Quiz Monetary System

Wk 4 Quiz 1. The roles of money Paolo wants to purchase a new computer and go to the Caribbean for spring break. The computer is priced at $1,299, and the vacation is priced at $750. He has only $1,537 in his checking account, so he cannot afford to purchase both. After much thought, Paolo buys the computer and writes a check for $1,299. Identify what role money plays in each of the following parts of the story. Hint: Select each role only once. Role of Money Medium of Exchange Unit of Account Store of Value Paolo can easily determine that the price of the computer is more than the price of the vacation. Paolo has $1,537 in his checking account. Paolo writes a check for $1,299. Points: 1/1 Close Explanation Explanation: Money acts as a unit of account by providing buyers and sellers a common reference point for valuing goods and services. The fact that the prices of both the computer and the vacation are listed in the same units (dollars) means that Paolo can easily compare the prices of his options. Money acts as a store of value by providing a means of transferring purchasing power from the present to the future. By keeping money in his checking account, Paolo stores wealth until he is ready to make a purchase. Finally, money acts as a medium of exchange by providing an accepted method of payment for goods and services. In this case, Paolo writes a check, and money is withdrawn from the checking account to pay the computer company $1,299 in exchange for a new computer. 2. Money aggregates Identify whether each of the following examples belongs in M1 or M2. If an example belongs in both, be sure to check both boxes. Example M1 M2 Rajiv has $1,200 in a checking account. Yakov has $2,500 in a savings account. Ana has $9,000 in a six-month certificate of deposit (CD). Points: 1/1 Close Explanation Explanation: M1 includes currency (like the money in Rajiv's checking account), traveler's checks, and checkable deposits. M2 includes everything in M1 plus money market deposit accounts, savings account deposits, certificates of deposit (such as Ana's CD), and what are called miscellaneous near-monies. 3. The Federal Reserve's organization While all members of the Federal Reserve Board of Governors vote at Federal Open Market Committee (FOMC) meetings, only 5 of the regional bank presidents are members of the FOMC. Points: 1/1 Close Explanation Explanation: The FOMC consists of the 7 members of the Board of Governors and 5 of the 12 regional bank presidents. The 5 voting positions in the FOMC rotate among the 12 regional bank presidents. The president of the New York Federal Reserve always has a vote, however, because the New York Federal Reserve conducts all open-market operations for the Federal Reserve System. Which of the following is a responsibility of the Federal Open Market Committee (FOMC)? Buying and selling stocks Issuing mortgages to homeowners Making decisions regarding monetary policy Points: 1/1 Close Explanation Explanation: The FOMC meets about once every six weeks to discuss the state of the economy and to consider changes in monetary policy. Through the FOMC's decisions, the Federal Reserve can alter the money supply in order to affect economic outcomes. The Federal Reserve's primary tool for changing the money supply is open market operations . In order to decrease the number of dollars in the U.S. economy (the money supply), the Federal Reserve will sell government bonds. Points: 1/1 Close Explanation Explanation: Open market operations are the Fed's primary tool for controlling the money supply. Open market operations involve buying and selling U.S. government bonds. To increase the money supply, the Fed creates dollars with which to purchase government bonds from the public. After the purchase, the Fed has bonds and the public has new dollars—an increase in the money supply. To reduce the money supply, the Fed sells U.S. government bonds to the public. After the sale, the public has bonds and the Fed has taken dollars out of circulation, thereby reducing the money supply. 4. Problems and Applications Q2 When the Fed buys bonds in open-market operations, it increases the money supply. Points: 1/1 If the Fed reduces the reserve requirement, the money supply increases . Points: 1/1 When the Fed increases the interest rate it pays on reserves, the money supply will decrease . Points: 1/1 When the FOMC decreases its target for the federal funds rate, the money supply will increase . Points: 1/1 When Citibank repays a loan it had previously taken from the Fed, it decreases the money supply. Points: 1/ 1 Close Explanation Explanation: When the Fed buys bonds in open-market operations, it increases the money supply by increasing the number of dollars in the economy. If the Fed reduces the reserve requirement, banks can lend out more of each dollar that is deposited. The lower reserve ratio raises the money multiplier, thereby increasing the money supply. An increase in the interest rate the Fed pays on reserves will tend to increase the reserves banks will choose to hold, thereby lowering the money supply. When the Federal Open Market Committee (FOMC) decreases its target for the federal funds rate, it is committing itself to buy bonds and inject reserves into the banking system, so that more banks would find themselves in excess of reserves, thereby bidding down the price of borrowing reserves (federal