Download The Main Event: Trade Really Does Create Value

CHAPTER 27 (11)
MONEY, BANKING, AND THE FINANCIAL
SECTOR
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LAUGHER CURVE
A central banker walks into a pizzeria to order a pizza.
When the pizza is done, he goes up to the counter to get it.
The clerk asks him: "Should I cut it into six pieces or eight pieces?"
The central banker replies: "I'm feeling rather hungry tonight.
You'd better cut it into eight pieces."
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CHAPTER OVERVIEW: What’s It All About?
In the macro economy, all real transactions have a financial transaction that mirrors it. In most
cases, this involves money, a highly liquid financial asset that is generally accepted in exchange
for other goods, is used as a reference in valuing other goods, and can be stored as wealth.
Whenever a bank makes a loan, it creates money. It is not in the public interest that they do this
willy-nilly. Enter central banks – in the case of the U.S., the Federal Reserve System. They and
other federal agencies are the regulators and guarantors of deposits in banks and other financial
institutions.
CHAPTER OBJECTIVES: Students Should Be Able To …
1. Explain why the financial sector is central to almost all macroeconomic debates. This is
because behind every real transaction, there is a financial transaction that mirrors it.
2. Explain what money is. Money is a highly liquid financial asset that is generally accepted in
exchange for other goods, is used as a reference in valuing other goods, and can be stored as
wealth.
3. Enumerate the three functions of money. Money as a medium of exchange, a unit of account,
and a store of wealth.
4. State the alternative measures of money and their primary components. M1 consists of
currency in the hands of the public, checking account balances, and travelers' checks. M2 is
made up of M1 plus savings deposits, small-denomination time deposits (certificates of
deposit or CDs), and money market mutual fund shares. L (which stands for liquidity) is the
broadest definition of the money. It consists of almost all short-term financial assets.
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5. Explain how banks create money. Banks create money whenever they make a loan.
6. Calculate both the simple and the approximate real-world money multiplier. The ratio 1/r is
called the simple money multiplier -- the measure of the amount of money ultimately created
per dollar deposited in the banking system, when people hold no cash. The approximate realworld money multiplier is 1/(r +c) where r is the percentage of deposits banks hold in reserve
and c is the ratio of money people hold in cash to the money they hold as deposits.
7. Explain how a financial panic can occur and the potential problem with government
guarantees to prevent such panics. If all the people, all at once, decided to ask for their
money ("a run on a bank"), there would not be nearly enough to satisfy everyone. To prevent
financial panics, the U.S. government has guaranteed the obligations of various government
institutions. The most important guaranteeing program is the Federal Deposit Insurance
Corporation (FDIC).
WHAT’S NEW? Revisions to This Edition
Formerly Chapter 29 (Chapter 13 in Macroeconomics), this appears earlier in the text so that
professors can turn sooner to a discussion of the central policy tool (monetary policy). Chapter
data has been updated and appendix A to Chapter 3 in the fourth edition “Valuing Stocks and
Bonds” has been integrated into the appendix to this chapter.
DISCUSSION STARTERS: Get Your Class Rolling
1. What effect would increasing or decreasing the legal reserve requirement have on the money
supply?
2. Is the sole purpose of the legal reserve requirement to ensure the liquidity of banks?
3. How important is it to the economy to have the Fed as a lender to banks?
4. How important are international financial institutions and markets to the U.S. economy?
TIPS FOR TEACHING LARGE SECTIONS
The Main Event: Trade Really Does Create Value
The Main Event is an activity designed to show students (1) why market participants might
be willing to engage in voluntary exchange, (2) that trade creates value, and (3) how allowing for
monetary exchange and "the middleman" creates greater value than a barter system. Students
discover the incentives that generate trade and experience the gains from trade first hand.
