ch 13 money and banking

CHAPTER 13Money and Banking

A. Short-Answer, Essays, and Problems

1. What are the three functions that a commodity must fulfill to be useful as money?

2. Money is what money does. Explain.

3. Some government bonds can be redeemed for currency or a check at banks. Why, then, isn’t it universally agreed that government bonds are part of the money supply?

4. What is the difference between the M1 and M2 definitions of the money supply?

New 5. Use the figures in the table below to answer the following questions.

$ BillionsSmall time deposits 1024Large time deposits 2026Saving deposits, including money-market deposit accounts 1812Money-market mutual funds 890Checkable deposits 578Currency 523

(a) What is the value of M1?(b) What is the value of M2?(c) What is the value of M3?

6. Use the figures in the table below to answer the following questions.

$ BillionsSmall time deposits 1,260Large time deposits 1,290Saving deposits, including money-market deposit accounts 1,750Money-market mutual funds 850Checkable deposits 896Currency 340


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8. How is a commercial bank different from a savings and loan association?

9. Are currency and checkable deposits owned by the government (U.S. Treasury) and the Federal Reserve Bank, commercial banks, and other financial institutions part of the money supply? Explain.

10. Explain the difference between a money-market deposit account and a money-market mutual fund.

New 11. (Consider This) Are credit cards money? Explain.

12. Why is money considered to be debt?

13. Discuss three major points about what gives money its value.

New 14. Complete the following table showing the relationship between a percentage change in the price level and the percentage change in the value of money. Calculate the percentage change in the value of money to one decimal place.

Change in valueChange in price level of money

a. rise by:8% _____.___%

16% _____.___24% _____.___

b. fall by:8% _____.___%

16% _____.___24% _____.___

New 15. How do high rates of inflation affect the acceptability of a nation’s currency?

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New 16. Explain what policies are used to stabilize the value of money.

17. What are the two reasons that people want to hold money? In other words, what are the two types of demand for money?

18. Explain how the GDP and the interest rate are related to the transactions and asset demands for money.

19. The total demand for money is equal to the transactions demand plus the asset demand for money.

(a) Assume that each dollar held for transactions purposes is spent on the average five times per year to buy final goods and services. If the nominal GDP is $5000 billion ($5 trillion), what is the transaction demand?(b) The table below shows the asset demand at certain rates of interest. Using your answer to part (a), complete the table to show the total demand for money at various rates of interest.

Interest rate Asset demand Total demand (in %) (billions) (billions)

10 $ 40 $_____8 80 _____6 120 _____4 160 _____

(c) If the money supply is $1080 billion, what will be the equilibrium rate of interest?(d) If the money supply rises, will the equilibrium rate of interest rise or fall?(e) If GDP rises, will the equilibrium rate of interest rise or fall?


(a) Assume that each dollar held for transactions purposes is spent on the average five times per year to buy final goods and services. If the nominal GDP is $10,000 billion ($10 trillion), what is the transaction demand?(b) The table below shows the asset demand at certain rates of interest. Using your answer to part (a), complete the table to show the total demand for money at various rates of interest.


10 $ 30 $_____8 60 _____6 90 _____4 120 _____

(c) If the money supply is $2,060 billion, what will be the equilibrium rate of interest?(d) If the money supply rises, will the equilibrium rate of interest rise or fall?(e) If GDP rises, will the equilibrium rate of interest rise or fall?

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21. Use the table below to answer the questions:

Interest rate Asset demand (in %) (billions)

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(a) If the transactions demand for money equals 10% of nominal GDP, the nominal GDP is $6000 billion, and the supply of money is $900 billion, what is the equilibrium interest rate?(b) If nominal GDP remains constant, and the money supply is increased from $900 to $1000 billion, what will the equilibrium rate of interest be?



14 $20013 30012 40011 500

(a) If the transactions demand for money equals 10% of nominal GDP, the nominal GDP is $5,000 billion, and the supply of money is $900 billion, what is the equilibrium interest rate?(b) If nominal GDP remains constant, and the money supply is decreased from $900 to $800 billion, what will the equilibrium rate of interest be?

23. Use the graph below to answer the following questions. Dt is the transactions demand for money, Dm is the total demand for money, and Sm is the supply of money.

