ECON 2301 Macroeconomics

Who in the United States is responsible for maintaining money's purchasing power?

Board of Governors of the Federal Reserve System EXP: The Board of Governors of the Federal Reserve System (the Fed) is responsible for managing the U.S. money supply so that money retains its purchasing power.

Which of the following would help a government reduce an inflationary output gap?

Decreasing government spending ; Raising Taxes EXP: Raising taxes and decreasing government spending are the correct answers because each of them helps to reduce aggregate demand. Consider raising taxes. When the government raises taxes, it takes money away from households and businesses. With less money to spend, households reduce consumption spending and businesses reduce investment spending. Thus, the C and I components of aggregate demand fall and the AD curve shifts left. Reductions in government spending also reduce aggregate demand by directly reducing G. By contrast, lowering taxes and increasing government spending would both increase aggregate demand and shift the AD curve to the right—something that would only increase the size of the inflationary output gap.

How does the purchasing power of money relate to the price level?

It is inversely related to the price level EXP: The purchasing power of money is inversely related to the price level.

What determines the value (domestic purchasing price) of money?

People's willingness to accept it in exchange for goods and services EXP: Paper money, which has no intrinsic value, has value only because people are willing to accept it in exchange for goods and services, including their labor services as employees. And people are willing to accept paper as money because they know that everyone else is also willing to do so. If the monetary authorities were issuing new bank notes at a rate far in excess of available output, the acceptability of paper money would diminish. People would start to worry about whether the bank notes would be worth much after they received them. Checks are part of the money supply and are not legal tender, but people accept them willingly from people believed trustworthy.

Which of the following statements is true?

There is no concrete backing to the money supply in the United States EXP: There is no concrete backing to the money supply in the United States.

True or False: In the United States, monetary policy has two key advantages over fiscal policy: (1) isolation from political pressure and (2) speed and flexibility.

True: This statement is true because U.S. monetary policy is indeed isolated from political pressure and does have notable advantages over U.S. fiscal policy in terms of speed and flexibility. Monetary policy's political isolation is provided by the Federal Reserve being a quasi-independent part of the government and by making sure that Federal Reserve governors are elected to extremely long, 14-year terms. As a result, the members of the FOMC are largely isolated from political pressures and can thus set monetary policy and interest rates in the way that is best for the economy (rather than in a way that would be best for getting current members of Congress or the president reelected). By contrast, fiscal policy is controlled entirely by Congress and the president and is therefore highly politicized. Monetary policy is also faster and more flexible than fiscal policy because the FOMC can react immediately whenever a crisis strikes whereas it can take many months for a new law regarding fiscal policy to work its way through Congress and then be signed by the president.

The economy is in a recession. A congresswoman suggests increasing spending to stimulate aggregate demand but also at the same time raising taxes to pay for the increased spending. Her suggestion to combine higher government expenditures with higher taxes is

a mediocre and contradictory combination of tax and expenditure changes EXP: The Congresswoman is right that that increased government spending will increase aggregate demand, other things equal. But her plan to raise taxes would decrease aggregate demand, other things equal. Thus, her two policy suggestions are going to offset each other, perhaps completely. It is for that reason that the correct answer is that her plan is a mediocre and contradictory combination of tax and expenditure changes. The best scenario would be to increase government spending while lowering tax rates. Any deficit would have to be covered by borrowing, but in terms of increasing aggregate demand in the short run, this combination would work very well.

The basic objective of monetary policy is to

assist the economy in achieving a full-employment, noninflationary level of total output EXP: The basic objective of monetary policy is to assist the economy in achieving a full-employment, noninflationary level of total output.

The banking system in the United States is referred to as a fractional reserve bank system because

banks hold a fraction of deposits in reserve. EXP: The banking system in the United States is a fractional reserve bank system because the banks do not hold enough cash or reserves on hand to pay every depositor on demand at the same time. That is, if everyone went to the bank at the same time and tried to close their accounts, the bank would not be able to meet this demand.

In a fractional reserve system, deposit insurance

guarantees that depositors will always get their money, avoiding bank runs EXP: To avoid the potential of these bank runs, there is deposit insurance in the United States and other countries. By guaranteeing depositors that they will always get their money, deposit insurance removes the incentive to try to withdraw one's deposit before anyone else can. It thus stops most bank runs.

A major strength of monetary policy is

its speed and flexibility EXP: The major strengths of monetary policy are its speed and flexibility compared to fiscal policy, the Board of Governors is somewhat removed from political pressure, and its successful record in preventing inflation and keeping prices stable. The Fed is given some credit for prosperity in the 1990s and early 2000s.

The three functions of money are:

medium of exchange, unit of account, and store of value EXP: Money serves three functions: It serves as a medium of exchange, a unit of account, and a store of value. Liquidity is not a good answer because liquidity is not a function of money, but is rather the ease with which any other asset besides money can be quickly converted into cash with little or no loss of purchasing power. For example, a house is not liquid because it can take many months to sell and convert into cash. By contrast, gold coins are very liquid because there are many places—including coin dealers, jewelry stores, pawn shops, and even many banks—where you can quickly sell a gold coin and turn that form of wealth into the most spendable form of wealth, cash. Gifting is also not a good answer because while money can certainly be given as a gift, so can nearly anything else. Thus, gifting is not a fundamental function of money that helps to set it apart from other assets.

Monetary policy is easier to conduct than fiscal policy because

monetary policy has a much shorter administrative lag than fiscal policy EXP: Monetary policy is formed by the seven members of the Board of Governors. Fiscal policy requires the consent of both houses in Congress and the president. One of the implications is that monetary policy has a much shorter administrative lag than fiscal policy.

The actual reason that banks must hold required reserves is

to give the Fed control over the lending ability of commercial banks EXP: By varying the required reserve ratio, the Fed can increase or decrease the total volume of lending made by commercial banks. For example, a higher required reserve ratio means that banks must hold more of their total deposits as reserves. And because any money that is held as reserves cannot be lent out, raising the required reserve ratio also means reducing the amount of money that banks can loan out. Keep in mind that the true point of required reserves is to give the Fed this control over lending. By contrast, it is a common fallacy to think that the point of reserves is to provide banks with a ready supply of funds to meet unexpectedly large cash withdrawals from depositors (as happens during bank panics). This line of thinking is not true because the legally required amount of reserves is not nearly large enough to deal with bank panics, which is why the government has also created the FDIC and NCUA to provide deposit insurance and why the Fed always stands ready to act as a lender of last resort to any banks suffering from bank panics. The deposit insurance and the availability of the Fed as a lender of last resort protect the banking system against bank panics while required reserves give the Fed control over lending.