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This activity requires ten to fifteen minutes of class time and twenty to thirty minutes of preclass preparation time. On any kind of paper, create ten to twenty tickets for various events. A few
suggestions include the following:
Michael Bolton in Concert
The Metropolitan Opera Performing Madame Butterfly
The Bolshoi Ballet Performing Swan Lake
NCAA Final Four, Final Game Center Court,
Super Bowl Fifty Yard Line Seat
Monster Tractor and Truck Pull
All-Star Championship Wrestling Ring-side Seat
Foo Fighters in Concert
Brittany Spears in Concert
Barry Manilow in Concert
Muppets on Ice
Garth Brooks in Concert
Santana in Concert
Backstreet Boys in Concert
Your tickets should cover a wide variety of events so that each student finds at least one ticket
appealing. Make sure that some of the tickets are very desirable, but also include a few that are
undesirable (Barry Manilow is usually the least favorite). Also, include a few events that a few
students will value highly, while others might not. In Kentucky, country music tickets often satisfy
this requirement. For this example consider the fourteen tickets suggested above.
Distribute the tickets to different students seated in the classroom. Select the initial
placement of the ticket to increase the likelihood that the student receiving the ticket will be
motivated to trade (i.e. give the ticket for Muppets on Ice to a football player). Select one student
who will record the reported valuations placed on the tickets on the board. Supply the recorder with
a calculator.
Have the fourteen students with tickets come to the front of the room and ask each to read
aloud the event listed on their ticket and tell the class how much they would be willing to pay for
the ticket. Make sure they know you are not asking them to quote its market price, but rather the
value they personally place on the ticket. On the board, the recorder will write the event and the
associated dollar valuation given by each student. Valuations below zero should only be recorded
as zero. Ask the recorder to sum the total value placed on all fourteen tickets and share the results
with the class.
The students now have 3 to 5 minutes to trade with one another. All trades must be
voluntary. They are not required to trade. After trading is complete, ask each to tell the class which
ticket they have and how much they value it. The recorder should write the new values down by
the ticket name on the board. If a student did not trade, re-enter their initial valuation. Have the
recorder tally the ticket values and share the new total with the class. Typically, the total value of
the tickets increases significantly after trade.
This demonstrates how trade creates value due to our subjective wants. Equally important
is that some people did not trade. Because the trades were voluntary, students with tickets not
valued by the market were unable to trade, while students with highly valued tickets chose not to
trade.
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Now, for the second phase of the exercise. The students have just been participants in a
barter system of trade. This second part incorporates a monetary system in a market open to the
entire class. Select one of the students with a ticket to come forward and again ask, "What is your
ticket and how much do you value that ticket?" After the student responds, ask if one of the
students still seated would be willing to pay more for the ticket. Suppose that originally the ticket
to see Barry Manilow was valued at zero. It was then traded to a student who valued it at $5. A
student in the audience loves Barry Manilow and offers $35 dollars for the ticket. At this point,
explain that adding the use of a monetary system increases our ability to create value from trade
because we are not burdened by the need for mutual coincidence of wants. Also, point out that you
are "the middleman" or perhaps the "middleperson" and you have increased the information
available to the traders; hence, reducing their transactions costs and allowing them to increase their
gains from trade.
Tearing up Money.
I always try to do something dramatic when I am teaching large classes to gain and keep
their attendance. Students can get bored rather quickly. When I teach money, one of the things I
do is to have a student come up and read what is on a $20 bill. It says “Federal Reserve Note”
and has a picture of Andrew Jackson on the front. On the back it has a statement, “In God we
Trust.” I then say “This is nothing but a sheet of paper; it is not worth anything—no gold,
nothing, and I proceed to tear it up into small pieces and throw it in a wastepaper basket.
Students react in horror. Having their attention, I then go on to discuss why they reacted the way
they did and how money is valuable because people think it is, not because of any inherent worth.
It costs me $20 but it’s worth that to me to have the students’ attention. (Often, students will go
and pick up the pieces from the wastepaper basket and tape the bill together.)
ON THE WEB: Integrating New Media into the Classroom
http://www.concordcoalition.org/ is the Web site of the Concord Coalition, “a nonpartisan, grass
roots organization advocating fiscal responsibility while ensuring Social Security, Medicare, and
Medicaid are secure for all generations.” Politics: neutral.
http://www.aflcio.org/issuespolitics/socialsecurity/upl is the Web site of the AFL-CIO’s Social
Security home page. There are links to Today’s News and to the News Archive. Politics: liberal.
http://www.cbo.gov is the Web site of the Congressional Budget Office in Washington. There
are links to studies and reports, cost estimates, testimony, and other documents. Politics:
bureaucratic, neutral.
http://www.whitehouse.gov/omb is the Web site of the White House’s Office of Management
and Budget. There are links to “Monthly Budget Review,” “Current Budget Projections,” and
“Current Economic Projections.” Politics: it depends who occupies the Oval Office.
