Assignment 2 Effective Managers and Leaders—Gender and Cultural D.docx

Assignment 2: Effective Managers and Leaders—Gender and
Cultural Diversity
In this assignment, you will examine men and women as
managers and leaders. All of us have experienced either being
managed by a man or a woman, some of us by both. Using the
Argosy University online library, the Internet, and your
personal experience, respond to the following questions:
· Analyze what you consider to be the four characteristics of an
effective manager or leader in the workplace. Consider
characteristics such as honesty, integrity, or people skills.
Should managers and leaders perform the same task?
· Compare and contrast the difference between a male and
female manager and/or leader.
· Using the four characteristics you chose, evaluate how one
gender may possess the four characteristics to a greater or lesser
degree. Based on this evaluation, does gender impact whether or
not an individual is a good manager or leader? Explain why, and
provide support for your conclusions.
· Using the four characteristics you chose, evaluate how culture
might impact an individual's leadership abilities. Based on this
evaluation, does culture impact whether or not an individual is a
good manager or leader? Explain why, and provide support for
your conclusions.
Write a 3–4-page paper in Word format (not counting title and
references pages), citing examples using APA rules for
attributing sources.
By Tuesday, February 10, 2015, deliver your assignment to the
M4: Assignment 2 Dropbox.
All written assignments and responses should follow APA rules
for attributing sources.
Assignment 2 Grading Criteria
Maximum Points
Essay adequately analyzes four characteristics of an effective
manager or leader.

40
Essay analyzes the impact of gender on leadership
characteristics.
20
Essay analyzes the impact of culture on leadership
characteristics.
20
Wrote in a clear, concise, and organized manner; demonstrated
ethical scholarship in accurate representation and attribution of
sources; displayed accurate spelling, grammar, and punctuation.
20
Total:
100
R. GLENN
HUBBARD
ANTHONY PATRICK
O’BRIEN
FIFTH EDITION
© 2015 Pearson Education, Inc..
Money, Banks, and the Federal Reserve System
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© 2014 Pearson Education, Inc.
Chapter Outline and
Learning Objectives14.1What is Money, and Why Do We Need
It?14.2How Is Money Measured in the United States
Today?14.3How Do Banks Create Money?14.4The Federal
Reserve System14.5The Quantity Theory of Money

CHAPTER
14
CHAPTER
Money
Money is one of the most important inventions of mankind.
Economists consider money to be any asset that people are
generally willing to accept in exchange for goods and services,
or for payment of debts.
Asset: Anything of value owned by a person or a firm.
We will begin by considering what role money serves, and what
can be used as money.
Then we will consider modern forms of money and the roles of
banks and the government in creating and managing money.
Finally, we will create a model relating prices to the amount of
money.
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What Is Money, and Why Do We Need It?
14.1
Define money and discuss the four functions of money.
LEARNING OBJECTIVE
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Barter and the Invention of Money
Suppose you were living before the invention of money.
If you wanted to trade, you would have to barter, trading goods
and services directly for other goods and services.

Trades would require a double coincidence of wants.
Eventually, societies started using commodity money—goods
used as money that also have value independent of their use as
money—like animal skins or precious metals.
The existence of money makes trading much easier and allows
specialization, an important step for developing an economy.
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The Functions of Money
Money fulfills four primary functions:
Medium of exchange
Money is acceptable to a wide variety of parties as a form of
payment for goods and services.
Unit of account
Money allows a way of measuring value in a standard manner.
Store of value
Money allows people to defer consumption till a later date by
storing value. Other assets can do this too, but money does it
particularly well because it is liquid, easily exchanged for
goods.
Standard of deferred payment
Money facilitates exchanges across time when we anticipate that
its value in the future will be predictable.
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What Can Serve as Money?
In order to serve as an acceptable medium of exchange (and
hence a potential “money”), a good should have the following