(a) What is the transactions demand for money in this market?(b) What is the asset demand for money if the interest rate is 4%?(c) If the money market is in equilibrium at 6%, describe the change that must occur for the equilibrium rate to change to 4%.(d) If the money market is in equilibrium at 6% and the money supply has increased to Sm3, by how much has total demand for money changed?

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24. Analyze what would happen to the equilibrium rate of interest in the money market if the supply of money were increased while the demand schedule remained the same.

25. Explain how the money market responds to a shortage of money or to a surplus of money.

26. Use the table below for the next set of questions. Column 1 shows the interest rate, column 2 shows the demand for money, and columns 3–5 show the supply of money. All quantities are in millions ($).

(1) (2) (3) (4) (5)Interest rate Dm Sm1 Sm2 Sm3

10% $1,500 $2,200 $2,500 $1,8008 1,800 2,200 2,500 1,8006 2,200 2,200 2,500 1,8004 2,500 2,200 2,500 1,8002 2,800 2,200 2,500 1,800

(a) Given the demand for money, what will the equilibrium interest rate be for each of the different supply of money schedules?(b) Assume the economy was in equilibrium at Dm and Sm1. If the FED decides to change the money supply to Sm2 and the interest rate stays the same, how much of a shortage or surplus in the money supply will there be? Describe what will happen in the money market and the bond market to eliminate the surplus or shortage and restore a new equilibrium interest rate.(c) Assume the economy was in equilibrium at Dm and Sm1. If the FED decides to change the money supply to Sm3 and the interest rate stays the same, how much of a shortage or surplus in the money supply will there be? Describe what will happen in this money market and the bond market to eliminate the surplus or shortage of money and restore a new equilibrium interest rate.

27. Answer the next two questions using the following information: The price of a bond with no expiration date is $1000 and its fixed annual interest payment is $50; bond annual rate of interest is 5%.

(a) If the price of this bond decreases by $250 to $750, what will its effective interest rate be for the new buyer?(b) If the price of this bond increases to $1200, what will its effective interest rate be for the new buyer?

New 28. Suppose that a bond having no expiration date has a face value of $5,000 and pays a fixed amount of interest of $500 annually. Compute and enter in the spaces provided the effective interest rate (to one decimal place) that a bond buyer could receive at the new bond price.

Bond price Interest rate (%) $ 3,750 ____

4,250 ____5,750 ____6,500 ____

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29. Suppose that a bond having no expiration date has a face value of $10,000 and pays a fixed amount of interest of $1000 annually. Compute and enter in the spaces provided either the effective interest rate which a bond buyer could receive at the new price or the bond price required to receive the interest rate shown.

Bond price Interest rate (%) $ 8,000 ____________ 11.110,000 ______12,000 ____________ 6.67

30. Suppose that a bond having no expiration date has a face value of $10,000 and pays a fixed amount of interest of $1000 annually. Compute and enter in the spaces provided either the effective interest rate which a bond buyer could receive at the new price or the bond price required to receive the interest rate shown.

Bond price Interest rate (%) $______ 12.5

9,000 ____________ 10.0______ 8.315,000 ______

New 31. Describe the three major units of the Federal Reserve System and their functions.

32. Who sits on the Federal Open Market Committee and what does this committee do?

33. What are the three major characteristics of the twelve Federal Reserve Banks?

34. The Federal Reserve Banks are bankers’ banks. Explain.

35. What are the seven functions of the Federal Reserve System? Which one is most important?

36. Is the Federal Reserve an independent institution?

37. Why did the U.S. Congress establish the Federal Reserve as an independent agency?

38. Cite five recent developments that have affected money and banking in the United States.

39. (Last Word) Why is there a large amount of U.S. currency circulating abroad? What are the economic effects on the global economy?

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B. Answers to Short-Answer, Essays, and Problems

1. What are the three functions that a commodity must fulfill to be useful as money?

The commodity must serve as a medium of exchange; it must provide a unit of account; and it must act as a store of value, that is, it must retain its worth in terms of other goods and services. [text: E pp. 232-233; MA pp. 232-233]

2. Money is what money does. Explain.

This refers to the idea that money (at least paper money and checks) has no intrinsic value. It is valuable only in terms of its acceptability in exchange for goods and services. In other words, it is valuable only in terms of what it does: act as a medium of exchange, a unit of account, and a store of value. [text: E pp. 232-233; MA pp. 232-233]

3. Some government bonds can be redeemed for currency or a check at banks. Why, then, isn’t it universally agreed that government bonds are part of the money supply?

