Money Creation, Banks and the Federal Reserve Homework Assignment: 1.

What are the three functions of money !ive an e"am#le for each$ Medium of exchange; buying goods at the mall Unit of account; comparing prices at the mall Store of value; saving, not going to the mall How do we measure the money su##ly M1; currency, travelers chec s, demand deposits, other chec able deposits M2; M1 plus savings deposits, small time deposits, money mar et mutual funds M!, M2 plus large time deposits, repurchase agreements, "urodollars, and institution only money mar et mutual fund balances What are financial intermediaries Why are they im#ortant #inancial intermediaries transfer funds from savers to borro$ers. %hey include& ban s, insurance companies, mutual funds finance companies, and investment ban s. #inancial intermediaries are important because they ma e the saving and lending process more efficient. #inancial intermediaries are a very important source of financing for corporations. What is meant %y the term &fractional reserve %anking ' ( fraction of every dollar that is deposited in a chec ing account in the United States must be held as re)uired reserves at the #ederal *eserve. %he ban s are permitted to ma e loans $ith the rest. Why do %anks hold re(uired reserves What a%out e"cess reserves ,an s hold re)uired reserves because they are re)uired to by la$. ,an s hold excess reserves as an insurance against unexpected deposit outflo$s. )ou take *+,, you had ke#t under your #illow and de#osit it in your %ank account$ -f this *+,, stays in the %anking system as reserves and if %anks hold reserves e(ual to +, #ercent of de#osits, %y how much does the total amount of de#osits in the %anking system increase By how much does the money su##ly increase Why %he .1// is a deposit on $hich the ban must hold re)uired reserves of .1/ 01/1 of .1//2. %he remaining .3/ may be loaned out. %he multiplier in this case is 14/.1/ 5 1/ so the maximum amount of deposits that can be created is .3/ x 1/ 5 .3//. %he assumes that there are no currency drains and that ban s do not hold excess reserves. Assume that the %anking system has total reserves of *+,, %illion$ Assume also that re(uired reserves are +, #ercent of checking de#osits, and that %anks hold no e"cess reserves and households hold no currency$ a. 7hat is the numerical value of the money multiplier8

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%he money multiplier is 1/. 9f the #ed raises re)uired reserves to 2/ percent of deposits, $hat is the ne$ money multiplier, the change in reserves, and the change in the money supply. %he ne$ money multiplier is +.

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.he economy of Country A contains /,,,, *+ %ills$ a. 9f people hold all money as currency, $hat is the )uantity of money8 .2/// b. 9f people hold all money as demand deposits and ban s maintain 1// percent reserves, $hat is the )uantity of money8 .2/// c. 9f people hold e)ual amounts of currency and demand deposits and ban s maintain 1// percent reserves, $hat is the )uantity of money8 .2///. d. 9f people hold all money as demand deposits and ban s maintain a reserve ratio of 1/ percent, $hat is the )uantity of money8 .16,/// e. 9f people hold e)ual amounts of currency and demand deposits and ban s maintain a reserve ratio of 1/ percent, $hat is the )uantity of money8 :urrency 5 .1///, ban deposits 5 .1///. %he ban must hold .1// as re)uired reserves and may lend the rest. :hange in deposits 5 .3// x 1/ 5 .3///. %he total money supply e)uals currency plus deposits or .1/,///. 0u##ose that the .1account for First 2ational Bank is as follows: Assets *eserves <oans a. b. .1//,/// .'//,/// 3ia%ilities ;eposits .+//,///

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9f the #ed re)uires ban s to hold + percent of deposits as reserves, ho$ much in excess reserves does #irst =ational hold8 *e)uired reserves 5 .2+/// so excess reserves 5 .1//,/// > .2+,/// 5 .?+,///. (ssume that all other ban s hold only the re)uired amount of reserves. 9f #irst national decides to loan out its excess reserves, by ho$ much $ould the economys money supply increase8 %he multiplier is 14/./+ 5 2/ so the money supply $ould increase by .1,+//,///.

11.

What is the Federal Reserve What is its most im#ortant function %he #ederal *eserve is the central ban of the United States. 9ts most important function is the conduct of monetary policy. How is the Federal Reserve structured What is the Federal 4#en Market Committee 5F4MC6 What does it do Who is a mem%er

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%he #ederal *eserve is comprised of t$elve district ban s and a ,oard of @overnors in 7ashington, ;.:. %he #AM: is comprised of the ,oard of @overnors and + ;istrict ,an presidents. %he members of the #AM: meet every - $ee s and determine monetary policy. 1!. What are the tools used %y the Federal Reserve to im#lement monetary #olicy a. 9f the #ed $ants to increase 0decrease2 the rate of gro$th in the money supply $ith open mar et operations, $hat does it do8 9t buys bonds on the open mar et $hen it $ants to increase the rate of gro$th in the money supply and sells bonds on the open mar et $hen it $ants to decrease the money supply. b. 7hat is the discount rate8 7hat happens to the money supply $hen the #ed raises 0lo$ers2 the discount rate8 %he discount rate is the interest rate the #ed charges ban s $hen the ban s borro$ from the #ed. 9f the #ed lo$ers the rate, ban s may borro$ more. 9n this case, ban reserves $ill rise and the money supply $ill increase. 9f the #ed raises the rate, ban s may borro$ less. 9n this case, ban reserves $ill not rise and the money supply $ill gro$ more slo$ly. c. 7hat are reserve re)uirements8 7hat happens to the money supply $hen the #ed raises 0lo$ers2 reserve re)uirements8 ,an s are re)uired by la$ to hold a fraction of every demand deposit in an account at the #ed. 9f the #ed raises reserve re)uirements, ban s have fe$er excess reserves and the money supply contracts. 9f the #ed lo$ers reserve re)uirements, ban s have more excess reserves the money supply increases. 7"#lain how e"#ansionary 5contractionary6 o#en market o#erations lead to an increase 5a decrease6 in !89$ 7hen the #ed buys on the open mar et 0expansionary2, excess ban reserves increase. (s the ban s ma e loans, ne$ deposits are created, and the gro$th rate of the money supply rises. 7hen the #ed sells on the open mar et 0contractionary2, excess ban reserves decrease. (s the ban s ma e fe$er loans, fe$er ne$ deposits are created, and the gro$th rate of the money supply decreases. What is meant %y the e"#ression &-nflation is always and everywhere a monetary #henomenon$' (s the money supply increases, it stimulates aggregate demand for goods and services. (t some point, full employment of resources is reached and at that point further stimulus results in rising prices only. %he economy is not able to produce more goods and services because all resources are employed. 7e, ho$ever, still demand more goods and services an in doing so bid up prices. ( rising price level is the definition of inflation.

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