characteristics:
The good must be acceptable to most people.
It should be of standardized quality so any two units are alike.
It should be durable so that value is not lost by storage.
It should be valuable relative to its weight, so that it can easily
be transported even in large quantities.
It should be divisible because different goods are valued
differently.
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Commodity Money
Commodity money has a value independent of its use as money.
Some important historical and modern commodity moneys:
Cowrie shells in Asia (the Classical Chinese character for
money/currency, 貝, originated as a pictograph of a cowrie
shell)
Precious metals, such as gold or silver
Beaver pelts in pre-colonial America
Cigarettes in prisons and prisoner-of-war camps
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Fiat Money
Beginning in China in the 10th century and spreading
throughout the world, paper money was issued by banks and
governments. The paper money was exchangeable for some
commodity, typically gold, on demand.
In modern economies, paper money is generally issued by a
central bank run by the government.
The Federal Reserve is the central bank of the United States.

However, money issued by the Federal Reserve is no longer
exchangeable for gold; nor is any current world currency.
Instead, the Fed issues currency known as fiat money.
Fiat money refers to any money, such as paper currency, that is
authorized by a central bank or governmental body, and that
does not have to be exchanged by the central bank for gold or
some other commodity money.
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Fiat Money—Advantages and Disadvantages
Fiat money has the advantage that governments do not have to
be willing to exchange it for gold or some other commodity on
demand.
This makes central banks more flexible in creating money.
However it also creates a potential problem: fiat money is only
acceptable as long as households and firms have confidence that
if they accept paper dollars in exchange for goods and services,
the dollars will not lose much value during the time they hold
them.
If people stop “believing” in the fiat money, it will cease to be
useful.
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Apple Didn’t Want My Cash!
A woman in California went to an Apple store and tried to buy
an iPad using $600 in currency.
Apple refused the sale. It wanted to keep track of people buying
multiple iPads to resell, so it was only accepting credit or debit

cards.
Can Apple do this legally? Yes! Firms are not obliged to accept
currency as payment. (Debts are a different story.)
Similarly, many convenience stores and gas stations refuse to
take large-denomination bills ($50 or more). Nor can you force
a store to accept a bucket of pennies as payment.
Due to bad publicity, Apple ended up giving the woman (who
was in a wheelchair!) an iPad for free.
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Making
the
Connection
Assets that are generally accepted in exchange for goods and
services or for payment of debts are specifically called:
wealth.
net worth.
money.
capital.
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The value of money as a medium of exchange is determined
primarily by:
The ability of money to be redeemed for gold.
The amount of goods and services that a dollar can buy.
The willingness of people to accept it.
The order of the central bank, stated on each bill, to be accepted

as legal tender.
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If prisoners of war use cigarettes as money, then cigarettes are:
token money.
fiduciary money.
fiat money.
commodity money.
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What is fiat money?
Money that has value independent of its use as money.
An asset that has the ability to be easily converted into the
medium of exchange.
Money that is authorized by a central bank and that does not
have to be exchanged for gold or some other commodity money.
Money issued by financial intermediaries, such as banks and
thrift institutions, not the central bank.
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How Is Money Measured in the United States Today?
14.2
Discuss the definitions of the money supply used in the United
States today.
LEARNING OBJECTIVE

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U.S. Money Supply, July 2013
How much money is there in America? This is harder to answer
than it first appears, because you have to decide what to count
as “money”.
M1 is the narrowest definition of the money supply: the sum of
currency in circulation, checking account deposits in banks, and
holdings of traveler’s checks.
There is a relatively large amount of U.S. currency, because
people in other countries sometimes hold and use U.S. dollars
instead of their own currency.
Measuring the money supply, July 2013
Figure 14.1
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The Federal Reserve uses two different measures of the money
supply:
M1 and M2. Panel (a) shows the assets in M1. Panel (b) shows
M2, which
includes the assets in M1, as well as money market mutual fund
shares,
small-denomination time deposits, and savings account deposits.
Source: Board of Governors of the Federal Reserve System,
“Federal Reserve
Statistical Release, H.6,” July 14, 2013.
17