funds rate). Therefore, the money supply will increase. When Citibank repays a loan it had previously taken from the Fed, it reduces the quantity of its reserves, thereby decreasing the money supply. See Sections: How the Fed Influences the Quantity of Reserves; How the Fed Influences the Reserve Ratio; Money Creation with Fractional-Reserve Banking; Money Multiplier; and The Federal Funds Rate. 5. The money creation process Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 20%. Larry, a client of First Main Street Bank, deposits $1,500,000 into his checking account at First Main Street Bank. Complete the following table to reflect any changes in First Main Street Bank's T-account (before the bank makes any new loans). Assets Reserves Liabilities $1,500,000 Deposits $1,500,000 Points: 1/1 Close Explanation Explanation: When Larry deposits the $1,500,000 into First Main Street Bank, it creates both an asset and a liability for the bank. On the asset side of the T-account, the $1,500,000 increases the bank's reserves. The bank can use some of these additional reserves to make loans to other people. On the liability side of the T-account, the $1,500,000 is recorded as a demand deposit, because Larry could demand his deposit back at any time by coming into the bank and asking for it, by writing a check, or by using a debit card. Assets Liabilities Reserves $1,500,000 Deposits $1,500,000 Complete the following table to show the effect of a new deposit on excess and required reserves when the required reserve ratio is 20%. Hint: If the change is negative, be sure to enter the value as negative number. Amount Deposited Change in Excess Reserves Change in Required Reserves 1,500,000 Points: 1/1 Close Explanation Explanation: Because the required reserve ratio is 20%, First Main Street Bank is required to hold 20% of its fresh reserves (that is, the initial deposit). Since 20% of $1,500,000 is $300,000, this means that First Main Street Bank's required reserve has increased by $300,000. The remaining 80% of the fresh reserves, or $1,200,000, is excess reserves and can be used to make loans. Now, suppose First Main Street Bank loans out all of its new excess reserves to Janet, who immediately uses the funds to write a check to Felix. Felix deposits the funds immediately into his checking account at Second Republic Bank. Then Second Republic Bank lends out all of its new excess reserves to Raphael, who writes a check to Megan, who deposits the money into her account at Third Fidelity Bank. Third Fidelity lends out all of its new excess reserves to Susan in turn. Fill in the following table to show the effect of this ongoing chain of events at each bank. Enter each answer to the nearest dollar. Increase in Deposits Increase in Required Reserves Increase in Loans First Main Street Bank Second Republic Bank Third Fidelity Bank Points: 1/1 Close Explanation Explanation: You already found that of the $1,500,000 initial deposit, 20% (or $300,000) had to be held as required reserves and the remaining 80% (or $1,200,000) could be loaned out. If you follow that $1,200,000 loan, you can see that when it is deposited into Second Republic Bank, 20% of that $1,200,000 must be held as required reserves by Second Republic Bank and the remaining 80% can be loaned out: Increase in 0. Second Republic Bank's Required Reserves = 20×$1,200,000 $240,000 = Increase in Sec 0. ond Republic Bank's Excess Reserves = 80×$1,200,000 = $960,000 Now, those $960,000 of excess reserves can be loaned out. When they are loaned and then deposited into Third Fidelity Bank, Third Fidelity Bank's required and excess reserves increase in the same way: Increase in Third Fidelity Bank's Required Reserves = = 0.2 0×$960,000 $192,000 Increase in Third Fidel 0.8 ity Bank's Excess Reserves = 0×$960,000 = $768,000 Assume this process continues, with each successive loan deposited into a checking account and no banks keeping any excess reserves. Under these assumptions, the $1,500,000 injection into the money supply results in an overall increase of $7,500,000 in demand deposits. Points: 1/1 Close Explanation Explanation: Under the assumptions stated in the problem, you can use the money multiplier to calculate the eventual effect of the $1,500,000 injection into the money supply. The formula for the money multiplier is 1r, where r is the required reserve ratio. Therefore, the resulting change in demand deposits is as follows: Change in Demand Deposits = = = Change in Fresh Reserves (that is, the Initial Deposit)×1r $1,500,000×10.20 $7,500,000 6. The reserve requirement, open market operations, and the moneysupply Assume that banks do not hold excess reserves and that households do not hold currency, so the only form of money is demand deposits. To simplify the analysis, suppose the banking system has total reserves of $300. Determine the money multiplier and the money supply for each reserve requirement listed in the following table. Reserve Requirement 5 10 Points: 1/1 Money Supply Simple Money Multiplier 20 10 6,000 3,000 A higher reserve requirement is associated with a smaller money supply. Points: 1/1 Close Explanation Explanation: The money multiplier is the reciprocal of the reserve ratio. Under the assumption that banks do not hold excess reserves, the reserve ratio will be equal to the reserve requirement set by the Federal Reserve. For a reserve requirement of 5%, the reserve ratio