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http://www.brillig.com/debt_clock is the Web site of the U.S. National Debt Clock. When I
accessed it on February 6, 2003, the national debt stood at $6.416 trillion, the U.S. population
was 289,084,018, and each citizen’s share of this debt was $22,192.92. There are five links to
other sites concerned about the national debt. Politics: slightly conservative.
[This is to be updated in 2003.]
http://www.publicdebt.treas.gov is the Web site of the U.S. Treasury’s Bureau of the Public Debt
On-Line. According to the home page, On February 6, 2003, the national debt was $6.388
trillion. Politics: bureaucratic, statistical.
STUDENT STUMBLING BLOCKS: Common Areas of Difficulty
The Money-Creation Process: An In-Class Review
Suppose you find a lost billfold with $1000 in it. The driver’s license is in the billfold so you
contact the owner. It turns out that this person is so pleased by your honesty that you are
rewarded $10,000 she has been holding as cash. After the owner insists on such a hefty reward,
you accept it and deposit it into your checking account. Assume that all banks have a reserve
ratio of 25 percent.
1. After your deposit, how much has the money supply changed in the economy?
ANS: It has not changed. Money has just changed hands. Otherwise stated, the amount of M2
as assets to the nonbanking public within the economy has not changed.
2. How much additional money can your bank now lend out?
ANS: $7,500 (note that 25 percent of your money must be held by the bank as reserves).
3. What is the simple money multiplier equal to?
ANS: 4 (the simple money multiplier = 1/r = 1/.25 = 4).
4. How much money could eventually be created by the banking system from your deposit of
$10,000?
ANS: $30,000. Note that you need to multiply the initial change in the money supply, or M2, by
the money multiplier to get the answer. The initial change is the first round loan amount. Your
bank will loan out 75 percent of $10,000, or $7,500. This $7,500 loan received by someone
increase M2 by that amount and is the initial change in the money supply. Multiply $7,500 by
the simple money multiplier -- $7,500 X 4 = $30,000.
5. Now assume the banks have a reserve ratio of 10 percent. How much money could eventually
be created by the banking system from your deposit of $10,000?
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ANS: $90,000 ($9,000 X 10).
6. Now suppose the reserve ratio is 20 percent, and the ratio of individuals’ cash holdings to
their deposits is 25 percent (previously we were assuming that it was zero). How much money
could eventually be created by the banking system from your deposit of $10,000? Use the
approximate real-world money multiplier.
ANS: $17,760 [1/(r + s) = 1/(0.2 +0.25)] = 2.22
TIES TO THE TOOLS: Bringing the Boxes into the Classroom
Knowing the Tools: Characteristics of a Good Money
The characteristics of a good money are that:
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Its supply be relatively constant,
It be limited in supply,
It be difficult to counterfeit,
It be divisible,
It be durable, and
It be relatively small and light.
Applying the Tools: Checking and Money Market Accounts
Negotiable orders of withdrawal (NOW) accounts are like interest-bearing checking accounts
although they are legally different. Savings and loan associations and credit unions popularized
them. Not to be undone, banks demanded similar instruments so they were given the right to pay
interest on checking accounts. Mutual funds that invested in the money market (T-bills,
commercial paper, and CDs) were also given the right to issue interest-paying accounts.
Applying the Tools: The Real-World Money Multiplier and Recent Banking Reforms
The Depository Institutions Deregulation Act of 1980 extended the reserve requirement to
institutions other than banks and also lowered the reserve requirement for most deposits. In the
1990s, the average reserve requirement was 2 percent. Banks held few excess reserves. By just
looking at the simple money multiplier, this works out to a multiplier of 50. But since some 40
percent of the money is held by individuals, the real-world money multiplier is about 2.4.
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LECTURE OUTLINE: A Map of the Chapter
I. Introduction.
A. In the real sector of the economy, real goods and services are exchanged.
B. For every real transaction, there is a financial transaction that mirrors it.
1. The financial sector is central to almost all macroeconomic debates because behind
every real transaction, there is a financial transaction that mirrors it (Chapter Objective
1).
