1. One of the functions of money is that it is a ‘store of value’. Explain
2. What is the difference between fiat money and a credit card?
3. How do commercial banks maximize their stockholders’ wealth?
4. The Federal Reserve System (the Fed) is the central bank of the United States. What are its primary functions?
5. Assume that the US economy is experiencing a rather severe recession. How might the Fed utilize the discount rate to speed up the economy? Explain in detail.
6. Assume that the US economy is experiencing a rather severe recession. How might the Fed utilize open market operations to speed up the economy (use lecture notes to answer this)? Explain in detail.
7. Using the explanation in the lecture, explain how the Fed’s purchase of bonds (securities) on the open market can not only increase the money supply through banks’ lending but also decrease the EFFECTIVE interest rate for borrowers. Use an example with actual interest rates.
8. Explain how the required reserve requirement can be used by the Fed to either expand or contract the money supply.
9. A) Using the formula given in the lecture, calculate how much the money supply would increase given an injection of $10 million with a required reserve ratio of 5%. B) Given the same data, how much would the money supply decrease if $10 million were taken out of the money supply with a 5% required reserve ratio?.
10. What 3 events turned an ordinary recession in 1929 into the Great Depression?
11. Ironically technological advancements have made bartering, which used to be an extremely inefficient exchange of values, more and more popular in the present day. Think of and identify four situations where present-day bartering becomes beneficial to both sides of the transaction.
12. Assume that you have 100 $1 bills. Assume also that I have 4 $100 bills. Explain why even though you have more paper money (100 pieces of paper), the value of my four pieces of paper is greater than yours.
13. The Federal Reserve can in effect expand or contract the supply of money in the US.
a. Explain what you think the Fed must do to expand the money supply.
b. Identify 2 reasons why the Fed would do this.
14. Is it possible that the Fed, since it supposedly acts independently of the US government, could use monetary policies (expanding or contracting the money supply) in order to benefit only the wealthiest corporations and individuals while ignoring the lower classes? Explain your opinion here in detail.
15. Explain your opinion as to whether you feel that using a central bank (the Fed) to control all of the US’s major monetary policies as well as all of its money is dangerous? What might be some of the unintended consequences of giving this much power to one private entity?
Module 7 Lecture (Ch. 18): Money and the Monetary System
What Is Money?
The answer seems simple enough, yet there are some false illusions as to what is and what is not money. Basically, money is anything that is commonly accept.
1. One of the functions of money is that it is a ‘store of value’..docx
1. 1. One of the functions of money is that it is a ‘store of value’.
Explain
2. What is the difference between fiat money and a credit card?
3. How do commercial banks maximize their stockholders’
wealth?
4. The Federal Reserve System (the Fed) is the central bank of
the United States. What are its primary functions?
5. Assume that the US economy is experiencing a rather severe
recession. How might the Fed utilize the discount rate to speed
up the economy? Explain in detail.
6. Assume that the US economy is experiencing a rather severe
recession. How might the Fed utilize open market operations to
speed up the economy (use lecture notes to answer this)?
Explain in detail.
7. Using the explanation in the lecture, explain how the Fed’s
purchase of bonds (securities) on the open market can not only
increase the money supply through banks’ lending but also
decrease the EFFECTIVE interest rate for borrowers. Use an
example with actual interest rates.
8. Explain how the required reserve requirement can be used by
the Fed to either expand or contract the money supply.
9. A) Using the formula given in the lecture, calculate how
much the money supply would increase given an injection of
$10 million with a required reserve ratio of 5%. B) Given the
same data, how much would the money supply decrease if $10
million were taken out of the money supply with a 5% required
reserve ratio?.
10. What 3 events turned an ordinary recession in 1929 into the
Great Depression?
11. Ironically technological advancements have made bartering,
which used to be an extremely inefficient exchange of values,
more and more popular in the present day. Think of and identify
four situations where present-day bartering becomes beneficial
to both sides of the transaction.
2. 12. Assume that you have 100 $1 bills. Assume also that I have
4 $100 bills. Explain why even though you have more paper
money (100 pieces of paper), the value of my four pieces of
paper is greater than yours.
13. The Federal Reserve can in effect expand or contract the
supply of money in the US.
a. Explain what you think the Fed must do to expand the money
supply.
b. Identify 2 reasons why the Fed would do this.
