Economics Answer Note #63

Question 1 The Federal Reserve, the central bank of the United States, is actually made up of 50 different district banks with each district bank being established for each state of the United States of America. True False Answer False. While it is true that the Federal Reserve has 12 regional Federal Reserve Banks, they do not align with each state in the United States. The 12 regional banks are located in cities across the country, including New York, San Francisco, Chicago, and Atlanta, to name a few. The Federal Reserve is divided into 12 regions to ensure that there is representation from various parts of the country in the decision-making process. However, these regions do not correspond to individual states, as the Federal Reserve's operations and responsibilities span across the entire country. Question 2 Which of the following monetary aggregates, those financial assets that make up the money supply, consists solely of currency-in-circulation, checkable deposit balances, savings deposit balances, and money market deposit balances? a. M1 b. M2 c. M3 d. M0 Answer The correct answer is M2. M2 is one of the most widely used monetary aggregates and it includes the following financial assets: currency-in-circulation, checkable deposit balances, savings deposit balances, and money market deposit balances. M2 is used to measure the money supply in an economy and is often considered a broad measure of the money supply. It also includes assets such as small time deposits and retail money market mutual fund shares. To understand the difference between M1, M2, and M3, let's first define each of them: 1. M1: M1 is the narrowest measure of the money supply and it includes only the most liquid assets such as physical currency and checkable deposits. It is often referred to as "transaction money" as it is used for day-to-day transactions. 2. M2: M2 is a broader measure of the money supply and includes all of the assets in M1 as well as savings deposits, money market deposit accounts, and small time deposits. It is often used as an indicator of the overall health of a country's economy and is considered a more stable measure of the money supply compared to M1. 3. M3: M3 is the broadest measure of the money supply and includes all of the assets in M2 as well as large time deposits, institutional money market mutual fund balances, and certain other assets. It is not commonly used by central banks as it can be volatile and includes assets that are not easily convertible into cash. Now, let's look at the other options in the question and understand why they are not the correct answer. 1. M0: M0 is another measure of the money supply, also known as the monetary base, and includes physical currency, reserves held by banks, and coins. It does not include deposit balances or money market deposit balances, so it is not the correct answer in this case. 2. M3: As mentioned earlier, M3 is a broader measure of the money supply compared to M2, but it also includes assets that are not considered as part of the money supply. These assets may not be as easily convertible into cash, so they are not the correct answer for this question. Question 3 In the market for money, an increase in household incomes leads to a(n) _____ in the demand for money, which leads to a(n) _____ in interest rates. a. increase; increase b. increase; decrease c. decrease; increase d. decrease; decrease Answer In the market for money, an increase in household incomes leads to an increase in the demand for money, which leads to a decrease in interest rates. This phenomenon can be explained through the Keynesian theory of supply and demand for money. According to the Keynesian theory, the overall demand for money is determined by the income levels in the economy. As household incomes increase, individuals tend to hold a higher portion of their income in the form of money for future expenditures. This results in an upward shift in the demand curve for money, leading to an increase in the equilibrium quantity of money demanded. Now, as the demand for money increases, there is more pressure on the supply of money to meet this demand. In order to maintain equilibrium, the central bank needs to increase the supply of money in the market. However, this increase in money supply is not able to keep up with the growing demand, resulting in a shortage of money in the market. This shortage of money then leads to an increase in the price of money, which is the interest rate. To further understand this concept, let's take a look at an example. Suppose there is an increase in household incomes in the economy and as a result, the demand for money increases from D1 to D2. This is shown in the graph below. [INSERT GRAPH HERE] The equilibrium interest rate at point E1 is where the demand and supply of money intersect, with an equilibrium quantity of money of Q1. However, with an increase in demand for money, the equilibrium interest rate increases from r1 to r2, and the equilibrium quantity of money decreases to Q2. This can also be explained through the Quantity Theory of Money, which states that the quantity of money in an economy is directly proportional to the level of prices. As household incomes increase, the demand for goods and services also increases, leading to an increase in prices. To counter this increase in prices, the central bank needs to increase the supply of money, which then lowers the interest rate. In conclusion, an increase in household incomes leads to an increase in the demand for money, which leads to a decrease in interest rates. This is due to the fact that a higher demand for money results in a shortage of money in the market, causing an increase in the price of money, which is the interest rate. This phenomenon is explained through both the Keynesian theory and the Quantity Theory of Money. Question 4 If the required reserve ratio is 10%, what is the maximum amount that the money supply could increase by if the Fed buys $10,000 worth of government bonds on the open market? a. $1,000,000 b. $10,000 c. $100,000 d. $1,000 Answer According to the required reserve ratio of 10%, the maximum amount by which the money supply could increase would be $100,000. This can be calculated by using the money multiplier formula, which is determined by dividing 1 by the required reserve ratio. In this case, 1 divided by 0.1 (or 10%) gives us a money multiplier of 10. This means that for every $1 increase in reserves, the money supply can increase by $10. Question 5 When the demand for bonds and the supply of bonds both increase, then the interest rate always decreases. True False Answer False Explanation: The relationship between bond demand, supply, and interest rates is more complex than the statement suggests. While an increase in both demand and supply can lead to a decrease in interest rates, there are other factors that can influence the relationship. Firstly, let's define some key terms. The demand for bonds refers to the willingness and ability of investors to purchase bonds at a given price. The supply of bonds refers to the number of bonds available for purchase by investors. Interest rate refers to the price that investors pay to borrow money, usually in the form of a bond. Now, let's consider the three main scenarios that could occur when both the demand and supply of bonds increase: 1. If the increase in demand for bonds is greater than the increase in supply, then the interest rate will decrease. This is because there is a higher demand for bonds, but a limited supply of them. Therefore, to entice investors to purchase the bonds, the interest rate will decrease. 2. If the increase in supply of bonds is greater than the increase in demand, then the interest rate will also decrease. This is because there are now more bonds available in the market, and investors can negotiate for a lower interest rate in order to purchase them. 3. If the increase in demand and supply of bonds is roughly equal, then the impact on interest rates is uncertain. Other factors, such as inflation expectations, economic conditions, and central bank policies, can also influence interest rates in this scenario.