2. All trades in the goods market involve both the real sector and the financial sector.
II. Why is the financial sector so important to macro?
A. The financial sector is important to macroeconomics because of its role in channeling
flows out of the circular flows -- such as savings -- back into the circular flow in the form
of consumer loans, business loans, and loans to government. See Figure 27-1.
B. Flow from the spending stream is channeled into the financial sector as savings when
individuals buy financial assets such as stocks or bonds and back into the spending stream
as investment.
C. These obligations by the issuer of the financial asset are called financial liabilities. For
every financial asset there is a corresponding financial liability.
D. Interest rates equilibrate supply and demand in the financial sector.
1. The interest rate is the price paid for use of a financial asset.
2. When financial assets make fixed interest payments, as do bonds -- promises to pay a
certain amount plus interest in the future -- the price of the financial asset is determined
by the market interest rate.
a. As the market interest rates go up, the price of the bond goes down.
b. As the market interest rates go down, the price of the bond goes up.
3. This relationship exists because when the interest rate rises, the value of the flow of
payments from fixed interest rate bonds goes down since one can earn more on new
bonds that pay the new, higher interest.
E. Saving escapes the circular flow in the form of money.
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1. Some economists do not believe that the interest rate balances demand and supply for
savings.
2. In order to make sense of the problem, macroeconomics divides the flows into two
types of financial assets.
a. The first type works its way into the system. Examples include bonds and loans.
b. The second type, money held by individuals, is not necessarily assumed to work its
way back into the flow.
III. The definition and functions of money.
A. Money is a highly liquid financial asset that is generally accepted in exchange for other
goods, is used as a reference in valuing other goods, and can be stored as wealth (Chapter
Objective 2).
1. To be liquid means to be easily changeable into another asset or good.
2. Social customs and standard practices are central to the liquidity of money.
B. The U.S. central bank is the Fed.
1. American currency is printed with the caption "Federal Reserve Note," meaning that it
is a liability of the Federal Reserve Bank (the Fed) -- the U.S. central bank whose
liabilities (Federal Reserve Notes) serve as cash in the U.S. [Internet address of the Fed:
http://www.federalreserve.gov].
a. A bank is a financial institution whose primary function is accepting deposits for,
and lending money to, individuals and firms.
b. Individuals' deposits in savings and checking accounts serve the same purpose as
does currency and are also considered money.
2. The Fed, being the nation's central bank has the right to issue these notes and by
convention the notes are acceptable for payment by all the people of the country.
C. Money serves three functions (Chapter Objective 3).
1. Money is a medium of exchange.
a. Without money, we would have to barter -- a direct exchange of goods and services.
b. Money facilitates exchange by reducing the cost of trading.
c. All that is necessary for money to work is that everyone believes that other people
will exchange it for their goods.
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(1) If there is too much money, compared to the goods and services at existing prices,
the goods and services will sell out, or the prices will rise.
(2) If there is too little money, compared to the goods and services at existing prices,
there will be a shortage of money and people will have to resort to barter, or prices
will fall.
2. Money is a unit of account.
a. Money prices are actually relative prices.
b. A single unit of account saves our limited memories and helps us make reasonable
decisions based on relative costs.
c. Money is a useful unit of account only as long as its value relative to other prices
does not change too quickly.
d. In a hyperinflation, all prices rise so much that our frame of reference is lost and
money loses its usefulness as a unit of account.
3. Money is a store of wealth.
a. Money is a financial asset. It is simply a government bond that pays no interest.
b. As long as money is serving as a medium of exchange, it automatically also serves as
a store of wealth.
c. Money's usefulness as a store of wealth also depends upon how well it maintains its
value. Hyperinflations destroy money's usefulness as a store of value.
d. Why do people keep currency under the mattress when they do not receive interest
on it? It is because our ability to spend money for goods makes money worthwhile to
hold even if it does not pay interest.
IV. Money is measured in different ways.
A. Since it is difficult to define money unambiguously, economists have defined different
concepts of money and have called them M1, M2, and L.
B. M1 (Chapter Objective 4a).
1. M1 consists of currency in the hands of the public, checking account balances, and
travelers' checks. See Figure 27-2.