is 1/20, and the multiplier is therefore 20. When the multiplier is 20, a banking system with $300 in reserves can support 20×$300=$6,000 in demand deposits. If the reserve requirement rises from 5% to 10%, the reserve ratio rises from 1/20 to 1/10, and the multiplier falls from 20 to 10. At the higher reserve requirement, the banking system's $300 in reserves supports 10×$300=$3,000 in demand deposits. For a given level of reserves, a higher reserve requirement is associated with a smaller money supply. At the higher reserve requirement, banks must hold a larger fraction of their deposits as reserves. This keeps more reserves away from the money creation process (it keeps new loans from being made, which would lead to more deposits, which would lead to more loans, and so on). Therefore, the higher the reserve requirement, the fewer demand deposits are generated in the money creation process from a given change in reserves. Suppose the Federal Reserve wants to increase the money supply by $200. Again, you can assume that banks do not hold excess reserves and that households do not hold currency. If the reserve requirement is 10%, the Fed will use open-market operations to buy worth of U.S. government bonds. Points: 1/1 Close Explanation Explanation: To increase the money supply, the Fed must buy government bonds. In order to pay for the bonds, the Fed creates money. Its purchase of bonds puts the new money in the hands of the public. Assuming that households do not hold cash, the new money will be placed in demand deposits with banks. At a reserve requirement of 10%, the money multiplier is 10. Therefore, the money supply will grow by 10 times the initial increase in demand deposits from the Fed's open-market purchase. If the Fed buys $20 worth of government bonds, demand deposits and bank reserves will rise by $20. The $20 increase in reserves will support an increase in the money supply of 10×$20=$200 as banks lend out the excess reserves generated by the Fed's purchase. Now, suppose that, rather than immediately lending out all excess reserves, banks begin holding some excess reserves due to uncertain economic conditions. Specifically, banks increase the percentage of deposits held as reserves from 10% to 25%. This increase in the reserve ratio causes the money multiplier to fall to 4 . Under these conditions, the Fed would need to buy worth of U.S. government bonds in order to increase the money supply by $200. Points: 1/1 Close Explanation Explanation: Uncertain economic conditions cause banks to hold some excess reserves, increasing the percentage of deposits held as reserves from 10% to 25% and increasing the reserve ratio from 1/10 to 1/4. The money multiplier falls from 10 to 4—the reciprocal of the new reserve ratio (1/4). When banks hold additional reserves, the Fed will have to buy more bonds in order to increase the money supply by a given amount. Specifically, an open-market purchase of $50 worth of bonds (rather than $20) is now required to increase the money supply by $200. When the Fed buys $50 in government bonds, demand deposits and bank reserves rise by $50. With the smaller multiplier, the $50 increase in reserves will support an increase in the money supply of 4×$50=$200. Which of the following statements help to explain why, in the real world, the Fed cannot precisely control the money supply? Check all that apply. The Fed cannot prevent banks from lending out required reserves. The Fed cannot control the amount of money that households choose to hold as currency. The Fed cannot control whether and to what extent banks hold excess reserves. Points: 1/1 Close Explanation Explanation: For most of this problem, you should have assumed that households hold money only in demand deposits and that banks do not hold excess reserves. A more realistic model of the banking system would relax both of these assumptions. In practice, banks can hold any level of excess reserves that they choose, much as households can hold as much currency as they like. Since the Fed cannot precisely control the level of excess reserves or the fraction of money households wish to hold as currency, it cannot precisely increase or decrease the money supply. However, it can get pretty close by monitoring the behavior of banks and households and adjusting monetary policy to reflect changes in banks' preferences for excess reserves or households' preferences for currency. 7. Problems and Applications Q7 Money serves three functions in the economy: medium of exchange, unit of account, and store of value. Which of the following statements describes how inflation affects the ability of money to serve as a unit of account? Check all that apply. Inflation causes menu costs. Inflation erodes money's purchasing power. In some countries with hyperinflation, prices are posted in terms of U.S. dollars rather than the local currency, even though the local currency is still used to purchase the good. Points: 1/1 Close Explanation Explanation: Inflation mainly affects the ability of money to serve as a store of value by eroding money's purchasing power, making it less attractive as a store of value. Money is also less useful as a unit of account when there is inflation because stores have to change prices more often, and because people are confused and inconvenienced by the changes in the value of money. In some countries with hyperinflation, stores post prices in terms of a more stable currency, such as the U.S. dollar, even when the local currency is still used as the medium of exchange. Sometimes countries even stop using their local currency altogether and use a foreign currency as the medium of exchange as well. See Sections: The Inflation Tax; and Menu Costs. 