The question literally answers itself. These assets must be exchanged for currency or a check (which is money by definition) before they are generally acceptable in exchange for goods and services. While they can be exchanged for currency or a check, bonds are one step removed from being spendable as money. [text: E pp. 232-233; MA pp. 232-233]

4. What is the difference between the M1 and M2 definitions of the money supply?

Both M1 and M2 are definitions of the economy’s money supply. M1 is the definition of the money supply with the highest degree of liquidity, the money supply used mainly for transactions purposes. M1 consists of currency (coins and paper money) and checkable deposits. M2 consists of everything in M1 plus noncheckable savings deposits, small time deposits, money-market deposit accounts and money-market mutual fund balances. M2 is a broader, but less liquid, definition of the money supply. It includes everything in M2 plus large time deposits ($100,000 or more). M2 and M3 are considered near monies because they do not function directly as a medium of exchange, but can be converted to currency or checkable deposits. [text: E pp. 233-235; MA pp. 233-235]

New 5. Use the figures in the table below to answer the following questions.

$ BillionsSmall time deposits 1024Large time deposits 2026Saving deposits, including money-market deposit accounts 1812Money-market mutual funds 890Checkable deposits 578Currency 523


(a) $523 + $578 = $1101 billion(b) $1101+ $1812 + $1024 + $890 = $4827 billion

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(c) $4827 + 2026 = $6853 billion [text: E pp. 233-235; MA pp. 233-235]6. Use the figures in the table below to answer the following questions.



(a) $896 + $340 = $1236 billion(b) $1236 + $1750 + $1290 + $850 = $5096 billion(c) $5096 + $1290 = $6386 billion [text: E pp. 233-235; MA pp. 233-235]




(a) $836 + $325 = $1161 billion(b) $1161 + $1620 + $1250 + $905 = $4936 billion(c) $4936 + $1300 = $6236 billion [text: E pp. 233-235; MA pp. 233-235]

8. How is a commercial bank different from a savings and loan association?

A commercial bank differs from a savings and loan association primarily in the type of loans each is allowed to make. Savings and loan associations were originally established to act as lending institutions for homebuyers. Thus, most of their assets were mortgages. Commercial banks, on the other hand, dealt with business loans and short-term consumer and installment loans. Banks were allowed to have checking accounts whereas S&Ls were not. Today, the difference between the two institutions is blurred as S&Ls offer checkable deposits and make short-term consumer loans. They still exist primarily to make home mortgage loans. Commercial banks are still the major source of business short-term borrowed funds and offer commercial checking accounts. While banks do make some long-term home loans, they are still primarily associated with business lending and short-term consumer loans. [text: E p. 234; MA p. 234]

9. Are currency and checkable deposits owned by the government (U.S. Treasury) and the Federal Reserve Bank, commercial banks, and other financial institutions part of the money supply? Explain.

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No. Currency and checkable deposits at these institutions are not counted. In the case of commercial banks and other financial institutions, if currency from an individual is deposited in a checking account, and both the currency and checkable deposit were then counted as part of the money supply, then it would be double counting. So, the money supply consists only of the currency and checkable deposits held by individuals or businesses at financial institutions. The exclusion of currency and checkable deposits held by government is more arbitrary, but permits economists to focus on the money supply in the private sector of the economy. [text: E p. 234; MA p. 234]

10. Explain the difference between a money-market deposit account and a money-market mutual fund.

A money market mutual fund is offered through a financial investment company and investors buy shares in the fund. Such funds invest in short-term (less than one year) credit instruments such as Treasury bills and short-term certificates of deposit that are known as money-market instruments. The money-market deposit account is a type of savings account offered by banks and thrifts that pool individual deposits to buy a variety of short-term securities. These accounts have minimum balance requirements and limit how often money can be withdrawn. Because they are bank accounts, however, they are insured by the relevant deposit insurance fund. [text: E p. 235; MA p. 235]

New 11. (Consider This) Are credit cards money? Explain.