2. Checking account deposits are included in all definitions of money.
C. M2 (Chapter Objective 4b).
1. M2 is made up of M1 plus savings deposits, small-denomination time deposits
(certificates of deposit or CDs), and money market mutual fund shares.
2. The money in savings accounts is counted as money because it is readily available.
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3. All M2 components are highly liquid and play an important role in providing reserves
and lending capacity for commercial banks.
4. The M2 definition is important because economic research has shown that the M2
definition most closely correlates with the price level and economic activity.
D. Beyond M2: L (Chapter Objective 4c).
1. The broadest definition of the money supply is L (which stands for liquidity -- the
ability to change an asset into an immediately spendable asset). It consists of almost all
short-term financial assets.
2. Because of the difficulty of defining money in an ever-changing world, measures of
money have lost some of their appeal, and broader concepts of asset liquidity have taken
their place.
E. Money is not credit; credit is not money.
1. Credit-card balances cannot be money since they are assets of a bank. In a sense, they
are the opposite of money.
2. Credit cards are prearranged loans.
3. Credit cards affect the amount of money people hold -- generally, credit card holders
carry less cash.
V. Banks and the creation of money.
A. What do banks do?
1. Banks take in deposits and use the money they borrow to make loans to others.
2. Banks make a profit by charging a higher interest on the money they lend out than they
pay for the money they borrow.
3. Banks can be analyzed from the perspective of asset management -- how a bank
handles its loans and other assets -- and liability management -- how a bank attracts
deposits and how it pays for them.
4. Thus, banks are both borrowers and lenders.
B. Banks create money.
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1. Banks create money because a bank's liabilities are defined as money. So when a bank
incurs liabilities (lends), it creates money (Chapter Objective 5).
2. When a bank places the proceeds of a loan it makes to you in your checking account, it
is creating money.
3. The first step in the creation of money is that the Fed issues currency.
4. The second step in the creation of money is that the holder of currency deposits it.
5. Banking and goldsmiths.
a. In the past, gold was used as payment for goods and services.
b. But gold is heavy and the likelihood of being robbed was great.
6. From gold to gold receipts.
a. It was safer to leave gold with a goldsmith who gave you a receipt.
b. The receipt could be exchanged for gold whenever you needed gold.
c. People soon began using the receipts as money since they knew the receipts were
backed 100 percent by gold.
d. At this point, there were two forms of money: gold and gold receipts.
7. The third step in the creation of money. Gold receipts become money.
a. Since so little gold was redeemed, the goldsmith began issuing more receipts than he
had in gold, and charged interest on the newly created gold receipts. He created
money.
b. The goldsmith realized he could make more money in interest than he could earn in
goldsmithing.
c. The gold receipts were backed partly by gold and partly by people's trust that the
goldsmith would pay off in gold on demand. The goldsmith had become a banker.
8. Banking is profitable.
a. As the goldsmiths became wealthy, others jumped, in offering to hold gold for free or
even offering to pay for the privilege of holding the public's gold.
b. That is why most banks today are willing to hold the public's money at no charge -they can lend it out and in the process, make profits.
C. The money multiplier.
1. Reserves and reserve ratios.
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a. Reserves are cash and deposits a bank keeps on hand or at the Fed or central bank,
enough to manage the normal cash inflows and outflows.
b. The reserve ratio is the ratio of cash (or deposits at the central bank) to deposits a
bank keeps as a reserve against cash withdrawals. The reserve ratio consists of
required and excess ratios.
(1) When banks are required by the Fed to hold a percentage of deposits, that
percentage is called the required reserve ratio.
(2) If banks choose to hold an additional amount, this is called the excess reserve
ratio.
c. Banks "hold" currency for people and in return allow individuals to write checks for
the amount they have on deposit at the bank.
2. Determining how many demand deposits will be created.
a. It is possible to determine the total amount of money that will eventually be created
by multiplying the original amount, say a $100 loan, that was deposited and
redeposited by 1/r, where r is the reserve ratio.
b. For a reserve ratio of 10 percent, the formula would be: 1/r = 1/0.10 = 10. (10 X
$100 (the original loan) = $1,000.
c. This means that $900 of new money was created ($1,000 - $100).