8. Problems and Applications Q8 Suppose that people expect inflation to equal 5 percent, but in fact, prices rise by 7 percent. Which of the following groups or individuals are hurt by this unexpectedly high inflation rate? Check all that apply. The government A union worker in the second year of a labor contract A college that has invested some of its endowment in government bonds that are not indexed Treasury bonds A homeowner with a fixed-rate mortgage Points: 1/1 Close Explanation Explanation: Unexpectedly high inflation helps the government by providing higher tax revenue and reducing the real value of outstanding government debt. Unexpectedly high inflation helps a homeowner with a fixed-rate mortgage because he pays a fixed nominal interest rate that was based on expected inflation, and thus pays a lower real interest rate than was expected. Unexpectedly high inflation hurts a union worker in the second year of a labor contract because the contract probably based the worker's nominal wage on the expected inflation rate. As a result, the worker receives a lower-than-expected real wage. Unexpectedly high inflation hurts a college that has invested some of its endowment in government bonds because the higher inflation rate means the college is receiving a lower real interest rate than it had planned. See Section: A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth. 9. The level of prices and the value of money Suppose the price level reflects the number of dollars needed to buy a basket of goods containing one cup of tea, one biscuit, and one magazine. In year one, the basket costs $8.00. In year two, the price of the same basket is $7.00. From year one to year two, there is at an annual rate of deflation 12.50% . Points: 1/1 In year one, $40.00 will buy 5 baskets, and in year two, $40.00 will buy 5.71 baskets. Points: 1/1 This example illustrates that, as the price level falls, the value of money rises . Points: 1/1 Close Explanation Explanation: An increase in the overall level of prices is called inflation. Negative inflation, or a decrease in the overall level of prices, is called deflation. The percentage change in the price level from year one to year two is calculated as follows: Inflation R 100×$7.00− ate = $8.00$8.00 = = 100×−$1.00$8.00 −12.50% In year one, $40.00 can purchase can purchase $40.00$8.00 per basket=5 baskets. In year two, $40.00 $40.00$7.00 per basket=5.71 baskets. Notice that $40.00 purchases fewer baskets in year one. As the price level falls from year one to year two, the value of money rises. 10. Using money creation to pay for government spending Consider Kharkeez, a hypothetical country that produces only cakes. In 2019, a cake is priced at $2.00. Complete the first row of the table with the quantity of cakes that can be bought with $700. Hint: In this problem, assume it is not possible to buy a fraction of a cake, and always round down to the nearest whole cake. For example, if your calculations result in 1.5 cakes, the answer should be 1 cake. Price of a Cake Cakes Bought with $700 Year 2019 2.00 2020 Points: 1/1 Suppose the government of Kharkeez cannot raise sufficient tax revenue to pay its debts. In order to meet its debt obligations, the government prints money. As a result, the money supply rises by 40% by 2020. Assuming monetary neutrality holds, complete the second row of the table with the new price of a cake and the new quantity of cakes that can be bought with $700 in 2020. Close Explanation Explanation: With $700, 350 cakes can be purchased at the initial price of $2.00 per cake. Monetary neutrality is the proposition that changes in the money supply do not affect real variables, such as the number of cakes produced. If monetary neutrality holds, a 40% increase in the money supply will be fully reflected in the dollar price of a cake. Thus, the price of a cake will rise by 40% as well, from $2.00 to $2.80. The price increase causes the purchasing power of money to decline, so that $700 can now buy only $700$2.80=250 cakes. It is important to note that the increase in the money supply impacts only the purchasing power of money (including money in non-inflation-adjusted accounts and assets) held while the government is printing money. Since wages tend to rise with the overall price level, nominal wages will rise to reflect changes in the quantity of money, and the purchasing power of earnings will not be affected in the long run. The impact of the government's decision to raise revenue by printing money on the value of money is known as the inflation tax . Points: 1/1 Close Explanation Explanation: When the government pays its debts by printing money, the value of money will decline, a phenomenon known as an inflation tax. Specifically, $700 will purchase fewer cakes—approximately 250 compared with 350 before the government's decision to print money. By printing money in order to pay its debts, the government effectively taxes anyone who holds money. Revenue raised through an inflation tax is known as seigniorage. 