Money and the Federal Reserve

money multiplier equation

1/reserve requirement

The Federal Reserve System was established by the Federal Reserve Act of

1913

If the reserve requirement is 20% and commercial bankers decide to hold additional excess reserves equal to 5% of any newly acquired checkable deposits, then the effective monetary multiplier for the banking system will be

4

If the reserve requirement were 15% percent, the value of the monetary multiplier would be

6.67.

One year before maturity the price of a bond with a principal amount of $1,000 and a coupon rate of 5% paid annually fell to $981. The one year interest rate must be

7.0%.

Suppose that Ava withdraws $300 from her savings account at Second Bank. The reserve requirement facing Second Bank is 10%. Assume the bank does not wish to hold any excess reserves of new deposits. Use this information to complete the balance sheet below to show how Second Bank's assets and liabilities change when Ava withdraws the $300 from the bank.

A Simple Bank Balance Sheet Assets Change in Reserves: $ -30 Change in Loans: $ -270 Liabilities Change in Deposits: $ -300 Explanation When Ava withdraws $300 from her savings account, it will decrease the amount of deposits at Second Bank by $300. This will reduce deposits and the amount that the bank has for reserves and loans. So -$300 should be entered into the response on the liabilities side. Since the reserve requirement is 10% and the bank holds no excess reserves, the bank will decrease reserves by 10% × -$300 = -$30, so -$30 should be entered into the response on the asset side as reserves. Given that banks do not hold excess reserves, any amount of deposits withdrawn that do not come from reserves would have to be a reduction in loans. This typically comes from loans that are repaid and not lent out again. Since the withdrawal is $300 and the bank only uses $30 from reserves, then $300 - $30 = $270 is the amount of the withdrawal that will need to come from a reduction in loans. To show the reduction in loans, the $270 decrease in loans would be entered into the response on the asset side as loans.

Money is created when

A bank grants a loan to a customer

money market mutual fund

A demand deposit that accepts deposits and purchases short-term bonds and commercial debt in order to pay interest on the deposited funds.

The Federal Reserve System consists of which of the following?

Board of Governors and the 12 Federal Reserve Banks

____ in active circulation includes money in everyone's pockets and is part of ___

Currency; M1

Which of the following are liabilities to a bank?

Demand and time deposits

The part of the Federal Reserve that determines and implements the nation's monetary policy and controls the money supply to promote stable prices and economic growth is the

Federal Open Market Committee

Which group is responsible for the policy decision of changing the money supply?

Federal Open Market Committee

An increase in nominal GDP will

Increase the transactions demand and the total demand for money

Which line in the graph above would best illustrate the asset demand for money curve?

Line 1

Which line in the graph would best illustrate the supply of money curve?

Line 2

Which definition(s) of the money supply include(s) only items that are directly and immediately usable as a medium of exchange?

M1

The M2 measure of money consists of the sum of

M1, savings deposits, small time deposits, and money market mutual funds.

____ facilitates trade between buyers and sellers, and makes specialization more possible, which helps make the economy more productive.

Money

A bank's required reserves can be calculated by:

Multiplying its checkable-deposit liabilities by the reserve ratio

Determine which of the Federal Reserve entities controls each of the following policy tools.

Open market operations are determined by the: Federal Open Market Committee The reserve requirement is determined by the: Board of Governors Explanation a. The Board of Governors oversees and determines the reserve requirement. b. The Federal Open Market Committee meets to determine open market operations to control the money supply.

reserve requirement (rr)

The fraction of checkable deposits that banks must keep on hand as reserves, either as currency or on deposit with the Federal Reserve

discount rate

The interest rate at which banks can borrow money directly from the Federal Reserve

The functions of money are to serve as a

Unit of account, store of value, and medium of exchange

M2

a broader definition of the money supply: it includes M1 plus savings account deposits, small-denomination time deposits, balances in money market deposit accounts in banks, and non institutional money market fund shares M2 = M1 + Savings Deposits + Money Market Funds + Small Time Deposits

traveler's check

a certificate, or check that can be converted to currency

What function is money serving when you deposit it in a savings account?

a store of value

If you put a $20 bill in the pocket of your winter coat at the beginning of spring so that you will be surprised when you find it again next winter, you are using money as

a store of value.