3. Calculating the money multiplier.
a. The ratio 1/r is called the simple money multiplier -- the measure of the amount of
money ultimately created per dollar deposited in the banking system, when people
hold no cash (Chapter Objective 6a).
b. The higher the reserve ratio, the smaller the money multiplier, and the less money
will be created.
4. An example of the creation of money.
a. Table 27-1 shows the process through 10 rounds assuming a deposit of $10,000 and a
reserve ratio of 20 percent.
b. If banks keep excess reserves – reserves held by banks in excess of what banks are
required to hold -- for safety reasons, the money multiplier decreases
5. Calculating the approximate real-world money multiplier.
a. The approximate real-world money multiplier in the economy is 1/(r +c) where r =
the percentage of deposits banks hold in reserve and c is the ratio of money people
hold in cash to the money they hold as deposits (Chapter Objective 6b) .
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b. An example: assume banks keep 8 percent in reserve and the ratio of individuals'
cash holdings to their deposits is 20 percent. The approximate real-world money
multiplier is: 1/(.08 +.20) = 1/.28 = 3.57.
D. Faith as the backing of our money supply.
1. Promises to pay underlie any financial system.
2. All that backs the modern money supply are bank loan customers' promises to pay and
the guarantee of the government to see that banks' liabilities to individuals will be met.
VI. Regulation of banks and the financial sector.
A. Financial panics.
1. The financial history of the world is filled with stories of financial upheavals and
monetary problems.
2. In the U.S. in the 1800s, local banks were allowed to issue their own notes, which were
often worthless.
B. Anatomy of a financial panic.
1. Financial systems are based on trust that expectations will be fulfilled. Banks borrow
short and lend long, which means that if people lose faith in banks, the banks cannot
keep their promises (Chapter Objective 7).
2. If all the people, all at once, decided to ask for their money ("a run on a bank"), there
would not be nearly enough to satisfy everyone.
C. Government policy to prevent panic.
1. To prevent financial panics, the U.S. government has guaranteed the obligations of
various government institutions.
2. The most important guaranteeing program is the Federal Deposit Insurance Corporation
(FDIC).
a. The financial institutions, say a bank, pay a small premium for each dollar of deposit
to the FDIC.
b. The FDIC puts the money into a fund used to bail out banks experiencing a run on
deposits.
3. These guarantees have two effects:
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a. They prevent the unwarranted fear that causes financial crises.
b. They prevent warranted fears.
D. The benefits and problems of guarantees.
1. The fact that deposits are guaranteed does not serve to inspire banks to make certain
deposits are covered by loans in the long run.
2. Since deposits are covered up to $100,000 by the FDIC, some financial institutions
make risky loans knowing that the guarantee is good.
E. The savings and loan bailout.
1. The deregulated S&Ls made so many bad loans that they failed.
2. The S&Ls could not repay depositors their money, so the government had to step in and
do it for them.
3. Banks and bad loans. How can banks make so many bad loans?
a. Part of the answer lay in out-and-out fraud. Part of it lies in the spread.
b. The spread is the difference between a bank's costs of funds and the interest it
receives on lending out those funds.
c. The S&Ls' cost of funds grew because of competition from other S&Ls.
d. The S&Ls were forced to make riskier loans to maintain the spread.
e. S&Ls bet there would be no recession -- they lost.
4. Should government guarantee deposits?
a. The guarantees served their purpose by preventing unwarranted runs on S&Ls.
b. However, the government should have charged much higher fees, or they should
have had a stronger regulatory presence by limiting the risks the S&Ls undertook.
NOTE: For an in depth view of financial institutions and financial markets, see Appendix A, "A
Closer Look at Financial Institutions and Financial Markets." Also see an alternative
approach to explaining the creations of money: Appendix B, "Creation of Money Using
T-Accounts."
CHAPTER SUPPLEMENTS: Other Classroom Aids to Use
 Classic Readings in Economics: "100 Percent Reserves," pp. 89-94. This selection, taken
from Irving Fisher's 1935 book, 100% Money, argues just the opposite of John Law -- that
banks should only be allowed to issue checks if they back them 100 percent with U.S.
currency or gold.
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 Experiments in Teaching and in Understanding Economics, pp. 12-13: A Moral Hazard
Experiment.
