Econ Ch. 14

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Commodity Money

a good used as money that also has value independent of its use as money

Fiat Money

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

What is not a function of money

open market operation

The use of money

eliminates the double coincidence of wants, reduces the transaction costs of exchange, allows for greater specialization

Money serves as a unit of account when

prices of goods and services are stated in terms of money

Money serves as a standard of deferred payment when

payments agreed to today but made in the future are in terms of money

The federal reserve uses two definitions of the money supply, M1 and M2, because

M1 is a narrow definition focusing more on liquidity, whereas M2 is a broader definition of the money supply

Distinguish among money, income, and wealth

A persons money is the currency held and the checking account balance, income is the earning and wealth is equal to value of assets minus all debts

The central bank of a country controls the money supply, which equals the currency held by

the public plus their checking account balances

Suppose you have $2000 in currency in a shoebox in your closet. One day, you decide to deposit the money in a checking account. How will this action affect the M1 & M2 definitions of the money supply?

Both M1 & M2 will remain unchanged

define M1

the sum of currency in circulation, checking account deposits in banks, and holdings of travelers checks.

define M2

includes M1 plus savings account deposits, small denomination time deposits, balances in money market deposit accounts in banks, and non institutional money market fund shares

Credit cards are

included in neither the M1 definition of the money supply nor in the M2 definition

What are the largest asset and the largest liability of a typical bank?

Loans are the largest asset and deposits are the largest liability of a typical bank

How do banks "create money"?

When there is an increase in checking account deposits, banks gain reserves and make new loans, and the money supply expands

Simple deposit multiplier formula

1/RR the ratio of the amount of deposits created by banks to the amount of new reserves; used to calculate the total increase in checking account deposits from an increase in bank reserves; the inverse, or reciprocal, of the required reserve ratio

Change in checking account deposits

1/RR {reserve ratio} X change in bank reserves

The real-world multiplier

is smaller than the simple deposit multiplier because banks keep excess reserves and households hold excess cash

Reserves are

deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve

Required reserves are

reserves that a bank is legally required to hold, based on its checking account deposits = required reserve ratio X the amount of deposits

Required reserve ratio is

the minimum fraction of deposits banks are required by law to keep as reserves

Excess reserves are

reserves that banks hold over and above the label requirement = total reserves – required reserves

A higher required reserve ratio _________ the value of the simple deposit multiplier.


Congress passed legislation to create the Federal Reserve System in 1913 in order to

end the instability created by bank panics by acting as a lender of last resort

the most important role of the Federal Reserve in today’s US economy is

controlling the money supply to pursue economic objectives

When the Federal Reserve purchases Treasury securities in the open market,

the sellers of such securities deposit the funds in their banks and bank reserves increase

When the federal reserve sells Treasury securities in the open market,

the buyers of these securities pay for them with checks and bank reserves fall

Fractional Reserve banking system

a banking system in which banks keep less than 100% of deposits as reserves

Why do most depositors seem to be unworried that banks loan out must of the deposits they receive?

The FDIC insures deposits up to $250,000

Suppose that you are a bank manager, and the Federal Reserve raises the required reserve ratio from 10% to 12%. What actions would you need to take?

you would have to reduce loans to make up of the necessary increase in reserves

When the Federal Reserve decreases the discount rate,

the money supply will increase

The FOMC (Federal Open Market Committee)

includes the Board of Governors and the presidents of the 12 Federal Reserve regional banks (though not all are voting members), determines the target federal funds rate and the direction of open market operation policies, & makes decisions that are voted on by all 7 members of the board of governors but only 5/12 regional bank presidents

The Federal Reserve Bank of New York is always voting member of the FOMC because

it carries out the policy directives of the FOMC

What monetary policy tool is used by the Federal Reserve Bank?

increasing the reserve requirement from 10% to 12.5%; buying $500 million worth of government securities, such as Treasury bills’ and decreasing the rate at which banks can borrow money from the federal reserve.

What is the least likely tool used by the Federal Reserve in order to actively change the money supply?

reserve requirements

Reserve requirements are changed infrequently because

banks set long-term policy decision, loan decisions, and deposit decisions based on the reserve requirement

In addition to the Federal Reserve Bank, what other economic actors influence the money supply?

households, firms, & banks

To increase the money supply, the FOMC directs the trading desk, located at the Federal Reserve Bank of New York, to

buy US Treasury securities from the public

By raising the discount rate, the Fed leads banks to make ________ loans to households and firms, which will _______ checking account deposits & the money supply

fewer; decrease

The quantity theory of money is better able

to explain the inflation rate in the long run

Very high rates of inflation are called


Governments sometimes allow hyperinflation to occur because

when governments want to spend more than they collect in taxes, central banks increase the money supply at a rate higher than GDP growth, often resulting in hyperinflation

What is true with respect to hyperinflation?

it can be hundreds- even thousands- of percentage points per year, it is caused by central banks increasing the money supply at a rate much greater than the growth rate of real GDP, and firms & households avoid holding money

Quantity theory of money

a theory of the connection between money and prices that assumes that the velocity of money is constant

Quantity equation=

m X v = p X y

Reserve requirements are changed infrequently because

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