14. Is it possible that the Fed, since it supposedly acts
independently of the US government, could use monetary
policies (expanding or contracting the money supply) in order to
benefit only the wealthiest corporations and individuals while
ignoring the lower classes? Explain your opinion here in detail.
15. Explain your opinion as to whether you feel that using a
central bank (the Fed) to control all of the US’s major monetary
policies as well as all of its money is dangerous? What might be
some of the unintended consequences of giving this much power
to one private entity?
Module 7 Lecture (Ch. 18): Money and the Monetary System
What Is Money?
The answer seems simple enough, yet there are some false
illusions as to what is and what is not money. Basically, money
is anything that is commonly accepted in an economy as a
means of payment.
Money in an economy serves 3 specific purposes:
1. Medium of Exchange – it’s an object that may be used to
trade for goods and services
2. Unit of Account – This takes a medium of exchange and
translates the value of economic goods or services into the
medium of exchange’s terms. For instance, a gallon of gas may
be translated into the medium of exchange’s terms as $5 for one
3. gallon.
3. Store of Value – just means that the medium of exchange will
retain much of its value into the future.
There was a funny story back in 2001 about someone who
printed up $200 dollar bills with George Bush’s picture on the
front and then used this currency at a fast-food restaurant. This
could make for a funny vignette about the fact that the clerk
accepted this as currency and then made change for the food
purchase (the customer paid for a $2 ice cream cone and
received $198 in change!). Also, note that this is not
counterfeiting because it doesn’t replicate an existing bill;
although the perpetrator would likely face a charge of theft by
deception (of a very slow ice cream clerk!). (
http://news.bbc.co.uk/1/hi/world/americas/1147246.stm Links
to an external site.). Thus, students could print their own
currency as long as others will accept their declaration that it is
now the medium of exchange (though I wouldn’t recommend
this…).
Money Today
Today, money is termed fiat money. This just means that it has
value only because it is given legal status (the law makes it so).
It only includes:
· Currency – pieces of paper manufactured by the government to
put in your wallet (dollar bills)
· Deposits – money people put into bank accounts, credit unions
etc.
Money does not include:
· Checks
· Credit Cards
· Debit Cards
· E-Checks
· Currency inside of the bank
The Federal Reserve System (Fed) and Its 4 Most Important
4. Functions
The Fed serves many functions in the US economy, but its four
most important are:
1. The Fed regulates the money supply in circulation
2. The Fed supplies the economy with paper currency and coins
3. The Fed provides a system for check collection and clearing
(it acts just like your bank but instead of holding deposits for
people, it holds the deposits of individual banks).
4. The Fed holds reserves for most of the nation’s banks,
savings, and loans, credit unions etc. All depository institutions
are required by law to keep a certain amount of their deposits
on hand, held in an account at the Fed.
The Fed’s Use of Monetary Policies to Speed Up or Slow Down
an Economy
NOTE: MONETARY POLICIES ARE ACTIONS BY THE FED
(a private institution)
FISCAL POLICIES ARE ACTIONS BY THE FEDERAL
GOVERNMENT (Ch. 20)
Most of the information in the text up to pg. 492 is fairly
straightforward. What it’s necessary for you to understand,
however; are the monetary policies the Fed uses to either speed
up a sluggish economy or slow down an overheated economy
(inflation). In the following portion of this lecture, I’ve
attempted to simplify and explain in more detail the monetary
policies of the Fed (pg. 493 & pg. 497) and then conclude with
a much more detailed but more simplified explanation of the
money multiplier.
The Fed’s 3 Monetary Tools To Speed Up or Slowdown
Economic Activity
The Discount Rate – this is the percent interest rate that the Fed
charges commercial banks for borrowing money from the Fed.
When the discount rate is raised, the interest rate on loans
throughout the entire economy (homes, cars, appliances etc.) are
also raised by the lending institutions. This may be used in two
5. ways:
1.
·
a. Raise the discount rate to discourage borrowing which
discourages investment, new jobs etc. Raising the discount rate
is used to combat inflation.
b. Lowering the discount rate to encourage borrowing,
investment, higher employment levels etc. Lowering the
discount rate is used to combat economic slumps, recessions, or
depressions. Since the 2008 economic crash, this rate has been
almost or exactly zero to help jump-start the economy.
The Required Reserve Ratio – this is a policy set by the Fed
establishing a specific % of deposits as reserves (can’t use it to
invest, lend etc.).
2.
