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Chapter 13: The Financial Sector and the Economy
Chapter 13: The Financial Sector and the Economy
Questions and Exercises
1.
Although financial institutions don't produce any tangible real assets, they are
nonetheless considered a vital part of the economy because of their central role in
transferring savings into investment and in making the real economy more
efficient.
2.
Loanable funds are financial assets available for lending and borrowing.
3.
Long-term interest rates are determined in the market for loanable funds.
4.
Short-term interest rates are determined in the money market.
5.
If the interest rate is higher than the rate that would equilibrate the supply and
demand for loanable funds, the supply of loanable funds will exceed the demand
and there will be too little investment.
6. a. As people sell municipal bonds, the supply of loanable funds decreases (there is
less money available to lend to municipalities). As the supply of loanable funds
shifts in to the left, the long-term interest rate rises as shown below in graph (a).
b. This reduces the transactions motive for holding money, shifting the demand for
money in to the left. Nothing happens in the loanable funds market.
c. An increase in investment shifts the demand for loanable funds to the right,
increasing the long-term interest rate as shown below in graph (c).
(a)
(c)
7.
Money functions as a medium of exchange, a unit of value, and a store of wealth.
8.
Money doesn't have to have any inherent value to function as a medium of
exchange. All that's necessary is that everyone believes that other people will
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Chapter 13: The Financial Sector and the Economy
accept it in exchange for their goods. This is the social convention that gives
money value.
9. a. Money- Wealth held in a checking account is considered money.
b. Not money- Foreign currencies are not accepted in exchange for other goods so
they do not qualify as money in the United States.
c. Not money- Credit cards are a form of instant loan, but they are not considered
money because they create a financial liability for their users, rather than for a
bank.
d. Not money- Only currency held by the public, not currency held by banks, is
counted as money.
e. Money- Currency held by the public is considered money.
f. Not money- Gold is neither highly liquid nor generally accepted in exchange for
other goods, so it does not fit the definition of money.
g. Not money- Coupons are only accepted in exchange for a very specific set of
goods and it cannot be used as a reference in valuing other goods, so it is not
considered money
10.
Money serves as a unit of account when people compare prices.
11.
Inflation reduces money’s function as a store of wealth because it reduces how
much can be purchased with a given amount of money (lowers money’s value).
12. a. Transactions motive.
b. Precautionary motive.
c. Speculative motive.
d. Transactions motive.
13.
Two components of M2 that are not components of M1 are savings deposits and
small-denomination time deposits.
14. a. Neither
b. Both
c. M2
d. Both e. Neither f. Neither
g. Both
15. a.
b.
c.
d.
Nothing happens to M2. M1 declines by $150
Nothing happens to M1 or M2
Nothing happens to M2, M1 rises by $50
Nothing happens to M1 or M2.
16.
Banks earn revenue by lending the money from deposits. They can do so because
at any specific day only a fraction of their deposits are withdrawn and they hold
just a fraction of their total deposits as reserves. So if everyone tried to withdraw
their deposits at the same time, the bank would not have enough money on hand
to let them do so unless at the same time all borrowers repaid their loans. (Note:
From Don Leet and Scott Houser, Journal of Economic Education, Fall 2003.)
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17. a. As more counterfeit money is printed and not identified as counterfeit, the value
of money circulated will decline.
b. As businesses become suspicious of currency that is circulated, they will favor
cashless transactions such as checks or debit cards, and likely offer benefits for
using such payment methods. In this case, the volume of cashless transactions will
increase.
c. As counterfeiting increases, the U.S. Treasury will likely spend more to introduce
additional security measures. The cost of not doing so will be the loss in the
purchasing power of circulating money and the loss to businesses that accept
identified counterfeit currency.
18.
The equation for the simple money multiplier is 1/r; the equation for the
multiplier is (1 +c)/(r + c). Since c is positive, the simple multiplier is larger than
the multiplier.
19.
False. Policymakers do not use the money multiplier to determine the amount of
reserves needed to achieve the desired money supply because the cash-to-deposit
rate fluctuates making the multiplier change. Policymakers focus on the interest
rate.
20.
If the U.S. government were to raise the reserve requirement to 100 percent, the
interest rates banks pay to depositors would decrease and possibly even become negative (you’d have to pay to have the bank handle your money), because
significant opportunities for profitable loans would be lost.
21.
For a deposit of $100 and a reserve ratio of 5 percent,
The bank can initially lend out $95.
There is now an additional $195 in the economy.
The multiplier is 20.
John’s $100 will ultimately turn into $2,000.
a.
b.
c.
d.
22. a. If individuals hold no cash, the simple money multiplier is the reciprocal of the
reserve requirement. Thus for the following reserve requirements the simple
multiplier is found by dividing the requirement percentage into 1: 5%, 20; 10%,
10; 20%, 5; 25%, 4; 50%, 2; 75%, 1.33; 100%, 1.
b. If the ratio of currency individuals hold to their deposits is 20%, the multiplier
becomes (1+c)/(r + c) and so for the following reserve ratios their multipliers are
now: 5%, 4.8; 10%, 4.0; 20%, 3.0; 25%, 2.67; 50%, 1.71; 75%, 1.26; 100%, 1.
23.
People will increase the amount of money they hold, and sell bonds, if they expect
interest rates to rise in the future because the price of those bonds will be falling.
24.
Interest rates vary inversely with the price of bonds. A bond pays interest plus the
value of the bond when it matures. So, if the price of a $100 bond falls to below
$100, you will get the coupon payments (interest paid along the way) plus $100 at
the end of its term. The difference between the amount paid and the value of the
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Chapter 13: The Financial Sector and the Economy
bond increases the implicit interest rate paid on the bond. The opposite is true
when the price of the bond rises above $100.