U.S. Money Supply, July 2013—continued
M2 is a broader definition of the money supply: it includes M1,
plus savings account balances, small-denomination time
deposits, balances in money market deposit accounts, and non-
institutional money market fund shares.
Measuring the money supply, July 2013
Figure 14.1
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M1 vs. M2
When we want to talk about the money supply, which definition
should we use?
Either one might be valid, but we are mostly interested in
money’s role as the medium of exchange, so this suggests using
M1.
In our discussion of money, we will therefore:
Treat both currency and checking account balances as “money”,
but nothing else. (Traveler’s checks are insignificant.)
Realize that banks play an important role in the money supply,
since they control what happens to money when it is in a
checking account.
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What about Credit and Debit Cards?
Debit cards directly access checking accounts, but the card is
not money, the checking account balance is.
Credit cards are a convenient way to obtain a short-term loan
from the bank issuing the card. But transactions are not really
complete until you pay the loan off—transferring money to pay
off the credit card loan.
So credit cards do not represent money.
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Are Bitcoins Money?
When we think of money, we typically think of currency issued
by a government.
But currency is only a small part of the money supply.
Over the last decade or so, consumers have come to trust forms
of e-money such as PayPal.
Bitcoins are a new form of e-money, owned not by a
government or firm, but a product of a decentralized system of
linked computers.
Bitcoins can be traded for other currencies on web sites.
Some web sites accept Bitcoins as a form of payment.
Should Bitcoins be included in a measure of the money supply?
For now, they are not; if they grow popular, maybe they should
be.
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Making
the
Connection
The sum of currency in circulation, checking account balances
in banks, and holdings of traveler’s checks equals:
M1.
M2.
M3.
None of the above.
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Saving account balances, small-denomination time deposits, and
noninstitutional money market fund shares are a component of:
M1.
M2.
M3.
financial instruments that are not included in the money supply.
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In the definition of the money supply, where do credit cards
belong?
M1.
M2.
M3.
None of the above.

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How Do Banks Create Money?
14.3
Explain how banks create money.
LEARNING OBJECTIVE
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Banks and Money
Banks play a critical role in the money supply.
Recall that there is more money held in checking accounts than
there is actual currency in the economy.
So somehow money is being created by banks.
Further, banks are generally profit-making private firms: some
small, but some among the largest corporations in the country.
Their activities are designed to allow themselves to make a
profit.
In order to understand the role that banks play, we will first try
to understand how banks operate as a business.
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Bank Balance Sheets
On a balance sheet, a firm’s assets are listed on the left, and its
liabilities (and stockholders’ equity, or net worth) are listed on
the right. The left and right sides must add to the same amount.

Banks use money deposited with them to make loans and buy
securities (investments).
Their largest liabilities are their deposit accounts: money they
owe to their depositors.
Balance sheet of a typical large bank
Figure 14.2
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The items on a bank’s balance sheet of greatest
economic importance are its reserves,
loans, and deposits. Notice that the difference
between the value of this bank’s total
assets and its total liabilities is equal to its
stockholders’ equity. As a consequence, the
left side of the balance sheet always equals
the right side.
Note: Some entries have been combined to
simplify the balance sheet.
27
Bank Balance Sheets
Reserves are deposits that a bank keeps as cash in its vault or
on deposit with the Federal Reserve.
Notice that the bank does not keep enough deposits on hand to
cover all of its deposits. This is how the bank makes a profit:
lending out or investing money deposited with it.
Balance sheet of a typical large bank

Figure 14.2
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Required and Excess Reserves
The bank must keep some cash available for its depositors; it
does this through a combination of vault cash and deposits with
the Federal Reserve.
Banks in the U.S. are required to hold required reserves:
reserves that a bank is legally required to hold, based on its
checking account deposits.
At least 10% of checking account deposits above some
threshold level ($58.8 million in 2011; $71.0 million in 2012,
$79.5 million in 2013).
This 10% is known as the required reserve ratio (RR): the
minimum fraction of deposits banks are required by law to keep
as reserves.
Banks might choose to hold excess reserves: reserves over the
legal requirement.
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Money Creation at Bank of America
A T-account is a stripped-down version of a balance sheet,
showing only how a transaction changes a bank’s balance sheet.

