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Spring Term 2017
Yaşar University
Introduction to Economics II (Econ 102)
Problem Sheet 6
The Monetary System
1.
List and describe the three functions of money.
The three functions of money are: (1) medium of exchange; (2) unit of account; and (3) store
of value. Money is used as a medium of exchange because money is the item people use to
purchase goods and services. Money is used as a unit of account because it is the yardstick
people use to post prices and record debts. Money is used as a store of value because it is an
item people use to transfer purchasing power from the present to the future.
2.
What is the difference between commodity money and fiat money? Why do people accept fiat
currency in trade for goods and services?
ANSWER: Commodity money has “intrinsic value,” or value in uses other than as money. Fiat money is
established as money by government. It has very little, if any, intrinsic value. Although fiat currency
has no intrinsic value, people accept it in trade when they are confident that others will also accept it.
The government’s decree that fiat currency serves as legal tender increases this confidence.
3.
Explain why banks can influence the money supply if the required reserve ratio is less than 100
percent.
ANSWER: When the reserve requirement is less than 100 percent, banks can lend out deposits. The money
they lend out is redeposited. In this way, deposits can be greater than reserves. Since deposits are
greater under fractional-reserve banking and since deposits are part of the money supply, the money
supply will be greater under fractional-reserve banking.
4.
Assume that the banking system has total deposits of $100 billion. Assume also that required reserves
are %10 of deposits and that banks hold no excess reserves and households hold no currency.
a. what is the money multiplier? What is the money supply?
b. If the Fed now raises required reserves to %20 of deposits, what is the change in the money supply?
a.
With banks holding only required reserves of 10 percent, the money multiplier is 1/.10 = 10. Since
reserves are $100 billion, the money stock is 10 x $100 billion = $1,000 billion.
b.
If the required reserve ratio is raised to 20 percent, the money multiplier declines to 1/.20 = 5. With
reserves of $100 billion, the money stock would decline to $500 billion, a decline of $500 billion.
5.
Draw a simple T-account for First National Bank of Me, which has $5,000 of deposits, a reserve ratio
of 10 percent, and excess reserves of $300.
ANSWER:
First National Bank of Me
Assets
Liabilities
Reserves
$800
Deposits
Loans
$4,200
6.
What are the functions of the Central Bank?
$5,000
The primary responsibilities of the Federal Reserve are to regulate banks, ensuring
the health of the banking system, and to control the quantity of money that is made
available in the economy. If the Fed wants to increase the supply of money, it usually
does so by creating dollars and using them to purchase government bonds from the
public in the nation’s bond markets.
7.
How many tools the Central Bank has in its toolbox to control money supply? Explain how
each of the following changes the money supply.
a. the Fed buys bonds
b. the Fed raises the discount rate
c. the Fed raises the reserve requirement
ANSWER:
.
The Fed controls the money supply through open-market operations. The purchase of
government bonds increases the money supply, and the sale of government bonds
decreases the money supply. The Fed can also expand the money supply by lowering
reserve requirements or decreasing the discount rate, and it can contract the money
supply by raising reserve requirements or increasing the discount rate (this is the most
widely used tool of monetary policy in developed economies).
a. If the Fed buys bonds, it pays for them with money. So there is more money.
b. If the Fed raises the discount rate banks will borrow less from the Fed, and so have fewer reserves,
which decreases the money supply.
c. If the Fed raises the reserve requirement, banks will have to hold more of their deposits as
reserves and so will have less to lend out. With less to lend out, deposits and the money supply
decrease.
8.
Suppose that T-account for First National Bank is as follows:
Assets
Reserves
Loans
Liabilities
$100.000
$400.000
Deposits
$500,000
a. If the Fed requires banks to hold 5% of deposits as reserves, how much in excess
reserves does the bank hold now?
b. Assume that all other banks hold only the required amount of reserves. If the First
National decides to reduce its reserves to only the required amount, by how much
would the economy’s money supply increase?
a.
If the required reserve ratio is 5 percent, then First National Bank's required
reserves are $500,000 x .05 = $25,000. Since the bank’s total reserves are
$100,000, it has excess reserves of $75,000.
b.
With a required reserve ratio of 5 percent, 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.