·
a. Example: the economy is overheated and inflation is
becoming a problem. Assume that the reserve ratio is 5% (for a
deposit of $100, the bank must keep $5 on hand with $95 left to
invest or loan). Now the Fed increases the ratio to 10%. The
bank must now keep $10 on hand and has only $90 to invest or
loan. This decreases the amount of economic activity by holding
that extra $5 in reserve (multiply that by the billions of dollars
deposited in banks, and you can see the economic impact.
b. Example: The exact opposite of the above. Assume the
economy is in an economic recession. To help create more
money for investment, loans, etc., the Fed will now lower the
reserve requirement. Assume the reserve requirement is 10%
(bank must hold $10 of a $100 deposit), but to increase
economic activity, the Fed lowers the reserve requirement to 5%
(bank must hold only $5 of the $100 deposit, adding an extra $5
to inject into the money supply.
6. Open Market Operations – this is when the Fed either purchases
or sells government securities (bonds) in the open market. This
accomplishes two goals:
3.
·
a. Increase or decrease the money supply. If the Fed purchases
bonds from individuals or banks, those individuals or banks
now have the cash to spend (the money received for the sale of
the government bonds they’ve been holding. This injection of
cash can help speed up an ailing economy. (The Fed would do
the exact opposite if it were contracting the money supply – sell
government bonds on the open market, taking cash out of the
economy.
b. Increase or decrease the interest rates throughout the
economy. By purchasing bonds in the open market, the Fed is
also decreasing interest rates throughout the economy. Here’s
how it works:
i. Assume the face value of a government bond is $1000 with an
interest rate of 6%. Whoever holds the bond gets $60 a year in
interest (1000 x 6%). Note that $60 ÷ $1000 = 6%
ii. Now to entice bondholders to let the Fed purchase their
government bonds, the Fed offers them a HIGHER price than
the original $1000. Let’s say the Fed offers $1200 per bond.
iii. No matter what, the interest on the bond will always be 6%
x $1000 = $60 (because that’s what’s printed on the bond. But
look what’s happened to the EFFECTIVE interest rate
throughout the economy)
iv. The interest received is still $60 after the purchase, but the
amount paid for the bond is no longer $1000; it’s now $1200.
The EFFECTIVE interest rate has gone from 6% to 5% ($60 ÷
$1200 = 5%).
1. What a neat tool! By purchasing bonds, the Fed has increased
the money supply AND decreased the interest rates throughout
the economy – a double whammy to increase economic activity
7. to help revive a sluggish economy.
2. This is pointed out in your text on pg. 493, where the author
describes the quantitative easing the Fed used following the
2008 economic crisis with huge purchases of government bonds
by the Fed.
If the Fed feels the economy is becoming overheated with too
much money and rising inflation rates, it would do the exact
opposite of the above (sell bonds for less than their face value,
contracting the money supply and increasing interest rates).
The Money Multiplier
The increase in the money supply combined with lower interest
rates as outlined above should help jump-start an ailing
economy, but there’s even another benefit to this: the amount
that this new injection of money will eventually grow into. This
is determined by the money multiplier. Let’s take a look at an
example.
· Assume the Fed purchases a $1000 bond from Commercial
Bank. Commercial now has added $1000 cash to its account.
· Assume that the reserve requirement is 10%.
· Commercial banks may now loan or invest $900 of that $1000
(10% of $1000 or $100 must be kept in reserves.
· Assume it loans $900 to John Smith. John Smith then deposits
that $900 into his bank.
· His bank now has an extra $900 and can loan or invest $810
(it must keep 10% x $900 or $90 in reserves.
· The initial $1000 injection into the economy has now grown to
$1810.
· We can calculate the total amount of money that the original
$1000 increase will grow into by using the following formula
(I’ve simplified the formula in your text to make sure you
understand the concept):
·
Potential Money Multiplier = 1 ÷ required reserve ratio.
· In this case, 1 ÷ 10% =10 or an initial injection of money into
8. the spending stream will grow by 10x.
· In the above case, the $1000 injection will grow into a
$10,000 injection (10 x $1000).
Let’s look at the first few rounds of the money multiplier:
Money Pultiplier
Round
Total Reserves
Deposits
Desired reserves
Loans
Total increase in the quantity of money
1
$1,000
$1,000
$100
$900
$1,000
2
$900
$900
$90
$810
$1,810
3
$810
$810
$81
$729
$2,539
If we followed this through to the finish we’d find an increase
in the money supply of $10,000. We used $1000 to simplify
things, but in reality, the Fed has been purchasing billions of
dollars of bonds in the attempt to revive the US economy from
the 2008 recession.