When you deposit $1,000 in currency at Bank of America, its
reserves increase by $1,000 and so do its deposits:
The currency component of the money supply decreases by the
$1,000, since that $1,000 is no longer in circulation; but the
checking deposits component increases by $1,000. So there is
no net change in the money supply—yet.
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T-Accounts
But Bank of America needs to make a profit; so it keeps 10% of
the deposit as reserves, and lends out the rest, creating a $900
checking account deposit.
The $900 initially appears in a BoA checking account but will
soon be spent; and Bank of America will transfer $900 in
currency to the bank at which the $900 check is deposited.
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When Will it End?
Each “round”, the additional checking account deposits get
smaller and smaller.
Every round, 10% of the deposits are kept as reserves. This
allows us to tell by how much the checking deposits will
eventually increase: the $1,000 in currency will become the
10% required reserves for all of the checking deposits, so a total
of $10,000 in checking deposits can be created.BankIncrease In
Checking Account DepositsBank of America$1,000PNC+ 900

(= 0.9 × $1,000)Third Bank+ 810(= 0.9 × $900)Fourth Bank+
729(= 0.9 × $810)• + •• + •• + •Total change in checking
account deposits = $10,000
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Simple Deposit Multiplier
An alternative way to find out how much money the original
$1,000 in currency will create is to add up all of the checking
account deposits.
$1,000 + [0.9 × $1,000] + [(0.9 × 0.9) × $1,000] + [(0.9 × 0.9 ×
0.9) × $1,000] + …
= $1,000 + [0.9 × $1,000] + [0.92 × $1,000] + [0.93 × $1,000] +
…
= $1,000 (1 + 0.9 + 0.92 + 0.93 + …)
The expression in the parentheses can be rewritten as:
So the total increase in deposits is $1,000(10) = $10,000.
The “10” here is the simple deposit multiplier: the ratio of the
amount of deposits created by banks to the amount of new
reserves.
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General Form for the Simple Deposit Multiplier
In general, we can write the simple deposit multiplier as:

So with a 10% required reserve ratio (RR), the simple deposit
multiplier is 10.
With a 20% required reserve ratio, the simple deposit multiplier
is 5.
Then:
For example, $100,000 in new deposit, with a 10% required
reserve ratio, results in:
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Real-World Deposit Multiplier
With a 10% required reserve ratio, the simple deposit multiplier
tells us that a currency deposit will be multiplied 10 times.
But in reality, we do not observe this: currency deposits only
end up being multiplied about 2.5 times, during “normal”
periods.
Why this difference?
Banks may not lend out as much as we predict, either because
they want to keep excess reserves, or they cannot find credit-
worthy borrowers.
Consumers keep some currency out of the bank; that currency
cannot be used as required reserves.
Note: during the recession of 2007-2009, research suggests that
the real-world multiplier fell to close to 1.

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Conclusions about Banks and the Money Supply
In general, we can assume that the real-world deposit multiplier
is greater than 1. So we conclude that:
When banks gain reserves, they make new loans, and the money
supply expands.
When banks lose reserves, they reduce their loans, and the
money supply contracts.
This is enough to establish the important relationship between
banks and the money supply.
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A small, but very important, asset on a bank’s balance sheet is:
reserves.
required reserves.
excess reserves.
deposits.
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Which of the following refers to the minimum fraction of
deposits banks are required by law to keep as reserves?
The quantity equation.
The simple deposit multiplier.
The required reserve ratio.
The cash to deposit ratio.