Credit cards represent the ability to get an instant loan that can be exchanged for goods or services. At some point, however, that loan must be paid with money (checks or currency). So credit card transactions are short-term loans that must be repaid with money. [text: E p. 236; MA p. 236]

12. Why is money considered to be debt?

The major parts of the money supply are currency and checkable deposits. These items are debts, or promises to pay. Paper money is the circulating debt of the Federal Reserve banks. Checkable deposits are debts of commercial banks and thrifts. Neither the currency nor checkable deposits have any intrinsic value. They are simply circulating paper to which people must attach value. [text: E p. 236; MA p. 236]

13. Discuss three major points about what gives money its value.

First, currency and demand deposits (M1 definition) are considered money because these items are accepted as payment for goods and services. Money must be acceptable to serve its function as a medium of exchange. Second, the government mandates through law that paper money be accepted as payment for debts. While checks are not mandated by law as money, government agencies do back demand deposits at banks with deposit insurance that helps to maintain the acceptability of this form of money. Third, money is relatively scarce. There is a reasonably constant demand for money for transactions purposes and future uses. The supply of money will determine the value or “purchasing power” of each unit of money. The supply of money is controlled by monetary institutions (the Federal Reserve System) that attempt to maintain a reasonably stable purchasing power for money. [text: E pp. 236-237; MA pp. 236-237]

New 14. Complete the following table showing the relationship between a percentage change in the price level and the percentage change in the value of money. Calculate the percentage change in the value of money to one decimal place.

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a. rise by:8% _____.___%

16% _____.___24% _____.___

b. fall by:8% _____.___%

16% _____.___24% _____.___


a. rise by:8% –7.4%

16% –13.7%24% –19.4%

b. fall by:8% +8.7%

16% +19.0%24% +31.5%

[text: E p. 237; MA p. 237]

New 15. How do high rates of inflation affect the acceptability of a nation’s currency?

High rates of inflation reduce the purchasing power of a nation’s currency. From the time the currency is received to the time that it is spent, fewer goods and services can be bought with that currency. Businesses and workers may not want to hold currency that loses value quickly because of high inflation. They may look for alternative currencies to hold or other assets that do not lose value. These actions reduce the economic efficiency provided by the institution of money. It is also difficult for consumers to evaluate prices as a reflection of the value of a product as the prices are changing rapidly. [text: E pp. 237-238; MA pp. 237-238]

New 16. Explain what policies are used to stabilize the value of money.

Monetary policy is used to regulate the money supply in the economy. If too much money is available for the given level of production of goods and services, this situation can lead to inflation and reduce the value of money. Fiscal policy can also be used to help maintain the value of money. The U.S. government needs to be prudent in its spending and taxing actions (fiscal policy) so that it does not reduce the value of money by running large deficits when the economy is at full-employment. [text: E pp. 238-239; MA pp. 238-239]

17. What are the two reasons that people want to hold money? In other words, what are the two types of demand for money?

People want to hold money for transactions purposes and as a form of liquid assets. Thus, economists talk about a transactions demand for money and an asset demand for money. [text: E pp. 238-240; MA pp. 238-240]

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18. Explain how the GDP and the interest rate are related to the transactions and asset demands for money.

The transactions demand for money is believed to have a direct relationship with GDP and the level of income, but is thought to be largely independent of interest-rate fluctuations. The asset demand for money is believed to be largely independent of the level of GDP, but is inversely related to the interest rate. [text: E pp. 238-240; MA pp. 238-240]


(a) Assume that each dollar held for transactions purposes is spent on the average five times per year to buy final goods and services. If the nominal GDP is $5000 billion ($5 trillion), what is the transaction demand?(b) The table below shows the asset demand at certain rates of interest. Using your answer to part (a), complete the table to show the total demand for money at various rates of interest.


10 $ 40 $_____8 80 _____6 120 _____4 160 _____

(c) If the money supply is $1080 billion, what will be the equilibrium rate of interest?(d) If the money supply rises, will the equilibrium rate of interest rise or fall?(e) If GDP rises, will the equilibrium rate of interest rise or fall?


10 $ 40 $1,0408 80 1,0806 120 1,1204 160 1,160

(a) $5000 billion / 5 = $1000 billion(b) See table above.(c) Where money supply is equal to total demand at 8%.(d) If the money supply increases, the rate will fall.(e) The rate will rise because transactions demand, hence total demand, will rise and intersect supply at a new higher rate of interest. [text: E pp. 238-240; MA pp. 238-240]


(a) Assume that each dollar held for transactions purposes is spent on the average five times per year to buy final goods and services. If the nominal GDP is $10,000 billion ($10 trillion), what is the transaction demand?(b) The table below shows the asset demand at certain rates of interest. Using your answer to part (a), complete the table to show the total demand for money at various rates of interest.