If product prices were stated in terms of tobacco leaves, then tobacco leaves would be functioning primarily as

a unit of account.

Use the following table to determine the levels of M1 and M2 in the United States.

a. Calculate the M1 money supply - $ 203 billion M1 = Currency + Demand Deposits + Other Checkable Deposits + Traveler's Checks $82 billion + $80 billion + $37 billion + $4 billion = $203 billion b. Calculate the M2 money supply - $ 729 billion M2 = M1 + Savings Deposits + Money Market Funds + Small Time Deposits $203 billion (found in part a) + $460 billion + $44 billion + $22 billion = $729 billion

For each of the following scenarios, determine whether money is being used as a medium of account, store of value, or unit of account.

a. Sam gives the grocery store clerk a $5 bill to pay for his purchase. - Medium of exchange b. Bill looks at the $20 price tag on a clock to see how much money he would need to purchase it. -Unit of account c. Maria writes a check to pay her electric bill. - Medium of exchange d. Susan transfers some of her wealth from her checking account into a certificate of deposit that earns interest. - Store of value

Suppose the Federal Reserve increases the amount of reserves by $100 million and the total money supply increases by $500 million.

a. What is the money multiplier? 5 b. Using the money multiplier from part a, how much will the money supply change if the Federal Reserve increases reserves by $50 million? $250m Explanation a. Depending on the data that you have, the money multiplier can be found by taking 1/rr or by taking the total change in the money supply divided by the change in reserves. In this case, we are given the change in reserves of $100 million and the total change in the money supply of $500 million. Therefore, we can find the money multiplier by taking the total change in the money supply divided by the change in reserves, which is equal to $500 million/$100 million = 5. b. When we know the money multiplier, we can find the total change in the money supply by taking the money multiplier times the change in reserves. If the money multiplier is 5 and reserves increase by $50 million, then the total change in the money supply can be found by taking 5 × $50 million = $250 million. Therefore, the money supply increases by a total of $250 million.

Explain the changes in M1 and M2 for each of the following scenarios.

a. When Lily transfers $100 from her savings account into her checking account, M1 increases by $100 and M2 remains the same . b. If Miguel deposits $200 cash into his money market mutual fund, M1 decreases by $200 and M2 remains the same . c. If Sam takes $1,000 from his savings account to purchase Microsoft stock, M1 remains the same and M2 decreases by $1,000 . Explanation Money is commonly computed into two types of money supplies: M1, which includes currency, demand deposits, traveler's checks, and other checkable deposits, and M2, which includes M1 (all of the assets in M1), savings accounts, retail money funds (money market mutual funds), and small-denomination time deposits. a. When $100 is transferred from a savings account into a checking account, M1 will increase by $100 since checking accounts are included in M1, but M2 will remain the same because both checking accounts and savings accounts are included in M2. b. When $200 of cash is deposited into a money market mutual fund, M1 will decrease by $200 because it is completely leaving M1. However, M2 will remain the same since both currency and money market mutual funds are included in M2. This is simply a reallocation of assets that are included in M2 and not a change in the total value. c. When $1,000 is removed from a savings account, it will have no effect on M1. So M1 will remain the same since M1 does not include savings accounts. M2 will decrease by $1,000 because savings accounts, which are included in M2, are reduced by this amount and the $1,000 is placed into an asset that is not part of M2.

money

any item that both buyers and sellers will generally accept in exchange for goods and services

Money is

anything that both buyers and sellers will accept in exchange for goods and services Explanation Money is more than just currency or metal. Money can be anything that both buyers and sellers will accept in exchange for goods and services. Other items, such as seeds, grains, or cows have been used as money in the past. However, some goods—like currency and coins—are better at facilitating trade than other goods.

