Unit 4: Money, Banking, and Monetary Policy

Problem Set #5
1. Money Banking and Financial Markets
a. Financial Assets are anything that have monetary value. Money is
anything that is generally accepted to have value. There are two types
of money, commodity money that serves a function beyond money,
but fiat money serves no function beyond being money. An example of
money is American cash, this is fiat money and while it is agreed to
have value, it can only be used to purchase goods. An example of
commodity money would be a society who uses coffee beans as
money, they agree that it has financial value, but it can also be used to
make coffee! Stocks are investments into a company or organization.
Stockowners are entitled to partial ownership of the company. Stock
are profitable in two ways; dividends are portions of the companies
profits that are distributed to stockholders, and capitol gains are
earned when stock holders sell the stock for more then they paid for
them. An example of this is a stockholder in Google, if Google wins a
lawsuit, they can distribute the money they make to their stockholders,
aka a dividend, and while Google grows, their stocks gain value, so
they could sell the stock for a greater price, meaning that they made
capitol gains. A bond is a loan that the government or a company sells
and must repay with interest, the owner of a bond has NO OWNERSHIP
of the company or government, money is only made through interest.
An example of this is an investor buying a bond from a start up
company, the company needs the bond to get off their feet, so they
promise a 20% return, in 10 years the investor can collect the money
with a 20% return. Start-ups use interest to attract investors to riskier
start-ups.
b. The value of money decreases over time. Currently it holds value at a
moderately stable rate, and allows buyers and sellers to have
confidence, this means that if today I have $50 and I could spend that
on new shoes, or I can wait until next week, and have the confidence
that my money will maintain the value. In the future however, it will
lose value due to inflation, this is expected and prepared for through
interest rates. An example of this is a bank offering a 10-year loan for
a car; they project inflation over 10 years to be 5%, so they must
charge at least 5% to protect their money, and an additional amount if
they want to make a profit.
c. The money supply is measured in three levels of liquidity. M1 is the
highest level of liquidity and is readily available to consumers. And
example of this is cash in your wallet; you can go directly to the store
and buy things with cash. M2 is medium liquidity, and partially
available, this means that you need to make a stop before making a
purchase and is not as available, an example of this is a time deposit,
you can get the money, but if you get it before the time is up, you pay
a fee, so its not completely accessible to you. M3 is the lowest liquidity

and is difficult to have access to, an example of this a time deposit

over $100k, you can go get it before the time is up, but you will be
charged a large fee, so it is not readily available for you with out going
to a bank and paying a large fee.
d. Banks create an illusion of more money through the multiplier effect.
This happens because when banks loan out money it is spent and then
re-deposited into a new bank, and a portion of that is then loaned out
again and that process is repeated creating the illusion of more money
in circulation. An example of this is Bobby takes out a loan of $4000 for
a new TV. Best Buy takes that money and deposits that into a new
bank, who then loans $2000 of it out to Sharon, who buys a couch.
Living spaces deposits that money in a new bank that loans out $1000
of it out to Garrett for house paint. As the process continues, the
money is still owed to the bank but part of it is re-loaned out. This
creates an illusion of more money.
e. The Demand for money is the amount of liquid funds required for
everyday purchases. The Demand curve for money is a downward
slope, meaning that the lower the interest rate in the bank, the more
liquid assets will be desired. This can be shifted by price level or
changes in income. An example of this is John, interest rates are .25%,
so there is no incentive for John to keep his money in the bank, so he
keeps all of his $200 available to him, but as interest rates rise to 5%,
there is now a reason to suffer the inconvenience of keeping money in
the bank. So he keeps half of his money, $100, in the bank and keeps
$100 to pay for what he needs in a week. Say price level rises, and he
needs $150 for the week, the Demand curve will shift because he
needs more money to pay for everyday goods, or his income rises to
$300, it will shift because he will keep $150 on him to buy more things
in his everyday life, because he can.
f. The money market is the supply and demand of available money in a
system. It shows that nominal interest rates and the quantity of money
have a relationship. As the quantity of money is decreased, the
interest rates increase, and visa versa. The FED manipulates the
Money Market by increasing and decreasing the money supply.
g. The loanable funds market shows the amount of loanable funds at any
given time. It shows the relationship between real interest rates and
the quantity of loanable funds. The suppliers are the lenders and the
demanders are borrowers. The shifters of the demand are change in
perceived business opportunities and changes in government
spending. Shifters of supply are changes in the private savings and
changes in foreign investment.
2. Central Bank and Control of the Money Supply
a. The tools of the Central Bank Policy are the Reserve Requirements, the
Discount Rate, and the Open Market Operations. The Reserve
requirements are the amount of money that the FED requires banks to
keep per deposit this increases the money multiplier which increases

the money supply, decreasing the interest rate, increasing investment

and shifting AD right. The Discount Rate is the interest rate that the
FED charges banks to borrow money. If they increase the interest rate
then the money supply decreases because the banks have less money
to loan out. The Open Market Operation is the buying and selling of
bonds to from the FED. When the FED sells bonds they take money out
of the money supply. Raising the money supply expands the economy
and visa versa.
b. Quantity theory of money states that there is a direct relationship
between the quantity of money in the economy and the level prices of
goods and services sold. If the amount of money in an economy
doubles, price level also doubles, causing inflation. The equation is
MV=PY, each variable denoted the following, m=supply of money,
v=the velocity of money, p=average price level, y=volume of
transactions of goods and services.
c. The difference between real and nominal interest rates is that real does
not factor in the inflation rate. And example of this is Joe got a 5% loan,
which is his nominal interest rate, how much more he will pay on his
loan. The inflation rate is 3% so his real interest rate is 2%, which is
what he really pays.
3. Practice Free Response Questions
FRQ #1:
(a) $5,000 is added
(b)(i) $4,500
(ii) $50,000
(c) This would decrease the change in the money supply because less money
is being added to the loanable funds market and crowding out the effect.
(d)This would decrease the change in the money supply because money is
removed from the banks decreasing their excess funds that they can loan
out.
FRQ #2:
(b) Buying bonds
(d) The decrease in interest rates will increase investment spending which
increases aggregate demand.
(f) (i) short run aggregate supply will eventually shift right because in a
recessionary gap people are willing to work for less money, lowering
resource prices and shifting AS right.
(ii) Output increases and price level decreases