11. Identifying costs of inflation Hubert manages a grocery store in a country experiencing a high rate of inflation. To keep up with inflation, he spends a lot of time every day updating the prices, printing new price tags, and sending out newspaper inserts advertising the new prices. His employees regularly deal with customer annoyance over the frequent price changes. This is an example of the menu costs of inflation. Points: 1/1 Close Explanation Explanation: Rapid inflation forces firms to change their prices more frequently to ensure that their revenues keep pace with the rate at which the overall price level is rising. Doing so requires resources that would otherwise be put to more productive uses. The costs associated with changing price tags, price lists, website content, catalogs, and menus are known as the menu costs of inflation. 12. Inflation-induced tax distortions Kevin receives a portion of his income from his holdings of interest-bearing U.S. government bonds. The bonds offer a real interest rate of 4.5% per year. The nominal interest rate on the bonds adjusts automatically to account for the inflation rate. The government taxes nominal interest income at a rate of 10%. The following table shows two scenarios: a low-inflation scenario and a high-inflation scenario. Given the real interest rate of 4.5% per year, find the nominal interest rate on Kevin's bonds, the after-tax nominal interest rate, and the after-tax real interest rate under each inflation scenario. Inflation Rate Real Interest Rate 2.0 4.5 9.5 4.5 Nominal Interest Rate After-Tax Nominal Interest Rate After-Tax Real Interest Rate Points: 1/1 Close Explanation Explanation: To maintain the level of the real interest rate, the nominal interest rate must adjust according to the Fisher equation: Nominal Interest Real Interest Rate+In Rate = flation At the lower inflation rate of 2% per year, the nominal interest rate is 6.5%, the 4.5% real rate plus the 2% inflation rate. At the higher inflation rate of 9.5% per year, the nominal interest rate is 14%, the 4.5% real rate plus the 9.5% inflation rate. The government taxes 10% of the nominal interest paid on the bonds. When the inflation rate is 2% per year and the nominal interest rate is 6.5% per year, the tax reduces the nominal interest payment from 6.5% to an after-tax nominal interest payment of 6.5%−0.1×6.5%=5.85% per year. At an inflation rate of 9.5% per year and a nominal interest rate of 14% per year, the tax reduces the nominal interest payment from 14% to an after-tax nominal interest payment of 14% −0.1×14%=12.6% per year. Rearranging the nominal interest rate equation, you can see that the real interest rate is the difference between the nominal interest rate and the inflation rate. The after-tax real interest rate is, therefore, the after-tax nominal interest rate minus the inflation rate. At the lower inflation rate, the after-tax real interest rate is calculated as follows: After-Tax Real Interest Rate = After-Tax Nominal Interest Rate − Inflation Rate 5.85%−2% = = 3.85% At the higher inflation rate, the after-tax real interest rate is 12.6% −9.5%=3.1%, which is lower than the after-tax real return at the lower inflation rate. Compared with lower inflation rates, a higher inflation rate will decrease the after-tax real interest rate when the government taxes nominal interest income. This tends to saving, thereby decreasing the quantity of investment in the economy and discourage decreasing the economy's long-run growth rate. Points: 1/1 Close Explanation Explanation: When the government taxes nominal interest income, inflation distorts the real returns to saving. Compared with a lower rate of inflation, a higher rate of inflation leads to a lower after-tax real interest rate, which tends to discourage saving. Because the economy's level of investment depends on the pool of savings available to finance investment projects (such as acquiring new tools or machinery or building new plants or office buildings), the lower volume of saving will decrease the quantity of investment, thereby decreasing the economy's rate of physical capital accumulation and depressing the long-run economic growth rate. Thus, to the extent that the central bank cannot reduce inflation in an economy in which the government taxes nominal interest income, inflation will discourage saving, investment, and growth. 13. Problems and Applications Q5 You take $200 you had kept under your mattress and deposit it in your bank account. Suppose this $200 stays in the banking system as reserves and banks hold reserves equal to 20 percent of deposits. The total amount of deposits in the banking system increases by , and the money supply increases by . Points: 1/1 Close Explanation Explanation: The amount of money the banking system generates with each dollar of reserves is called the money multiplier. The money multiplier is the reciprocal of the reserve ratio. If banks in the economy, then each dollar of reserves generates R is the reserve ratio for all 1R dollars of money. If you take $200 that you held as currency and put it into the banking system, you can compute the increase in the total amount of deposits in the banking system in the following way: Increase in De Money Multiplier×D posits = eposit 1Reserve Ratio×Deposit = = = 10.2×$200 $1,000 Because deposits increase by $1,000 but currency declines by $200, this means the money supply increases by $1,000−$200=$800. See Section: The Money Multiplier.