25.
The demand for money is downward sloping because the interest rate reflects the
opportunity cost of holding money. The higher the interest rate, the higher the
opportunity cost of holding money. So, people hold less of it when its cost rises.
26.
If the interest rate that equilibrates the loanable funds market is higher than the
rate that equilibrates the money market, the price of financial assets will rise as
people hold less money and more long-term financial assets (loanable funds).
27. a. The interest rate declines as the supply of money shifts to the right as shown
below in the graph on the left.
b. The interest rate declines as demand for money shifts to the left as shown below
in the graph on the right.
c. The interest rate declines as demand for money shifts to the left as shown below
in the graph on the right.
Issues to Ponder
1.
Money is to the economy as oil is to an engine because money is a financial asset
that makes the real economy function smoothly by serving as a medium of
exchange, a unit of account, and a store of wealth. Without it, the economy comes
to a screeching halt.
2.
To be considered money, the currencies would have to fulfill the functions of
money. They only partially fulfill those functions since they have only limited
acceptability as a medium of exchange, store of value, and unit of account. Thus,
while they are partial moneys, we would not consider them full moneys.
3. a. No, because they are hard to move. In this case, pearl shells were used for small
transactions.
b. It would lower the value of the stones, causing a general inflation in prices.
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c. If they could be distinguished, which in this case they could, the new stones
would sell at a discount to the older stones, which they did.
d. It depends, in some ways money is a marker of individuals’ “gifts to the
marketplace.” Oftentimes, however, people assume that wealthy individuals got
their money at the expense of others.
Chapter 30: Appendix A
1.
Students gain a financial asset and the government incurs a financial liability.
2.
It is a financial asset because it has value due to an offsetting liability of the
Federal Reserve Bank.
3.
No. In economic terminology he is saving. Investing is the act of spending the
money on real investment goods in economic terminology.
4.
No, she is not correct. While a loan is a loan, that loan is a financial asset to the
one issuing the loan because it has value just as a bond does.
5.
$2.50.
6.
$0.50
7.
At 6% interest rate, $2,000 five years from now is worth $1500 today, so take the
$2,000 five years from now (assuming you don't really need the money right
away). At a 10% interest rate, the $2,000 five years from now is worth about
$1,241, so take the $1,400 today.
8. a. Market rates are likely to be above 10 percent because the price of the bond is
below face value.
b. Its yield is 12.24 percent.
c. Its price would rise.
9.
As interest rates rise, one would have to save less money today to get $100 in ten
years, so the present value falls.
10.
Substituting into the present value formula PV = $1,060/1.1, we find that the bond
is worth $964 now.
11.
Using the annuity table, we find that a dollar a year for 40 years with a 6 percent
interest rate is worth $15.05 now. Thus $100 would be worth $1,505.
12.
Using the present-value table, we see that at a 3 percent interest rate, $1 30 years
from now would be worth $0.41 now, so $200 in 30 years would be worth $82
now.
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13.
Since we're not sure how long your expected lifetime is, we can use the annuity
rule which says that the present value of an annuity is the flow of income divided
by the interest rate, which in this case would be $200/.09 = $2,222.22. You should
be willing to pay no more than $2,222.22 for that annuity. The amount you are
willing to pay does depend on your expectations about future changes in the
interest rate and about your own life expectancy; if you expected the interest rate
to decline in the future, you would be willing to pay more than $2,222.22,
whereas if you expect to live for only a few more years, you would be willing to
pay less.
14.
If the interest rate is still 9 percent, the value of a lump sum of $20,000 in 10
years can be calculated using the present-value table in Table A30-1. You should
be willing to pay $20,000 X 0.42, or about $8,400 for this offer.
15.
To find the present value of a perpetuity of $100 per year, use the annuity rule,
which says that the present value is equal to the amount of the cash flow divided
by the interest rate. Thus the present value will be: $1,000 if the interest rate is 10
percent; $2000 if the interest rate is 5 percent; $500 if the interest rate is 20
percent.
a. Using the same interest rates, the future values of $100 are: $110 in one year and
$121 in two years at 10 percent; $105 in one year and $110.25 in two years at 5
percent; and $120 in one year and $144 in two years at 20 percent
b. Using the rule of 72, your money will double in: about 7.2 years at 10 percent,
about 14.4 years at 5 percent, and about 3.6 years at 20 percent.
16. a. Agree/Disagree. Technically, a rise in stock prices does not imply a richer
economy. If, however, the rise in stock prices reflects underlying real economic
improvement such as finding the cure for cancer or a technological advance,
society will be richer not because of the rise in stock prices, but because of the
underlying cause of their rise.
b. Disagree. If both the real and financial assets are worth $1 million, then they have
the same value as long as they are valued at market prices. Just as financial assets
bear a risk of no repayment, real assets bear a risk of a fluctuation in prices.
c. Disagree. Financial assets facilitate trades that could not otherwise have taken
place and thus have enormous value to society.
d. Disagree. The value of an asset depends not only on the quantity but also on its
price per unit. The price of land per acre in Japan exceeds that in the United States
by so much that the total value of land in Japan also exceeds that in the United
States.
e. Disagree. The stock market valuation depends on the supply and demand for
existing stock. There is, however, a relationship between relative growth in GDP
and the rise in stock prices to the extent that growth in stock prices and GDP
growth both reflect economic well-being in a country. Also, many of the
companies are multinational companies, and where the company is based may not
reflect where its value added is generated.
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Chapter 13: The Financial Sector and the Economy
Colander’s Economics, 8e. McGraw Hill © 2010
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