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POP QUIZ
NAME: __________________________________
COURSE: ________________________________
1. Which of the following statements about money is false?
a. Credit cards are not money.
b. Money is anything that serves the functions of money.
c. The narrowest definition of money is L, which stands for liquidity.
d. When a bank incurs liabilities it creates money.
2. Which of the following statements concerning money is true?
a. Money must have an inherent value to function as a medium of exchange.
b. The unit-of-account function of money requires that prices never change.
c. As long as money is serving as a medium of exchange, it automatically also serves as a
store of wealth.
d. The largest component of money is currency in circulation.
3. Which of the following is true of banks?
a. Banks hold reserves either as cash or as deposits at the Fed.
b. Banks operate in a regulatory-free environment.
c. The existence of deposit insurance makes runs on banks likely.
d. Spread is calculated by adding the interest rate a bank receives on funds loaned out and the
bank’s cost of funds.
4. The required reserves of a bank:
a. is calculated by multiplying the required reserve ratio by the bank’s demand deposit
liabilities.
b. is determined by the Office of the President.
c. represents an amount of money that the bank can loan out.
d. would increase if the required reserve ratio decreased.
5. Which of the following statements is true?
a. Liability management refers to a bank’s handling of loans and other assets.
b. Small-denomination time deposits are included in M1.
c. Excess reserves equal total reserves minus required reserves.
d. The form of money that best fulfills the medium of exchange function is credit cards.
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6. Suppose a single bank has reserves totaling $160,000, demand deposits equal $800,000, and
the reserve requirement is 20 percent. If the Fed gave the bank $100,000 in reserves,
a. the simple money multiplier is 4.
b. this single bank could initially loan out $20,000, but the entire banking system could
expand the money supply by $500,000.
c. this single bank could initially loan out $100,000, but the entire banking system could
expand the money supply by $400,000.
d. this single bank could initially loan out $900,000, but the entire banking system could
expand the money supply by $1,250,000.
7. When a single bank:
a. makes a loan, it increases the money supply equal to the amount of the loan.
b. has a loan repaid, this will increase the money supply equal to the amount of the loan
repayment.
c. is faced with a required reserve ratio of 0.15, then it can loan out 150 percent of its demand
deposits.
d. has a reserve requirement of 10 percent, and a customer deposits $1000, the banks can lend
out $1000 more.
8. Which of the following statement is true?
a. If banks keep 20 percent in reserve and the ratio of individuals’ cash holdings to their
deposits is 20 percent; the approximate real-world money multiplier will be equal to 4.5
b. If the reserves in U.S. banks totaled $25,000, there were no excess reserves, and total
deposits were $100,000, the banking system’s reserve ratio would be 20 percent.
c. Total reserves of the banking system of $300 billion could support $1,500 billion of
checkable deposits assuming a required reserve ratio of 20 percent.
d. If individuals hold no cash and the required reserve ratio is 25 percent, then the money
multiplier is 5.
9. Suppose the banking system has $200,000 in outstanding deposits and reserves of $20,000.
Assume a simple money multiplier. If the required reserve ratio were 10 percent, and the Fed
bought $5,000 of the bank’s reserves what would happen to the money supply within this
banking system?
a. fall by $50,000.
c. fall by $5,000.
b. rise by $50,000.
d. rise by $5,000.
10. Which of the following statements is false?
a. According to some economists, the crisis with savings and loans was in part caused by a
lack of enforcement of government regulation of these institutions.
b. According to some economists, the crisis with savings and loans was in part caused by too
much government guaranteeing of depositor’s funds.
c. The main problem with deposit insurance is that it reduces the incentive for individuals to
worry about whether their financial institutions are financially sound.
d. The Federal Reserve is responsible for guaranteeing the deposits of commercial banks.
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Chapter 27 (11): Money, Banking, and the Financial Sector
ANSWERS TO POP QUIZ
1. c 2. c 3. a 4. a 5. c 6. b 7. a 8. c 9. a 10. d
CASE STUDIES: Real-World Cases of Textbook Concepts
Case Study 27-1: How Much Insurance is Enough?
Federal deposit insurance came into being with the establishment of the Federal Deposit
Insurance Corporation in 1933, three months after Franklin Roosevelt took the oath of office. In
the beginning, Roosevelt, his Treasury Secretary, and the chairman of the Senate Banking
Committee didn’t like it, thinking it to be an expensive subsidy for poorly managed banks. But
the House Banking Committee chairman loved it, as did the general public having been badly
seared by bank failures. Each account in a federally chartered bank was insured for $25,000,
later raised to $40,000 per account.