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The largest liability for most banks is:
deposits.
loans.
reserves.
all of the above.
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If the reserve requirement is 10% and there is no currency
leakage in the loan – deposit cycle, how much is the total
increase in checking account deposits caused by an initial
deposit of $1,000?
$100
$1,000
$10,000
$100,000
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Whenever banks gain reserves and make new loans, the money
supply ___________; and whenever banks lose reserves, they
reduce their loans and the money supply __________.
expands; expands
expands; contracts
contracts; contracts
contracts; expands

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The Federal Reserve System
14.4
Discuss the three policy tools the Federal Reserve uses to
manage the money supply.
LEARNING OBJECTIVE
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Bank Runs and Bank Panics
We have described that, in the United States, banks keep less
than 100 percent of deposits as reserves. This is known as a
fractional reserve banking system, and is in a system shared by
nearly all countries.
But what if depositors lost confidence in a bank, and tried to
withdraw their money all at once? This situation is known as a
bank run; if many banks simultaneously experience bank runs, a
bank panic occurs.
A central bank, like the Federal Reserve, can help to prevent
bank runs and panics by acting as a lender of last resort,
promising to make loans to banks in order to pay off depositors.
This assurance helps make people confident in being able to
eventually receive their money and prevents the panic.
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The Establishment of the Federal Reserve System
In the late 19th and early 20th centuries, the United States
experienced several bank panics.
In 1914, the Federal Reserve system started. “The Fed” makes

loans to banks called discount loans, charging a rate of interest
called the discount rate.
During the Great Depression of the 1930s, many banks were hit
by bank runs. Afraid of encouraging bad banking practices, the
Fed refused to make discount loans to many banks, and more
than 5,000 banks failed.
Today, many economists are critical of the Fed’s decisions in
the early 1930s, believing they made the Great Depression
worse.
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Response to the Great Depression
In 1934, Congress established the Federal Deposit Insurance
Corporation (FDIC).
The FDIC insures deposits in many banks, up to a limit
(currently $250,000). This government guarantee has helped to
limit bank panics.
Bank runs are still possible; during the recession of 2007-2009,
a few banks experienced runs from large depositors whose
deposits exceeded the FDIC limit.
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The Federal Reserve System
In 1913, Congress divided the country into 12 Federal Reserve
districts, each of which provides services to banks in the
district.
But the real power of the Fed lies in Washington, DC, with the

Board of Governors.
In 2013, the chair of the Board of Governors was Ben Bernanke.
The Federal Reserve system
Figure 14.3
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The United States is divided into 12 Federal Reserve districts,
each of which
has a Federal Reserve Bank. The real power within the Federal
Reserve System,
however, lies in Washington, DC, with the Board of Governors,
which consists of
7 members appointed by the president. The 12-member Federal
Open Market
Committee carries out monetary policy.
Source: Board of Governors of the Federal Reserve System.
46
The Federal Reserve System—continued
The Fed is also responsible for managing the money supply.
The Federal Open Market Committee (FOMC) conducts
America’s monetary policy: the actions the Federal Reserve
takes to manage the money supply and interest rates to pursue
macroeconomic policy objectives.
The Federal Reserve system
Figure 14.3
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47
How the Fed Manages the Money Supply
The Fed has three monetary policy tools at its disposal:
Open market operations (most common)
Open market operations refers to the buying and selling of
Treasury securities by the Federal Reserve in order to control
the money supply.
To increase the money supply, the Fed directs its trading desk
in New York to buy U.S. Treasury securities—Treasury “bills”,
“notes”, and “bonds”, which are short-term (1 year or less),
medium-term (2-10 years), or long-term (30 years) tradable
loans to the U.S. Treasury.
To decrease the money supply, the Fed sells its securities.
These open market operations can occur very quickly, and are
easily reversible.
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Open Market Operations in Action
Open market operations (most common)
Suppose the Fed engages in an open market purchase of $10
million.
The banking system’s T-account reflects an increase in reserves,
and a corresponding decrease in assets due to its debt to the
Fed.
The banking system’s reserves are liabilities for the Fed, but it
gains assets equal to the debt owed to it by the banking system.

