and enter in the spaces pro ided either the effecti e interest rate which a bond buyer could recei e at the new price or the bond price 1rounded to the nearest B1)))2 re(uired to recei e the interest rate shown. Bond ri!e B====== ."))) ====== ====== 1&"))) #nterest rate %&' 12.& ====== 1).) -.3 ====== 223

Chapter 13

Bond ri!e B -"))) ."))) 1)"))) 12"))) 1&")))

#nterest rate %&' 12.& 11.1 1).) -.3 +.+0

Ftext; E pp. 2$),2$1D M4 pp. 2$),2$1G %ew 31. 9escribe the three ma:or units of the 6ederal 7eser e System and their functions. 6irst" the 6ederal 7eser e System is o erseen by the 8oard of @o ernors. 5his 8oard is responsible for control of the supply of money and the ban!ing system. 5he Aresident appoints the se en members of the 8oard. Second" Federal Open Market Committee FOMC! helps the 8oard by establishing policy o er the buying and selling of go ernment securities. 5hird" there are twel e regional 6ederal 7eser e 8an!s. 5hey ser e as central ban!s" (uasi,public ban!s" and ban!ers# ban!s. Ftext; E pp. 2$2,2$$D M4 pp. 2$2,2$$G 32. Who sits on the 6ederal Epen Mar!et /ommittee and what does this committee do? 5he 6ederal Epen Mar!et /ommittee is made up of the se en members of the 8oard of @o ernors plus fi e of the presidents of the twel e 6ederal 7eser e 8an!s 1always including the president of the %ew Nor! 6ed2. 5he other se en presidents attend meetings but do not ha e oting power. 5his committee sets monetary policy with regard to the purchase and sale of go ernment securities" a ma:or tool in regulating the supply of money in the economy. Ftext; E p. 2$3D M4 p. 2$3G 33. What are the three ma:or characteristics of the twel e 6ederal 7eser e 8an!s? 5hey act together as the central ban! of the 'nited States. 5hey are (uasi,public in that they are owned by pri ate commercial ban! members" but are controlled by the go ernment since the system was established by an act of /ongress. 6inally" they are ban!ers# ban!s because they perform essentially the same functions for depository institutions that those institutions perform for their customers. 5hat is" the 6ederal 7eser e 8an!s ma!e loans to financial institutions" !eep their reser e deposits" and pro ide them with paper money. Ftext; E pp. 2$3,2$$D M4 pp. 2$3,2$$G 3$. 5he 6ederal 7eser e 8an!s are ban!ers# ban!s. Explain. 5his means that the 6ederal 7eser e 8an!s perform essentially the same functions for ban!s as the ban!s perform for the public. Oust as ban!s and thrifts accept deposits of and ma!e loans to the public" so the 6ederal 7eser e 8an!s accept deposits and ma!e loans to ban!s and thrifts. Ftext; E p. 2$$D M4 p. 2$$G 3&. What are the se en functions of the 6ederal 7eser e System? Which one is most important? 5he se en functions are; 112 issuing currencyD 122 setting reser e re(uirements and holding re(uired reser es of ban!s and thrift institutionsD 132 lending money to ban!s and thriftsD 1$2 collecting and clearing chec!s for ban!s and thriftsD 1&2 ser ing as the fiscal agent for the '.S. go ernmentD 1+2 super ising the operation of member ban!sD

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Money and Banking and 102 controlling the money supply. /ontrolling the money supply to meet the needs of the economy is the most important function. Ftext; E p. 2$&D M4 p. 2$&G 3+. ?s the 6ederal 7eser e an independent institution? 5he 6ederal 7eser e is generally considered to be independent of control by the '.S. /ongress and the Aresident. 4lthough it was created by /ongress and can be eliminated by /ongress" any change in its role and mission will re(uire extensi e legislati e action" which is unli!ely to occur. 5he Aresident also has no direct control o er the operation of the 6ederal 7eser e" other than lobbying influence and the power to appoint members of the 8oard of @o ernors. 5hese members" howe er" are appointed to long terms ,, fourteen yearsPwhich gi es them protection from immediate political pressures. 5he long terms also reduce the possibility for any one Aresident from pac!ing the 8oard. Ftext; E p. 2$&D M4 p. 2$&G 30. Why did the '.S. /ongress establish the 6ederal 7eser e as an independent agency? 5hose who support the notion of an independent 6ederal 7eser e System argue that the 6ed should be protected from political pressures so that it can focus on the control of the money supply and the needs of the economy. Etherwise" the 6ed would often be under intense political pressure to expand the money supply to accommodate an expansionary fiscal policy of the '.S. /ongress. 4n independent 6ed is more li!ely to maintain a stable currency and shield the economy from the intense inflationary pressure created by an o erly expansionary fiscal policy. Ftext; E p. 2$&D M4 p. 2$&G 3-. /ite fi e recent de elopments that ha e affected money and ban!ing in the 'nited States. 6irst" there has been a relati e decline in the number of ban!s and thrifts. Second" there has been consolidation among ban!s and thrifts because of mergers. 5hird" the ser ices offered by financial institutions are becoming similar because of fewer legal restrictions on acti ity by type of institution. 6ourth" financial mar!ets are now more globali>ed and integrated because of ad ances in computer and communications technology. 6ifth" the character of money has changed with the shift to the use of electronic money and other forms of payment. Ftext; E pp. 2$&,2$0D M4 pp. 2$&,2$0G 3.. 1*ast Word2 Why is there a large amount of '.S. currency circulating abroad? What are the economic effects on the global economy? 5he initial reason for '.S. currency being circulated abroad was that it was used to pay for the imports of goods and ser ices purchased by 4mericans from producers abroad. 5he '.S. currency has since been circulated within other countries" especially in those countries whose currencies are not ery stable and in which inflation is high. 6or example" it is estimated that 7ussians hold about B$) billion worth of '.S. dollars. 5he exchange of goods and ser ices are often conducted in dollars inside 7ussia because 7ussians fear that when they accept the 7ussian ruble" it may lose its purchasing power. 5he fear of the loss of purchasing power also moti ates the holding of the '.S. dollar in other nations with high rates of inflation. 5he dollar is also appealing for use for both legal and illegal transactions in other nations because it holds its alue. 5hese appealing characteristics ha e increased the demand for dollars in many nations to facilitate the exchange of legal and illegal goods and ser ices. 6or the international economy" the circulation of the '.S. dollar increases exchange because it gi es people a stable form of money that ser es as a medium of exchange" a store of alue" and unit of account when domestic currencies are unstable. Ftext; E p. 2$-D M4 p. 2$-G

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