Practice set 9 Answers

Fill in the Blank

1. The fact that money can be immediately used in exchange, whereas valuable jewellery cannot,
illustrates the fact that money is very _liquid_________________.

2. The measure of the money supply that includes currency in circulation, traveller’s checks, and
checking accounts is called M1__________________.

3. When the aggregate price level falls economists use the term Deflation____________ to describe
the situation.

4. When something contains intrinsic value and also serves as a medium of exchange it is known as
Commodity Money____________________.

5. The M2__________ definition of the money supply is broad enough to include savings deposits as
well as checkable deposits and currency.

6. A medium of exchange that is valuable because a government says that it has value is known as
_Fiat Money______________.

7. Institutions that accept funds and provide loans are known as financial
Intermediaries_________________________.

8. Vault cash and deposits at the Federal Reserve both count towards Reserves_____________, a
term that describes funds not lent out or invested by a private bank.

9. When banks are only required to hold a fraction of their deposits on reserve they are part of
_Fractional Reserve System________________________.

10. The portion of bank reserves that a bank must keep on reserve are known as _Required
Reserves______________________.

11. The portion of bank reserves that banks are permitted to lend or invest are known as _excess
Reserves______________________.

True or False

16. When a government finances its expenditures by printing money rather than collecting taxes,
this can lead to “too much money chasing too few goods” and hyperinflation. True

17. Coins and paper money have in some periods been commodity money and in other periods fiat
money.True

18. Nelson takes a $100 bill he had in his wallet and deposits it into his checking account. Thus, M1
increases by $100.False

Short Answers

Explain the difference between required reserves and excess reserves

Banks generate much of their profit from the use of other peoples’ money. Checking account
deposits entrusted to banks are also known as “demand deposits” because the depositors have
access to their money whenever they want. Consequently banks are obligated to hold a minimal
portion of these deposits in liquid reserves. This portion is a percentage (set by the Federal Reserve
in the U.S.) of total deposits and is known as required reserves. All of the reserves a bank has beyond
this category of required reserves are referred to as excess reserves.
. What are the three roles of money? And what are two types of money?

The three roles of money are: medium of exchange, store of value, and unit of account. Two types
of money are commodity money and fiat money. Commodity money is a good that is used as money
that is also valuable in itself. Fiat money is a medium of exchange used as money because the
government declares it as such and people accept it.

Answers to Problems

1. a. The following are in M1, M2, or neither:

2. $100 in her wallet = M1
3. $800 in her checking account = M1
4. $1,000 in her savings account = M2
5. A $20 traveler’s check from her last business trip to China = M1
6. A $300 outstanding credit card bill = Neither
7. $3,000 in a small certificate of deposit = M2
8. A car worth $5,000 = Neither
9. A house, worth $200,000 = Neither

b. Suppose she takes the $100 in her wallet and deposits it in her checking account. What is the
change in M1 and M2?

M1 and M2 remain unchanged, since both cash and checking account deposits are counted in both
M1 and M2.

2. Assume a required reserve ratio of 0.10 to complete the following.

Assets Liabilities

Reserves $150 million Deposits $ 500 million

Loans $ 250 million Bank Capital $ 25 million

Bonds $ 125 million

TOTAL: 525 Million TOTAL: $ 525 Million

a) Calculate the initial required reserves for this bank. b) Calculate the initial excess reserves for
this bank. c) Convert all of the excess reserves into loans. Construct the new balance sheet.

a. Required Reserves = reserve ratio * deposits = (0.10) * 500 million = $ 50 million

b. Excess Reserves = total reserves – required reserves = 150 million – 50 million = $ 100 million

c. Assets Liabilities & Net Worth

Reserves $ 50 million Deposits $ 500 million
Loans $ 350 million Bank Capital $ 25 million
Bonds $ 125 million
Explain the difference between required reserves and excess reserves
Banks generate much of their profit from the use of other peoples’ money. Checking account
deposits entrusted to banks are also known as “demand deposits” because the depositors have
access to their money whenever they want. Consequently banks are obligated to hold a minimal
portion of these deposits in liquid reserves. This portion is a percentage (set by the Federal Reserve
in the U.S.) of total deposits and is known as required reserves. All of the reserves a bank has beyond
this category of required reserves are referred to as excess reserves.
 TOTAL: 525 Million TOTAL: $ 525 Million
Self test Questions
4. Which of the following is NOT a function of money?
a. A hedge against inflation.
b. A unit of account.
c. A store of value.
d. A medium of exchange.
e. All of these are functions of money.

5. Which of the following is NOT a type of money described in the textbook?

a. Fishhooks as money.
b. Fiat money.
c. Commodity money.
d. Silver coins as money.
e. All of these are types described in the text.