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How the Fed Manages the Money Supply—cont.
Discount policy
The discount rate is the interest rate paid on money banks
borrow from the Fed.
By lowering the discount rate, the Fed encourages banks to
borrow (and hence lend out) more money, increasing the money
supply. Raising the discount rate has the opposite effect.
Reserve requirements
The Fed can alter the required reserve ratio. A decrease would
result in more loans being made, increasing the money supply.
An increase would result in fewer loans being made.
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The Rise and Effects of the Shadow Banking System
The banks we have been discussing so far are commercial
banks, whose primary role is to accept funds from depositors
and make loans to borrowers.
In the last 20 years, two important developments have occurred
in the financial system:
Banks have begun to resell many of their loans rather than keep
them until they are paid off.
Financial firms other than commercial banks have become
sources of credit to businesses.
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Securitization Comes to Banking
A security is a financial asset—such as a stock or a bond—that
can be bought and sold in a financial market.
Traditionally, when a bank made a loan like a residential
mortgage loan, it would “keep” the loan and collect payments
until the loan was paid off.
In the 1970s, secondary markets developed for securitized
loans, allowing them to be traded, much like stocks and bonds.
Securitization: The process of transforming loans or other
financial assets into securities.
The process of securitization
Figure 14.4
(a) Securitizing a loan
(b) The flow of payments on a securitized loan
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Panel (a) shows how in the securitization process banks grant
loans to households
and bundle the loans into securities that are then sold to
investors.
Panel (b) shows that banks collect payments on the original
loans and, after taking
a fee, send the payments to the investors who bought the
securities.
52
The Shadow Banking System
The 1990s and 2000s brought increasing important of non-bank
financial firms, including:
Investment banks: banks that do not typically accept deposits
from or make loans to households; they provide investment
advice, and engage also engage in creating and trading
securities such as mortgage-backed securities.
Money market mutual funds: funds that sell shares to investors
and use the money to buy short-term Treasury bills and
commercial paper (loans to corporations).
Hedge funds: funds that raise money from wealthy investors and
make “sophisticated” (often non-standard) investments.
By raising funds from investors and providing them directly or
indirectly to firms and households, these firms have become a
“shadow banking system”.
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The Financial Crisis of 2007-2009
What made this “shadow banking system” different from
commercial banks?
These firms were less regulated by the government, including
not being FDIC-insured.
These firms were highly leveraged, relying more heavily on

borrowed money; hence their investments had more risk, both of
gaining and losing value.
Beginning in 2007, firms in the shadow banking system were
quite vulnerable to runs.
In spring of 2008, investment bank Bear Stearns avoided
bankruptcy only by being purchased by JPMorgan Chase.
In fall of 2008, investment bank Lehman Brothers did declare
bankruptcy, after most of its clients pulled their money out.
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The Aftermath of Lehman Brothers’ Collapse
After Lehman Brothers failed, a panic started, with many
investors withdrawing their funds.
Securitization ground to a halt; with banks unable to resell their
loans, they stopped making as many.
The resulting credit crunch significantly worsened the
recession.
Beginning in fall 2008, the Fed took vigorous action under the
Troubled Asset Relief Program (TARP):
Providing funds to banks in exchange for stock
Offering discount loans to previously ineligible investment
banks
Buying commercial paper for the first time since the 1930s
These combined actions appear to have stabilized the financial
system, but full financial recovery has still (2013) not occurred.
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55
In banking terminology we say that a central bank, like the
Federal Reserve in the United States, can help stop a bank panic
by acting as:
a financial intermediary.
a borrower.
a lender of last resort.
the regulator of the withdrawal limit that banks can disburse
each day during the panic run.
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The Federal Reserve System is:
the central bank of the United States.
the institution that regulates all state banks.
an institution that regulates all securities and exchange in
financial markets.
an institution also known as the Treasury of the United States.
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The Fed uses three monetary policy tools. Which of the
following is not one of those tools?
Open market operations.
Discount policy.
Reserve requirements.
Federal funds rate setting.
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Which of the following people vote on monetary policy at the
Federal Open Market Committee (FOMC) meetings?
The seven members of the Federal Reserve’s Board of
Governors.
The president of the Federal Reserve Bank of New York.
Four presidents from Federal Reserve banks other than the
president of the Federal Reserve Bank of New York (rotating
basis).
All of the above.
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By raising the discount rate, the Fed encourages banks to make
_________ loans to households and firms, which will
_________ checking account deposits and the money supply.
more; increase
more; decrease
less; increase
less; decrease
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The Quantity Theory of Money
14.5
Explain the quantity theory of money and use it to explain how
high rates of inflation occur.
LEARNING OBJECTIVE
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How Does the Money Supply Affect Prices?
Beginning in the 16th century, Spain sent gold and silver from
Mexico and Peru back to Europe.
These metals were minted into coins, increasing the money
supply.
Prices in Europe rose steadily during those years.
This helped people to make the connection between the amount
of money in circulation and the price level.
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Connecting Money and Prices: The Quantity Equation
In the early 20th century, Irving Fisher formalized the
relationship between money and prices as the quantity equation:
Money supply real output
velocity of money price level
Velocity of money: the average number of times each dollar in
the money supply is used to purchase goods and services
included in GDP.
Rewriting this equation by dividing through by M, we obtain:
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63
Calculating the Velocity of Money
Measuring:

The money supply (M) with M1,
The price level (P) with the GDP deflator, and
The level of real output (Y) with real GDP,
We obtain the following value for velocity (V):
We can always calculate V. But will we always get the same
answer? The quantity theory of money asserts that, subject to
measurement error, we will:
Quantity theory of money: A theory about the connection
between money and prices that assumes that the velocity of
money is constant.
‹#› of 74
The Quantity Theory Explanation of Inflation
When variables are multiplied together in an equation, we can
form the same equation with their growth rates added together.
So the quantity equation:
generates:
Rearranging this to make the inflation rate the subject, and
assuming that the velocity of money is constant, we obtain:
‹#› of 74
The Inflation Rate According to the Quantity Theory
This equation provides the following predictions:

If the money supply grows faster than real GDP, there will be
inflation.
If the money supply grows slower than real GDP, there will be
deflation (a decline in the price level).
If the money supply grows at the same rate as real GDP, there
will be neither inflation nor deflation: the price level will be
stable.
Is velocity truly constant from year to year? The answer is no.
But the quantity theory of money can still provide insight:
In the long run, inflation results from the money supply growing
at a faster rate than real GDP.
‹#› of 74
How Accurate Are Estimates of Inflation from the QTM?
Real GDP growth has been relatively consistent over time.
So based on the quantity theory of money (QTM), there should
be a predictable, positive relationship between the annual rates
of inflation and growth rates of the money supply.
There is a positive relationship, but not the consistent
relationship implied by a constant velocity of money.
The relationship between money growth and inflation over time
and around the world
Figure 14.5a
Inflation and money supply growth in the United States, 1870s-
2000s
‹#› of 74

Panel (a) shows that, by and large, the rate of inflation in the
United States
has been highest during the decades in which the money supply
has increased
most rapidly, and the rate of inflation has been lowest during
the decades in
which the money supply has increased least rapidly. Panel (b)
shows the relationship
between money supply growth and inflation for 56 countries
between
1995 and 2011. There is not an exact relationship between
money supply
growth and inflation, but countries such as Bulgaria, Turkey,
and Ukraine that
had high rates of money supply growth had high inflation rates,
and countries
such as the United States and Japan had low rates of money
supply growth and
low inflation rates.
Sources: Panel (a): For the 1870s to the 1960s, Milton Friedman
and Anna J.
Schwartz, Monetary Trends in the United States and United
Kingdom: Their
Relation to Income, Prices, and Interest Rates, 1867–1975,
Chicago: University of
Chicago Press, 1982, Table 4.8; and for the 1970s to the 2000s,
Federal Reserve Board
of Governors and U.S. Bureau of Economic Analysis; Panel (b):
International Monetary
Fund, International Monetary Statistics.
67
Accuracy of the QTM—continued