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10 $ 30 $_____8 60 _____6 90 _____4 120 _____

(c) If the money supply is $2,060 billion, what will be the equilibrium rate of interest?(d) If the money supply rises, will the equilibrium rate of interest rise or fall?(e) If GDP rises, will the equilibrium rate of interest rise or fall?


10 $ 30 $2,0308 60 2,0606 90 2,0904 120 2,120

(a) $10,000 billion / 5 = $2000 billion(b) See table above.(c) Where money supply is equal to total demand at 8%.(d) If the money supply increases, the rate will fall.(e) The rate will rise because transactions demand, hence total demand, will rise and intersect supply at a new higher rate of interest. [text: E pp. 238-241; MA pp. 238-241]



14 $20013 30012 40011 500

(a) If the transactions demand for money equals 10% of nominal GDP, the nominal GDP is $6000 billion, and the supply of money is $900 billion, what is the equilibrium interest rate?(b) If nominal GDP remains constant, and the money supply is increased from $900 to $1000 billion, what will the equilibrium rate of interest be?

(a) Transactions demand will be $600 billion, so the asset demand must be $300 billion because at equilibrium total demand equals supply of $900 billion. When asset demand is $300 billion, the interest rate is 13%.(b) Rate will be 12% because that is where demand = supply. [text: E pp. 238-240; MA pp. 238-240]



14 $20013 30012 40011 500

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(a) If the transactions demand for money equals 10% of nominal GDP, the nominal GDP is $5,000 billion, and the supply of money is $900 billion, what is the equilibrium interest rate?(b) If nominal GDP remains constant, and the money supply is decreased from $900 to $800 billion, what will the equilibrium rate of interest be?

(a) Transactions demand will be $500 billion, so the asset demand must be $400 billion because at equilibrium total demand equals supply of $900 billion. When asset demand is $400 billion, the interest rate is 12%.(b) Rate will be 13% because that is where demand = supply. [text: E pp. 238-241; MA pp. 238-241]

23. Use the graph below to answer the following questions. Dt is the transactions demand for money, Dm is the total demand for money, and Sm is the supply of money.

(a) What is the transactions demand for money in this market?(b) What is the asset demand for money if the interest rate is 4%?(c) If the money market is in equilibrium at 6%, describe the change that must occur for the equilibrium rate to change to 4%.(d) If the money market is in equilibrium at 6% and the money supply has increased to Sm3, by how much has total demand for money changed?

(a) $125(b) $325 – 125 = $200(c) On the above graph, the money supply must increase to 325. Although not indicated on the diagram, a decrease in demand could achieve the same effect assuming the supply remained at 250, demand would have to shift leftward until it intersected supply at 250 and 4%.(d) $75 [text: E pp. 238-241; MA pp. 238-241]

24. Analyze what would happen to the equilibrium rate of interest in the money market if the supply of money were increased while the demand schedule remained the same.

Because the quantity of money demanded is inversely related to the interest rate, an increase in the supply of money would result in a higher equilibrium quantity of money being demanded at a lower equilibrium rate of interest. [text: E pp. 238-241; MA pp. 238-241]

25. Explain how the money market responds to a shortage of money or to a surplus of money.

In the money market, the demand for money and the supply of money determine the interest rate. Graphically, the demand for money is a downsloping line and the supply

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of money is a vertical line, and their intersection determines the interest rate. Disequilibrium in this market (a shortage or a surplus of money) is corrected by changes in bond prices and their inverse relationship with interest rates. If there is a shortage of money, bonds will be sold. The increase in supply of bonds will drive down bond prices causing interest rates to rise until the shortage is eliminated. If there is a surplus of money, bonds will be bought. The increased demand for bonds will drive up bond prices causing interest rates to fall until the surplus is eliminated. [text: E pp. 240-241; MA pp. 240-241]

26. Use the table below for the next set of questions. Column 1 shows the interest rate, column 2 shows the demand for money, and columns 3–5 show the supply of money. All quantities are in millions ($).