6. “Fiat money” refers to …

a. Older U.S. coins that contain a high (90%) silver content
. b. A creative alternative to modern money (such as cigarettes in a prisoner of war camp.)
c. Money that is valuable because a government says it has value.
d. Paper money backed by gold or other precious metals.
e. None of these is fiat money.

7. Which of the following is the most liquid?

a. A $20 bill in your pocket
b. A gold necklace
c. Three shares of Microsoft stock
d. A certificate of deposit (CD) in your bank.
e. A new Toyota Prius automobile

8. Which of these sequences best captures the liquidity continuum?

a. Checking accounts, precious metal, real estate, share of stock
b. Checking accounts, precious metal, share of stock, real estate
c. Checking accounts, share of stock, precious metal, real estate
d. Checking accounts, share of stock, real estate, precious metal
e. Precious metal, checking accounts, share of stock, real estate

9. Which of the following is not one of the characteristics necessary for commodity money to
be used as money?
a. It must be durable.
b. It must be portable.
c. It must be generally acceptable.
d. It must be differentiated
. e. It must be scarce.
Explain the difference between required reserves and excess reserves
Banks generate much of their profit from the use of other peoples’ money. Checking account
deposits entrusted to banks are also known as “demand deposits” because the depositors have
access to their money whenever they want. Consequently banks are obligated to hold a minimal
portion of these deposits in liquid reserves. This portion is a percentage (set by the Federal Reserve
in the U.S.) of total deposits and is known as required reserves. All of the reserves a bank has beyond
this category of required reserves are referred to as excess reserves.
 10. Which of the following is not included as “money” in M1?
a. Currency in circulation
b. Checkable deposits
c. Traveler’s checks
d. The use of a credit card
e. The use of debit cards that take funds from a checking account

11. Suppose Tabatha takes $500 from her savings account and deposits it in her checking
account. What is the change in M1 and M2?
a. M1 increases and M2 decreases
b. M1 increases and M2 remains unchanged
c. M1 and M2 both increase
d. M2 increases and M1 remains unchanged
e. M1 and M2 both remain unchanged

12. Which of the following is NOT a component of the M2 definition of the money supply?
a. Certificates of deposit
b. Checking account deposits
c. Retail money market funds
d. Travelers checks
e. All of these are components of the M2 definition of the money supply.

13. Which of these is (was) NOT a financial intermediary?

a. The New York Stock Exchange
b. Bank of America c. MetLife Insurance Company
d. Washington Mutual Savings and Loan
e. All of these are (were) financial intermediaries

14. Which of these would be an INCORRECT use a balance sheet for a private bank?
a. A “government bonds” entry listed as an asset. b.
A “deposits” entry listed as a liability.
c. A “loans” entry listed as an asset.
d. Both (b) and (c) are incorrect.
e. All three of (a), (b), AND (c) are correct entries.

19. Nonbank institutions …

a. have been growing in importance in our financial system
b. often provide much more attractive alternatives to traditional savings accounts.
c. are typically subject to less government regulation than traditional banks.
d. include pension funds and insurance companies.
e. All of these statements are accurate

Explain the difference between required reserves and excess reserves

Banks generate much of their profit from the use of other peoples’ money. Checking account
deposits entrusted to banks are also known as “demand deposits” because the depositors have
access to their money whenever they want. Consequently banks are obligated to hold a minimal
portion of these deposits in liquid reserves. This portion is a percentage (set by the Federal Reserve
in the U.S.) of total deposits and is known as required reserves. All of the reserves a bank has beyond
this category of required reserves are referred to as excess reserves.
 Active Review Fill in the Blank
1. When the Federal Open Market Committee (FOMC) directs the Federal Reserve Bank in
New York to buy or sell government bonds on the open market, it is conducting Open
Market Operations.
2. Suppose the Fed buys bonds on the open market. By doing so, it is increasing the
Monetary base_______________ (also known as High powered money____________),
which is the currency in circulation plus bank reserves.
3. The ratio of the money supply to the monetary base is called the Money Multiplier
4. The interest rate that the Fed charges banks on loans it makes to banks so they can to
meet their reserve requirements is called the Discount rate or Bank rate in India
5. The interest rate that banks pay one another when they borrow on an overnight basis is
called the Call money rate in India or Federal Fund Rate in US.______________________.
6. The _Prime rate____________ is the interest rate that banks charge their most
creditworthy commercial borrowers
7. The theory that assumes that the velocity of money is constant in the equation MV=PY is
called Quantity Theory of Money.

