Economics Answer Note #65

Question 1 Which of the following is not one of the Fed's three main tools it uses to conduct monetary policy? a. setting reserve requirements b. lender of last resort to banks through its operation of the discount window and other credit facilities c. lender of first resort to businesses in the federal funds market d. open-market operations Answer The Fed, or the Federal Reserve System, is the central banking system of the United States and is responsible for setting monetary policy to promote economic growth and stability. The Federal Reserve has three main tools at its disposal to conduct monetary policy. These tools are setting reserve requirements, acting as a lender of last resort to banks, and conducting open-market operations. The third option, lender of first resort to businesses in the federal funds market, is not one of the Fed's primary tools for conducting monetary policy. According to the Federal Reserve Bank of New York, the Fed's main tools are “open market operations, the discount rate, and reserve requirements.” Open market operations refer to the buying and selling of government securities by the Federal Reserve, which affects the amount of money in circulation. The discount rate is the interest rate at which banks can borrow from the Federal Reserve, and reserve requirements specify the percentage of deposits that banks must hold in reserve. In contrast, being a lender of first resort to businesses in the federal funds market is not a primary tool of the Fed, but rather an indirect result of its other tools. In the federal funds market, banks lend and borrow funds from each other to meet reserve requirements. The Federal Reserve's actions in setting reserve requirements and conducting open market operations indirectly influence the federal funds rate, which can then impact the borrowing and lending activities of banks in the federal funds market. Question 2 When you supply a bond, you are borrowing money, and when you demand a bond, you are lending money. a. This understanding explains why the quantity of bonds supplied decreases as the price of bonds increases and why the quantity of bonds demanded increases as the price of bonds increases, holding other factors constant. b. This understanding explains why the quantity of bonds supplied increases as the price of bonds decreases and why the quantity of bonds demanded decreases as the price of bonds decreases, holding other factors constant. c. This understanding explains why the quantity of bonds supplied is unchanged as the price of bonds increases and why the quantity of bonds demanded is unchanged as the price of bonds decreases, holding other factors constant. d. This understanding explains why the quantity of bonds supplied increases as the price of bonds increases and why the quantity of bonds demanded increases as the price of bonds decreases, holding other factors constant. Answer According to the basic principles of supply and demand in economics, the price and quantity of a good or service are inversely related. When the price of a good or service increases, the quantity supplied also increases, while the quantity demanded decreases. Similarly, when the price of a good or service decreases, the quantity supplied decreases while the quantity demanded increases. This understanding also applies to bonds. When a bond is supplied, it is essentially a form of borrowing money. On the other hand, when a bond is demanded, it is a form of lending money. Therefore, the price of a bond plays a crucial role in determining the quantity of bonds that are supplied and demanded. a. This understanding explains why the quantity of bonds supplied decreases as the price of bonds increases and why the quantity of bonds demanded increases as the price of bonds increases, holding other factors constant. When the price of a bond increases, the cost of borrowing money also increases. This makes it more expensive for entities to issue bonds, leading to a decrease in the quantity of bonds supplied. On the other hand, as the price of bonds increases, investors are willing to buy more bonds, resulting in an increase in the quantity of bonds demanded. b. This understanding explains why the quantity of bonds supplied increases as the price of bonds decreases and why the quantity of bonds demanded decreases as the price of bonds decreases, holding other factors constant. Conversely, when the price of a bond decreases, the cost of borrowing money decreases as well. This makes it more attractive for entities to issue bonds, resulting in an increase in the quantity of bonds supplied. However, as the price of bonds decreases, investors are likely to demand fewer bonds as they are now receiving a lower return on their investment. c. This understanding explains why the quantity of bonds supplied is unchanged as the price of bonds increases and why the quantity of bonds demanded is unchanged as the price of bonds decreases, holding other factors constant. In some cases, the quantity of bonds supplied and demanded may remain unchanged even as the bond price increases or decreases. This can occur when other factors such as interest rates, inflation, and overall market conditions remain