In 1980, the limit was raised to $100,000 from $40,000 per account, much too high in the
opinion of most economists. That increase helped create the savings-and-loan debacle that cost
taxpayers billions.
Now Congress is talking about raising the ceiling to $130,000, and to $260,000 for retirement
accounts, arguing that inflation has eroded the value of a limit without mentioning that the limit
was set too high in the first place. There are some people who have lost money in the face of a
bank failure since they had more than the limit in their account. This could easily be solved by
having bank computers programmed to alert depositors when this happens. A married couple
could have $300,000 fully insured: $100,000 for Dad, $100,000 for Mom, and another $100,000
for Dad and Mom.
Only 2 percent of households with bank accounts have any uninsured deposits at all. As one Fed
official put it: “We frequently receive letters from banks urging that we support increased deposit
insurance coverage. But we virtually never receive similar letters from depositors.”
So what’s the problem? Deposit insurance needs some fixing but it is virtually impossible to get
movement without the support of small banks and they want more coverage. They rely on large
accounts to a greater extend than large banks do but they are having trouble attracting them.
They would like to lure money to banks from money-market accounts, mutual funds, and other
uninsured investments.
Source: David Wessel, “A Solution in Search of a Problem,” The Wall Street Journal, March 14,
2002, p. A1; and “Deposit Insurance Folly,” The Wall Street Journal, May 28, 2002, p. A18.
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Chapter 27 (11): Money, Banking, and the Financial Sector
Questions:
1. Who would benefit if the limit is raised?
2. Who would be hurt if the limit is raised?
3. Would the public benefit if in raising the limit, people moved their money out of uninsured
institutions and into insured banks?
4. Does deposit insurance prevent runs on banks?
5. English banks have no deposit insurance at all. Has deposit insurance been oversold to the
American public?
Case Study 27-2: Where Are All the $100 Bills?
When was the last time you saw a $100 bill?



Stores don’t like them
ATMs don’t issue them.
Cash registers don’t even have slots for them.
Yet Ben Franklins make a little less than two-thirds of the all of the value of currency in
circulation. See the following table.
YEAR
1960
1970
1980
1990
1997
TOTAL CURRENCY
IN CIRCULATION
(BILLIONS)
$33
55
151
280
458
$100 BILLS IN
CIRCULATION
(BILLIONS)
6
12
50
160
292
RATIO OF $100
BILLS TO TOTAL
CURRENCY
18%
22
33
57
64
The increasing ratio is partly a function of inflation. But inflated or not, where are they?
1. They are a proxy of the underground economy. Data show that there is a surge of $100 bills
immediately following an increase in marginal tax rates. This happened late in the Carter
administration, midway through the Bush administration, and at the beginning of Clinton’s
term.
2. These bills are among the principal exports of the U.S. Over half of the $458 billion currency
in circulation is held abroad in places like Latin America. The dollar is also the de jure
currency in Ecuador, Panama, Cuba, Liberia, and Russia. These large greenbacks are
especially coveted.
3. This is great for the U.S. Treasury, which in effect gets an interest-free loan from dollarholding foreigners.
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Chapter 27 (11): Money, Banking, and the Financial Sector
Source: Peter Brimelow, “Going Underground,” Forbes, September 21, 1998, p. 206; and
Michael Lambert and Kristin D. Stanton, “Opportunities and Challenges of the U.S. Dollar as an
Increasingly Global Currency: A Federal Reserve Perspective,” Federal Reserve Bulletin,
September 2001, p. 567. See http://federalreserve.gov//Pubs/Bulletin/2001/0901lead,pdf.
Questions:
1. Why are $100 bills used in the underground economy?
2. Why is American money so attractive to foreigners?
3. Would the $100 bills foreigners own appear in our M1 and M2 figures?
4. Would Fed action in the U.S. affect the value of U.S. dollars held by foreigners?
5. Do you think the euro would ever try to go into competition against the U.S. dollar? Would
it be attractive for them to do so?
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Chapter 27 (11): Money, Banking, and the Financial Sector