In theory, all of the above definitely shows a way in which an
economy can bounce back from a recession or depression. The
9. one thing it doesn’t take into consideration, however, is the
cooperation of the financial institutions involved. After the
2008 crash banks tended to lean toward the
DESIRED reserve ratio, actually keeping more money
on hand in reserves because of the high level of risk. This, of
course, put the brakes on the money multiplier. Let’s look at
what occurred:
Banks pre-2008 desired reserve ratio was about 1.2%
After the crash, banks increased their desired reserve ratio to
upwards of 12% even though the Fed’s required reserve ratios
were between 0% and 3% and up to 10% on deposits exceeding
a certain level.
This had the effect of limiting the multiplier from a normal
value of 9 (a deposit would grow into 9x that amount) to a value
of 5 (see pg. 503).
The Fed now has to wait until DESIRED reserve ratios decrease
enough to allow injections of money (purchasing bonds) can
take full advantage of the multiplier effect.
So What Does Monetary Policy Have To Do With Inflation?
There is quite a bit of evidence to support monetarists’ school
of economic thought (pg. 447) concerning the relationship
between the amount of money in circulation and inflation.
Let’s look at a simple fictitious example. Suppose the Fed
decided to print up and give to each adult $2 million. When you
first get your $2 million checks you can’t believe your luck.
What a deal! Remember though that everyone will get $2
million. That means that, like you, everyone will go out and
begin buying all of those items they couldn’t afford. The
problem though is that those items are limited. Production
levels have not increased, only the amount of money people
have has increased. This takes us back to our aggregate supply
and demand curves – the demand curve shifts outward and to
the right with corresponding HIGHER prices.
AS PEOPLE DEMAND MORE AND MORE OF A
10. SCARCE RESOURCE OR PRODUCT, THE PRICE OF THAT
RESOURCE OR PRODUCT WILL INCREASE. Put another
way, the value of the money that people have has fallen. Before
the $2 million injections, a basket of economic goods cost the
consumer $10. After the injection, the amount of goods in the
basket has not changed but its price has risen to $100. The
purchasing power of the dollar has decreased by 900% ((100-
10)÷10). What used to cost $10 now costs 9 times that much
(900% as much).
I’ve drawn a chart (Chart 18-A) to illustrate the effect that an
injection of money into the economy might have on inflation:
Notice that the ‘y’ vertical axis on the left (up and down) shows
the value of the dollar starting at $1 and moving downward to
$.20. Look all the way to the right side and you’ll see the price
level starting at $5 and moving upward to $25.
· Now, look at the vertical line labeled ‘Money Supply 1’. Point
‘A’ is the initial equilibrium point where the value of the dollar
is at $33, and the price level is at $15.
· Assume that the Fed decides to begin purchasing bonds,
putting more money into the hands of the consumer as well as
lowering effective interest rates throughout the economy.
· This pushes the supply of money from ‘Money Supply 1’ to
‘Money Supply 2’.
· With this increase in the money supply, the demand for money
begins to decrease from point ‘A’ to point ‘B’.
· As this occurs, the value of money (excess supply) has
decreased from $.33 at point ‘A’ to $.20 at point ‘B’.
· Coinciding with this is an increase in the price level from $15
to $25. This is because there is a larger supply of money for
consumers to spend, but the actual amount of goods and
services to spend the money upon has not increased. The extra
spending money for consumers has just given them the
opportunity to bid up the prices of goods and services, which
11. have remained the same in terms of quantity supplied.
So Do the Fed’s Monetary Tools Help or Hurt the U.S.
Economy?
Good question, and there’s considerable debate as to the
answer. When you read the Policy Application, the answer at
first seems fairly obvious, but the Fed’s policies have had
mixed results. The 1990’s were a positive for Fed policies as
opposed to its potential enhancement of the economic problems
of the 30’s, 70’s, and early 80’s. Added to that are the three
potential time lags (recognition, action, and effect) which tend
to hinder the Fed’s use of its monetary tools to stimulate or
slow down the economy.
It remains to be seen how positive the Fed’s use of discretionary
monetary policy will be in the 21st century. The years 2008-
2009 have already posed one of the biggest economic
stabilization challenges the Fed has faced since the Great
Depression. Only time will tell if its policies combined with the
fiscal policy will be able to lift the U.S. out of a deep recession.
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