True or False
17. The most common monetary policy tool used by the Fed is changing the discount rate.
False
18. A contractionary or “tight” money policy entails a decrease (or fall in the growth rate
of) the money supply, M1, leading to a lower interest rate.False
19. When the Fed conducts open market operations, it is either trying to keep the federal
funds rate at its existing level, or trying to push the federal funds rate up or down. True
20. Quantitative easing refers to the purchase of a diverse collection of financial assets to
increase the money supply. True
21. The quantity theory of money is an important component of Keynesian thinking.False

Short Answers

24. Identify the three tools of monetary policy, and what the Fed would do to increase (or
decrease) the (growth of the) money supply.
The three tools of monetary policy are: open market operations (buying and selling of
bonds), discount rate( bank rate), and reserve requirement. To increase the (growth of the)
money supply, the Fed could either buy bonds, lower the reserve requirement ratio, or
lower the discount rate. To decrease the (growth of the) money supply, the Fed could
either sell bonds, raise the reserve requirement ratio, or raise the discount rate.

.
Explain the difference between required reserves and excess reserves
Banks generate much of their profit from the use of other peoples’ money. Checking account
deposits entrusted to banks are also known as “demand deposits” because the depositors have
access to their money whenever they want. Consequently banks are obligated to hold a minimal
portion of these deposits in liquid reserves. This portion is a percentage (set by the Federal Reserve
in the U.S.) of total deposits and is known as required reserves. All of the reserves a bank has beyond
this category of required reserves are referred to as excess reserves.
 Problems
1. Suppose the Fed buys $5 million worth of government bonds from TrustMe bank.
a. Show the changes in the Fed’s Balance sheet, and the changes in TrustMe bank’s
balance sheet.
b. How much in new loans can TrustMe Bank make, given this change in its balance sheet?
(Assume the borrowers deposit the amount they borrow in other banks.)
c. Assume that when the new loans are deposited in other banks in the banking system, all
these banks loan out all of their excess reserves. Assume further that the money multiplier
equals 2. By how much has the money supply increased from the Fed’s bond purchase?

Suppose the Fed buys $5 million worth of government bonds from TrustMe bank.
a. The changes in the Fed’s Balance sheet are:

Assets Liabilities
Government bonds +$ 5 million Bank reserves +$ 5 million

(b) The changes in TrustMe bank’s balance sheet are:

Assets Liabilities
Government bonds −$ 5 million
Reserves +$ 5 million

b. $5 million
c. $5 million × 2 = $10 million

Self Test
1. Which of the following is not one of the functions of the Federal Reserve?
a. Performing banking functions for private banks
b. Issuing Treasury bills and bonds (The govt does this)
c. Regulating banks
d. Promoting confidence and stability in the financial sector
e. Conducting monetary policy.

2. An open market purchase by the Fed

a. increases bank reserves, loans, and deposits, and thus increases the money supply.
b. decreases bank reserves, loans, and deposits, and thus decreases the money supply.
c. increases bank reserves, loans, and deposits, and thus decreases the money supply.
d. decreases bank reserves, loans, and deposits, and thus increases the money supply.
e. None of the above.

3. Suppose the Fed buys $15 million worth of government bonds from Richland bank.
Which of the following is Richland Bank most likely to do?
Explain the difference between required reserves and excess reserves
Banks generate much of their profit from the use of other peoples’ money. Checking account
deposits entrusted to banks are also known as “demand deposits” because the depositors have
access to their money whenever they want. Consequently banks are obligated to hold a minimal
portion of these deposits in liquid reserves. This portion is a percentage (set by the Federal Reserve
in the U.S.) of total deposits and is known as required reserves. All of the reserves a bank has beyond
this category of required reserves are referred to as excess reserves.
 a. Reduce its outstanding loans by $15 million.
b. Borrow more reserves at the “discount window”
c. Borrow more reserves from other banks.
d. Make new loans totalling about $15 million.
e. None of the above

4. Suppose the Fed makes an open market purchase of $3 million. Assume that the money
multiplier equals 2. What is the change in the money supply?
a. The money supply has increased by $1.5 million.
b. The money supply has increased by $6 million.
c. The money supply had decreased by $1.5 million.
d. The money supply has decreased by $6 million.
e. None of the above

6. Which of the following is not one of the Fed’s monetary policy tools?
a. Buying bonds on the open market
b. Selling bonds on the open market
c. Raising or lowering taxes
d. Raising or lowering the reserve requirement ratio
e. Raising or lowering the discount rate

Explain the difference between required reserves and excess reserves

Banks generate much of their profit from the use of other peoples’ money. Checking account
deposits entrusted to banks are also known as “demand deposits” because the depositors have
access to their money whenever they want. Consequently banks are obligated to hold a minimal
portion of these deposits in liquid reserves. This portion is a percentage (set by the Federal Reserve
in the U.S.) of total deposits and is known as required reserves. All of the reserves a bank has beyond
this category of required reserves are referred to as excess reserves.