We see a similar story when we compare average rates of
inflation and growth rates of the money supply across different
countries.
Although the relationship is not entirely predictable, countries
with higher growth in the money supply do have higher rates of
inflation.
The relationship between money growth and inflation over time
and around the world
Figure 14.5b
Inflation and money supply growth in 56 countries, 1995-2011
‹#› of 74
High Rates of Inflation
Very high rates of inflation—in excess of 100 percent per
year—are known as hyperinflation.
Hyperinflation results when central banks increase the money
supply at a rate far in excess of the growth rate of real GDP.
This might happen when governments want to spend much more
than they raise through taxes, so they force their central bank to
“buy” government bonds.
Recently, hyperinflation has occurred in Zimbabwe; during the
2000s, prices increased by (on average) 7500% per year.
At that rate, a can of soda costing $1 this year would cost $75
next year, and over $5600 the year after that.
Hyperinflation tends to be associated with slow growth, if not
severe recession.

‹#› of 74
The German Hyperinflation of the Early 1920s
After Germany lost WWI, the Allies forced Germany to pay
reparations.
Unable to cover both its regular spending and the reparations,
the German government sold bonds to its central bank, the
Reichsbank.
The value of the German mark started to fall, and the Allies
demanded payment in their own currencies; so Germany was
forced to buy their currency with its own. This required massive
expansion of the money supply.
From 1922-1923, the German price index rose from 1,440 to
126,160,000,000,000, making the German mark (and any
savings held in German currency) worthless.
‹#› of 74
Making
the
Connection
Common Misconceptions to Avoid
Money is not the same as income or wealth, though the latter
two concepts are often denominated in the former.
“Assets” and “liabilities” can be confusing, especially as a
checking account deposit. An asset for the depositor is a
liability for the bank. Remember in this chapter to consider

things from the bank’s perspective.
When the Fed “buys” securities, it pays with “electronic
money”. It doesn’t actually print money, instead simply
increasing the checking account balance of the Treasury, on the
promise that the Treasury will “pay the money back” later.
‹#› of 74
The theory connecting the money supply and the prices level
that assumes the velocity of money is constant is called:
The quantity equation.
The quantity theory of money.
The constant velocity of money theory.
The purchasing power parity theory of money.
‹#› of 74
If Irving Fisher was correct about his prediction of velocity,
then the quantity equation can be written to solve for inflation
as follows:
Inflation rate = Growth rate of the money supply + Growth rate
of real output.
Inflation rate = Growth rate of the money supply − Growth rate
of real output.
Inflation rate = Growth rate of the money supply − Growth rate
of velocity.
Inflation rate = Growth rate of the money supply + Growth rate
of velocity.
‹#› of 74

Which of the following predictions can be made using the
growth rates associated with the quantity equation?
If the money supply grows at a faster rate than real GDP, there
will be inflation.
If the money supply grows at a slower rate than real GDP, there
will be inflation.
If the money supply grows at the same rate as real GDP, the
price level will be fall. There will be deflation.
All of the above.
‹#› of 74
9
.
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Principles of Economics
HW#3
Chapter 14 Money, Banks, and The Federal Reserve System
Please answer the following questions and submit it to me next
class for an extra credit (2 points)
NAME:______________________________________________
_______________________________
1. What is a commercial bank? How do they act?
2. What is an investment bank? How do they act?

3. What is a Ponzi Scheme?
4. What is a security? Name 2 or 3 different type of securities?
5. What is a securitization?
6. What is “Shadow Banking System”? How did it happen? Who
named it?
7. What is a hedge fund?

8. What is a CDO? What is their role in the new financial
system?
9. What was Glass-Steagall Act?
10. What is Gramm-Leach-Bliley Act?
11. Explain the cause s of the financial crisis in 2007-2009?
Please discuss if you agree on deregulation during these years?
Discuss if you believe regulation or deregulation in the
financial system. (You san use the back page).

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