(1) (2) (3) (4) (5)Interest rate Dm Sm1 Sm2 Sm3

10% $1,500 $2,200 $2,500 $1,8008 1,800 2,200 2,500 1,8006 2,200 2,200 2,500 1,8004 2,500 2,200 2,500 1,8002 2,800 2,200 2,500 1,800

(a) Given the demand for money, what will the equilibrium interest rate be for each of the different supply of money schedules?(b) Assume the economy was in equilibrium at Dm and Sm1. If the FED decides to change the money supply to Sm2 and the interest rate stays the same, how much of a shortage or surplus in the money supply will there be? Describe what will happen in the money market and the bond market to eliminate the surplus or shortage and restore a new equilibrium interest rate.(c) Assume the economy was in equilibrium at Dm and Sm1. If the FED decides to change the money supply to Sm3 and the interest rate stays the same, how much of a shortage or surplus in the money supply will there be? Describe what will happen in this money market and the bond market to eliminate the surplus or shortage of money and restore a new equilibrium interest rate.

(a) Dm and Sm1: 6%; Dm and Sm2: 4%; Dm and Sm3: 8%.(b) There will be a surplus of $300 million. People will now try to get rid of money by buying more bonds. The collective attempt to buy bonds increases the demand for bonds relative to the supply and drives up their price. Bond prices will rise and interest rates will fall until a new higher equilibrium interest rate is established at 8%.(c) There will be a shortage of $300 million. People will attempt to make up for this shortage by selling some of the financial assets they own such as bonds. The collective attempt to sell bonds increases their supply relative to the demand and drives down their price. Bond prices will fall and interest rates will rise until a new higher equilibrium interest rate is established at 8%. [text: E pp. 240-241; MA pp. 240-241]

27. Answer the next two questions using the following information: The price of a bond with no expiration date is $1000 and its fixed annual interest payment is $50; bond annual rate of interest is 5%.

(a) If the price of this bond decreases by $250 to $750, what will its effective interest rate be for the new buyer?(b) If the price of this bond increases to $1200, what will its effective interest rate be for the new buyer?

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(a) $50/$750 = 1/15 = 6.67%(b) $50/$1200 = 1/24 = 4.17% [text: E pp. 240-241; MA pp. 240-241]

New 28. Suppose that a bond having no expiration date has a face value of $5,000 and pays a fixed amount of interest of $500 annually. Compute and enter in the spaces provided the effective interest rate (to one decimal place) that a bond buyer could receive at the new bond price.

Bond price Interest rate (%) $ 3,750 ____

4,250 ____5,750 ____6,500 ____

Bond price Interest rate (%) $ 3,750 13.3

4,250 11.85,750 8.76,500 7.7

[text: E pp. 253-254; MA pp. 253-254]

29. Suppose that a bond having no expiration date has a face value of $10,000 and pays a fixed amount of interest of $1000 annually. Compute and enter in the spaces provided either the effective interest rate which a bond buyer could receive at the new price or the bond price (rounded to the nearest $1000) required to receive the interest rate shown.

Bond price Interest rate (%) $ 8,000 ____________ 11.110,000 ______12,000 ____________ 6.67


9,000 11.110,000 10.012,000 8.315,000 6.67

[text: E pp. 240-241; MA pp. 240-241]

30. Suppose that a bond having no expiration date has a face value of $10,000 and pays a fixed amount of interest of $1000 annually. Compute and enter in the spaces provided either the effective interest rate which a bond buyer could receive at the new price or the bond price (rounded to the nearest $1000) required to receive the interest rate shown.

Bond price Interest rate (%) $______ 12.5

9,000 ____________ 10.0______ 8.315,000 ______

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9,000 11.110,000 10.012,000 8.315,000 6.67

[text: E pp. 240-241; MA pp. 240-241]

New 31. Describe the three major units of the Federal Reserve System and their functions.

First, the Federal Reserve System is overseen by the Board of Governors. This Board is responsible for control of the supply of money and the banking system. The President appoints the seven members of the Board. Second, Federal Open Market Committee (FOMC) helps the Board by establishing policy over the buying and selling of government securities. Third, there are twelve regional Federal Reserve Banks. They serve as central banks, quasi-public banks, and bankers’ banks. [text: E pp. 242-244; MA pp. 242-244]

32. Who sits on the Federal Open Market Committee and what does this committee do?

The Federal Open Market Committee is made up of the seven members of the Board of Governors plus five of the presidents of the twelve Federal Reserve Banks (always including the president of the New York Fed). The other seven presidents attend meetings but do not have voting power.

