Chapter 29
Problems and Applications 1. a. A U.S. penny is money in the U.S. economy because it is used as a medium of exchange to
buy goods or services, it serves as a unit of account because prices in stores are listed in terms of dollars and cents, and it serves as a store of value for anyone who holds it over time.
b. A Mexican peso is not money in the U.S. economy, because it is not used as a medium of
exchange, and prices are not given in terms of pesos, so it is not a unit of account. It could serve as a store of value, though.
c. A Picasso painting is not money, because you cannot exchange it for goods or services, and
prices are not given in terms of Picasso paintings. It does, however, serve as a store of value.
d. A plastic credit card is similar to money, but represents deferred payment rather than
immediate payment. So credit cards do not fully represent the medium of exchange
function of money, nor are they really stores of value, because they represent short-term loans rather than being an asset like currency.
2. For an asset to be useful as a medium of exchange, it must be widely accepted (so all transactions
can be made in terms of it), recognized easily as money (so people can perform transactions easily and quickly), divisible (so people can provide change), and difficult to counterfeit (so people will not print their own money). That is why nearly all countries use paper money with fancy designs for larger denominations and coins for smaller denominations.
For an asset to be useful as a store of value, it must be something that maintains its value over time and something that can be used directly to buy goods and services or sold when money is needed. In addition to currency, financial assets (like stocks and bonds) and physical assets (like real estate and art) make good stores of value.
3. a. Currency holdings jumped at the end of 1999. Many individuals were worried about Y2K
and its effect on computers. They withdrew large sums of money from banks to protect themselves from any possible problems.
b. Many answers are possible. 4. When your uncle repays a $100 loan from Tenth National Bank (TNB) by writing a check from his
TNB checking account, the result is a change in the assets and liabilities of both your uncle and TNB, as shown in these T-accounts:
Your Uncle Assets Liabilities Before: Checking Account $100 Loans $100 After: Checking Account $0 Loans $0
1
Chapter 29/The Monetary System 2
Tenth National Bank Assets Before: Loans After: Loans
By paying off the loan, your uncle simply eliminated the outstanding loan using the assets in his checking account. Your uncle's wealth has not changed; he simply has fewer assets and fewer liabilities.
5.
a.
Here is BSB's T-account:
Beleaguered State Bank Assets Liabilities $25 million Deposits $250 million $225 million $100 Deposits $0 Deposits Liabilities $100 $0 Reserves Loans
b.
When BSB's largest depositor withdraws $10 million in cash and BSB reduces its loans outstanding to maintain the same reserve ratio, its T-account is now:
Beleaguered State Bank Assets Liabilities $24 million Deposits $240 million $216 million Reserves Loans
c.
d.
Because BSB is cutting back on its loans, other banks will find themselves short of reserves and they may also cut back on their loans as well.
BSB may find it difficult to cut back on its loans immediately, because it cannot force
people to pay off loans. Instead, it can stop making new loans. But for a time it might find itself with more loans than it wants. It could try to attract additional deposits to get additional reserves, or borrow from another bank or from the Fed.
6.
If you take $100 that you held as currency and put it into the banking system, then the total amount of deposits in the banking system increases by $1,000, because a reserve ratio of 10% means the money multiplier is 1/.10 = 10. Thus, the money supply increases by $900, because deposits increase by $1,000 but currency declines by $100.
With a required reserve ratio of 10%, the money multiplier could be as high as 1/.10 = 10, if banks hold no excess reserves and people do not keep some additional currency. So the maximum increase in the money supply from a $10 million open-market purchase is $100 million. The smallest possible increase is $10 million if all of the money is held by banks as excess reserves. a.
If the required reserve ratio is 5%, then First National Bank's required reserves are
$500,000 x .05 = $25,000. Because the bank’s total reserves are $100,000, it has excess reserves of $75,000.
With a required reserve ratio of 5%, the money multiplier is 1/.05 = 20. If First National lends out its excess reserves of $75,000, the money supply will eventually increase by $75,000 x 20 = $1,500,000.
7.
8.
b.
9. a.
b.
10. a.
b.
11. a. b. c. d.
e.
Chapter 29/The Monetary System 3
With a required reserve ratio of 10% and no excess reserves, the money multiplier is 1/.10 = 10. If the Fed sells $1 million of bonds, reserves will decline by $1 million and the money supply will contract by 10 x $1 million = $10 million.
Banks might wish to hold excess reserves if they need to hold the reserves for their day-to-day operations, such as paying other banks for customers' transactions, making change, cashing paychecks, and so on. If banks increase excess reserves such that there is no overall change in the total reserve ratio, then the money multiplier does not change and there is no effect on the money supply.
With banks holding only required reserves of 10%, the money multiplier is 1/.10 = 10. Because reserves are $100 billion, the money supply is 10 x $100 billion = $1,000 billion. If the required reserve ratio is raised to 20%, the money multiplier declines to 1/.20 = 5. With reserves of $100 billion, the money supply would decline to $500 billion, a decline of $500 billion. Reserves would be unchanged.
If people hold all money as currency, the quantity of money is $2,000.
If people hold all money as demand deposits at banks with 100% reserves, the quantity of money is $2,000.
If people have $1,000 in currency and $1,000 in demand deposits, the quantity of money is $2,000.
If banks have a reserve ratio of 10%, the money multiplier is 1/.10 = 10. So if people hold all money as demand deposits, the quantity of money is 10 x $2,000 = $20,000.
If people hold equal amounts of currency (multiplier for reserves is 10, then two equations must be satisfied: C) and demand deposits (C
D) and the money (1) = D, so that people have equal amounts of currency and demand deposits; and (2) 10 x ($2,000 – that are not being held by people ($2,000 C) = D, so that the money multiplier (10) times the number of dollar bills – Using the first equation in the second gives 10 x ($2,000 C) equals the amount of demand deposits (– D) = D, or $20,000 – 10D = DD). , or $20,000 = 11 DD, so D = $1,818.18. Then C = $1,818.18. The quantity of money is C + = $3,636.36.