constant. In such a scenario, the market for bonds will be in equilibrium, with the quantity of bonds supplied equaling the quantity demanded. d. This understanding explains why the quantity of bonds supplied increases as the price of bonds increases and why the quantity of bonds demanded increases as the price of bonds decreases, holding other factors constant. When the price of bonds increases, it becomes more profitable for entities to issue bonds, leading to an increase in the quantity of bonds supplied. At the same time, as the price of bonds decreases, investors may see this as an opportunity to invest at a lower cost, resulting in an increase in the quantity of bonds demanded. In summary, the relationship between bond price and the quantity of bonds supplied and demanded follows the basic principles of supply and demand. When the price of bonds increases, the quantity supplied decreases while the quantity demanded increases and vice versa. However, other factors such as interest rates and market conditions also play a significant role in determining the quantity of bonds supplied and demanded. Question 3 Which of the following is not one of the functions of money? a. medium of exchange b. store of value c. unit of account d. means of barter Answer The correct answer is d. means of barter. Money serves as a medium of exchange, store of value, and unit of account, but it is not a means of barter. Money is a widely accepted form of payment for goods, services, and debts. It simplifies the trade process as people do not have to engage in a direct exchange of goods or services. This function of money is known as a medium of exchange. Money also serves as a store of value, meaning it holds its purchasing power over time. This is made possible by its durability, divisibility, and portability. By storing wealth in the form of money, individuals can access it at a later time and use it to purchase goods and services. In addition, money serves as a unit of account, providing a common measuring unit for the value of goods and services. This makes it easier for individuals to compare prices and make informed decisions about their purchases. While money serves many functions, it is not a means of barter. Bartering is a direct exchange of goods or services between two parties. It does not involve the use of money to facilitate the exchange, making it different from the other functions of money. Question 4 When the demand for money and the supply of money both increase, then the interest rate always increases. True False Answer False. According to the quantity theory of money, when both demand and supply for money increase, the interest rate may not necessarily increase. The relation between demand and supply of money and interest rate is dependent on how the increase in demand and supply affects the price level. In an economy, the quantity theory of money states that the total amount of money in circulation (M) is equal to the price level (P) multiplied by the velocity of money (V) where V represents the number of times the average unit of currency is spent over a given period of time. This can be represented as M = P x V. Now, when the demand for money increases, people want to hold more money, which results in an increase in the quantity of money demanded (Md). Similarly, an increase in the supply of money (Ms) leads to an increase in the quantity of money supplied. As a result, the equation now becomes (Md + Ms) = P x V. According to the quantity theory of money, the velocity of money is relatively more stable in the short run. Therefore, if both demand and supply of money increase proportionally, the velocity of money remains constant and the equation becomes (Md + Ms) = P. In this case, the interest rate does not change as there is no change in the price level. However, if the increase in demand for money is relatively higher than the increase in the supply of money, the equation becomes (Md > Ms) = P x V. This leads to a higher price level, causing inflation. As a result, to maintain the same level of interest rate, the nominal interest rate must increase. On the other hand, if the increase in supply of money is relatively higher than the increase in demand for money, the equation becomes (Md < Ms) = P x V. This leads to a lower price level and deflation, resulting in a decrease in the nominal interest rate. In summary, the relation between demand and supply of money and interest rate is not a direct one. It depends on the movement of price level caused by any changes in either demand or supply of money. Question 5 Fiat money, unlike commodity money, has instrinsic value and therefore has value apart from its use as money. True False Answer False. Fiat money does not have intrinsic value, unlike commodity money which has inherent value based on its physical properties. Fiat money is essentially paper currency that is declared legal tender by a government, and its value is determined by supply and demand in the economy. Intrinsic value refers to the inherent or natural value of a good or service, independent of its use as money. Commodity money, such as gold or silver, has inherent value as these precious metals have industrial, decorative, and jewelry uses.