This committee sets monetary policy with regard to the purchase and sale of government securities, a major tool in regulating the supply of money in the economy. [text: E p. 243; MA p. 243]

33. What are the three major characteristics of the twelve Federal Reserve Banks?

They act together as the central bank of the United States. They are quasi-public in that they are owned by private commercial bank members, but are controlled by the government since the system was established by an act of Congress. Finally, they are bankers’ banks because they perform essentially the same functions for depository institutions that those institutions perform for their customers. That is, the Federal Reserve Banks make loans to financial institutions, keep their reserve deposits, and provide them with paper money. [text: E pp. 243-244; MA pp. 243-244]

34. The Federal Reserve Banks are bankers’ banks. Explain.

This means that the Federal Reserve Banks perform essentially the same functions for banks as the banks perform for the public. Just as banks and thrifts accept deposits of and make loans to the public, so the Federal Reserve Banks accept deposits and make loans to banks and thrifts. [text: E p. 244; MA p. 244]

35. What are the seven functions of the Federal Reserve System? Which one is most important?

The seven functions are: (1) issuing currency; (2) setting reserve requirements and holding required reserves of banks and thrift institutions; (3) lending money to banks and thrifts; (4) collecting and clearing checks for banks and thrifts; (5) serving as the

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fiscal agent for the U.S. government; (6) supervising the operation of member banks; and (7) controlling the money supply. Controlling the money supply to meet the needs of the economy is the most important function. [text: E p. 245; MA p. 245]

36. Is the Federal Reserve an independent institution?

The Federal Reserve is generally considered to be independent of control by the U.S. Congress and the President. Although it was created by Congress and can be eliminated by Congress, any change in its role and mission will require extensive legislative action, which is unlikely to occur. The President also has no direct control over the operation of the Federal Reserve, other than lobbying influence and the power to appoint members of the Board of Governors. These members, however, are appointed to long terms -- fourteen years—which gives them protection from immediate political pressures. The long terms also reduce the possibility for any one President from packing the Board. [text: E p. 245; MA p. 245]

37. Why did the U.S. Congress establish the Federal Reserve as an independent agency?

Those who support the notion of an independent Federal Reserve System argue that the Fed should be protected from political pressures so that it can focus on the control of the money supply and the needs of the economy. Otherwise, the Fed would often be under intense political pressure to expand the money supply to accommodate an expansionary fiscal policy of the U.S. Congress. An independent Fed is more likely to maintain a stable currency and shield the economy from the intense inflationary pressure created by an overly expansionary fiscal policy. [text: E p. 245; MA p. 245]

38. Cite five recent developments that have affected money and banking in the United States.

First, there has been a relative decline in the number of banks and thrifts. Second, there has been consolidation among banks and thrifts because of mergers. Third, the services offered by financial institutions are becoming similar because of fewer legal restrictions on activity by type of institution. Fourth, financial markets are now more globalized and integrated because of advances in computer and communications technology. Fifth, the character of money has changed with the shift to the use of electronic money and other forms of payment. [text: E pp. 245-247; MA pp. 245-247]

39. (Last Word) Why is there a large amount of U.S. currency circulating abroad? What are the economic effects on the global economy?

The initial reason for U.S. currency being circulated abroad was that it was used to pay for the imports of goods and services purchased by Americans from producers abroad. The U.S. currency has since been circulated within other countries, especially in those countries whose currencies are not very stable and in which inflation is high. For example, it is estimated that Russians hold about $40 billion worth of U.S. dollars. The exchange of goods and services are often conducted in dollars inside Russia because Russians fear that when they accept the Russian ruble, it may lose its purchasing power.

The fear of the loss of purchasing power also motivates the holding of the U.S. dollar in other nations with high rates of inflation. The dollar is also appealing for use for both legal and illegal transactions in other nations because it holds its value. These appealing characteristics have increased the demand for dollars in many nations to facilitate the exchange of legal and illegal goods and services. For the international economy, the circulation of the U.S. dollar increases exchange because it gives people a stable form of money that serves as a medium of exchange, a store of value, and unit of account when domestic currencies are unstable. [text: E p. 248; MA p. 248]

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ch 13 money and banking

Documents

value of money

money supply

price levelof money

credit cards money

value change

value of m1

value of m2

value of m3