Members of the Federal Reserve Board of Governors are

appointed by the president to staggered 14-year terms.

Credit card balances are not considered to be money primarily because they

are not part of people's wealth.

A wealthy executive is holding money, waiting for a good time to invest in the stock market. This action would be an example of the

asset demand for money.

A checkable deposit at a commercial bank is a(n)

asset to the depositor and a liability to the bank.

A bank's net worth is equal to its

assets minus its liabilities.

the money multiplier will equal 1/rr so long as:

banks loan out all of their excess reserves people can't hold any loaned money as cash

Total Change in Money Supply

change in reserves and multiply by the money multiplier (1/rr) * the initial change in reserve

Traditionally, the Federal Reserve can give emergency loans only to

commercial banks.

The main function of the Federal Reserve System is to

control the money supply.

The M1 measure of money consists of the sum of

currency, checking deposits, and travelers' checks

Money functions as a store of value if it allows you to

delay purchases until you want the goods.

One hundred percent reserve banking refers to a situation in which banks' reserves equal One hundred percent of their

deposits.

Fractional reserve banking refers to a system where banks

hold only a fraction of their deposits in their reserves.

Assume that the required reserve ratio is 20%. A business deposits a $50,000 check at Bank A; the check is drawn against Bank B. What happens to the reserves at Bank A and Bank B?

increase by $50,000 at Bank A and decrease by $50,000 at Bank B

Other things being equal, an expansion of commercial bank lending

increases the money supply.

The transactions demand for money is least likely to be a function of the

interest rate.

The Federal Reserve District Banks are divided

into geographical regions with the majority of the district banks located in the eastern half of the United States. Explanation The 12 Federal Reserve District Banks were designed and created to allow smaller geographical regions representation in the nation's monetary policies. The regions were formed in 1913 based on where the majority of the population and economic interests were concentrated. Therefore, the majority of the district banks were located in the eastern half of the United States, which made up most of the economic activity of the United States in 1913.

A bank has $2 million in checkable deposits. In the bank's balance sheet, this would be part of

liabilities.

Money eliminates the need for a coincidence of wants in trading primarily through its role as a

medium of exchange.

demand deposits

money held in an account that can be converted to currency on demand. often called checkable deposits or checking accounts

time deposit

money held in an account that cannot be converted to currency, without penalty, before a specified time

currency

physical units of money, such as cash and coins

The reason for the Fed being set up as an independent agency of government is to

protect it from political pressure.

The required-reserve ratio is equal to a commercial bank's

required reserves divided by its checkable-deposit liabilities.

Assets of the commercial banking system include:

reserves and loans

Cash held by a bank in its vault is a part of the bank's

reserves.

Which of the following items are included in money supply M2 but not M1?

savings deposits

The Federal Open Market Committee (FOMC)

sets policy on the sale and purchase of government bonds by the Fed.

The Federal Open Market Committee (FOMC) of the Federal Reserve System is primarily for

setting the Fed's monetary policy and directing the purchase and sale of government securities.

The equilibrium rate of interest in the market for money is determined by the intersection of the

supply-of-money curve and the total-demand-for-money curve.

monetary policy

the actions taken by a country's central bank to influence the supply of money and credit in the economy

liquidity

the degree to which an asset can be readily converted into currency

The coupon rate is the

the interest rate promised when a bond is issued

M1

the most liquid measure of money supply; includes demand deposits, traveler's checks, currency, and other checkable deposits M1 = Currency + Demand Deposits + Other Checkable Deposits + Traveler's Checks

one way to solve for the money multiplier is to divide:

the overall change in the money supply by the initial change in reserves

open market operations

the purchase or sale of government securities by a central bank; a key tool of monetary policy used to influence the money supply and interest rates

A consumer holds money to meet spending needs. This would be an example of the

transactions demand for money.

When a consumer wants to compare the price of one product with another, money is primarily functioning as a

unit of account.