Download 8 MONEY, THE PRICE LEVEL, AND INFLATION**

8
MONEY, THE PRICE
LEVEL, AND
INFLATION**
Answers to the Review Quizzes
Page 188
1.
(page 590 in Economics)
What makes something money? What functions does money perform?
Why do you think packs of chewing gum don’t serve as money?
Money is anything that is generally acceptable as a means of
payment. Money has three functions: medium of exchange (money is
accepted in exchange for goods and services), unit of account
(prices are quoted in terms of money), and store of value (money can
be held and exchanged for goods and services later). Packs of
chewing gum do not function as money because they are not
particularly good as a store of value—gum deteriorates.
Additionally, packs of gum are not generally accepted in exchange
for goods and services, so packs of gum are not a medium of
exchange.
2.
What are the problems that arise when a commodity is used as
money?
Commodities are not used as money because of several problems. Many
commodities are bulky. And many commodities change in value over
time. Using as money a commodity that changes in value would be
awkward. Prices would change simply because the commodity’s value
changed. Additionally, using a commodity as money has a higher
opportunity cost than do currency and bank deposits because the
commodity has alternative uses that must be foregone.
3.
What are the main components of money in the United States today?
The main components of money in the United States today are currency
and deposits at banks and other depository institutions.
What are the official measures of money? Are all the measures
really money?
4.
The official measures of money are M1 (the sum of currency,
traveler’s checks, and checking deposits owned by individuals and
businesses) and M2 (the sum of M1, savings deposits, time deposits,
and money market mutual funds and other deposits). All of the
components of M1 are truly money because all the components serve as
a means of payment. Some of the components of M2 are not truly money
because they are not a means of payment. (For instance, funds at
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* This is Chapter 25 in Economics.
money market mutual funds cannot be used as a means of payment for
small purchases.) But all of these “non-money” assets are highly
liquid so they are operationally similar to money.
5.
Why are checks and credit cards not money?
Checks and credit cards are not money because they are not a means
of payment. A check is an order to transfer a deposit from one
person to another. The deposits are money but the checks are not. A
credit card is an ID card that lets a person take out a loan at the
instant he or she buys something. The loan still needs to be repaid
with money so the credit card is not a means of payment, that is, it
is not money.
Page 191
1.
(page 593 in Economics)
What are depository institutions?
Depository institutions are financial firms that take deposits from
households and firms. They then make loans available to other
households and firms.
2.
What are the functions of depository institutions?
Depository institutions have four major economic functions: They
create liquidity, pool risk, lower the cost of borrowing, and lower
the cost of monitoring borrowers.
3.
How do depository institutions balance risk and return?
Banks earn a higher return by using the funds they acquire from
their deposits to buy higher-yielding, riskier assets such as loans.
But these assets are risky. If the loans fail, then the bank might
not have sufficient funds to repay their depositors. If the bank
undertakes too much risk, then its depositors might rush to withdraw
their deposits, which would cause the bank to fail. But if the bank
forgoes all risky assets its profit will be much lower. So the bank
must balance its search for higher return against the risk earning
the return entails.
4.
How do depository institutions create liquidity, pool risks, and
lower the cost of borrowing?
Liquidity is the property of being easily convertible into a means
of payment without loss in value. Depository institutions create
liquidity when they offer deposits that can be withdrawn as money at
short (or no) notice and then use these deposits to make long-term
loans.
Depository institutions pool risk because they use funds obtained
from many depositors to make loans to many borrowers. As a result,
if a borrower defaults, no one depositor bears the entire loss
because the loss is spread over all depositors. By spreading the
risk, depository institutions are pooling risk.
Depository institutions lower the cost of borrowing because they
specialize in borrowing. For instance, a firm that wants to borrow a
large sum of money need only visit one depository institution to
arrange such a loan. In the absence of depository institutions, the
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WHAT IS ECONOMICS?
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firm would need to undertake many transactions with many lenders,
which would be a costly process.
5.
How have depository institutions made innovations that have
influenced the composition of money?
Checking deposits at thrift institutions such as S&L’s savings
banks, and credit unions are examples of deposits that were created
by innovations in the 1980s and 1990s. These deposits have become an
increasingly large percentage of M1. Savings deposits have decreased
as a percentage of M2, while time deposits and money market mutual
funds have increased, and checking deposits at commercial banks have
become a decreasing percentage of M1.
Page 195
1.
(page 597 in Economics)
What is the central bank of the United States and what functions
does it perform?
The Federal Reserve System is the central bank of the United States.
The Federal Reserve conducts the nation’s monetary policy and
regulates the nation’s depository institutions. The Fed provides
banking services to commercial banks.
2.
What is the monetary base and how does it relate to the Fed’s
balance sheet?
The monetary base is the sum of Federal Reserve notes, coins, and
depository institutions’ deposits at the Fed. Aside from coins, the
rest of the monetary base consists of Federal Reserve liabilities.
Federal Reserve notes and depository institutions’ deposits are
liabilities of the Federal Reserve.
3.
What are the Fed’s three policy tools?
The Federal Reserve has three policy tools: required reserve ratio,
last resort loans, and open market operations.
4.
What is the Federal Open Market Committee and what are its main
functions?
The Federal Open market Committee (FOMC) is the main policy-making
group within the Federal Reserve System. It decides upon the
nation’s monetary policy as conducted through open market
operations. The FOMC meets approximately once every six weeks.
Page 197
1.
(page 599 in Economics)
How do banks create money?
Banks within the banking system create money by creating deposits,
which are part of the nation’s money. Banks create deposits by
making loans because part or all of the loans they make will be
deposited in another bank. For instance, a student given a loan may
purchase books at the local bookstore. The bookstore will then
deposit the proceeds into its bank as part of the bookstore’s
checking account. Thus the loan has created new deposits at the
bookstore’s bank.
2.
What limits the quantity of money that the banking system can
create?
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The quantity of money that the banking system can create is limited
by: the monetary base, desired reserves, and desired currency
holdings.
3.
A bank manager tells you that she doesn’t create money. She just
lends the money that people deposit. Explain why she’s wrong.
Though the manager does not see the entire process, nonetheless the
loans the manager makes create more deposits and more money. Point
out to the manager that when she makes a loan, the deposits at her
bank do not change. And, when the loan is spent, the recipient
selling the goods or services that have been purchased will deposit
part or all of the proceeds in his or her bank. When the recipient
makes this deposit, the total amount of the nation’s deposits
increase and, because deposits are part of the nation’s money, the
quantity of money also increases. However, actions of other economic
agents also affect the creation of money. For example, if people
decide to hold less currency and more deposits, the immediate effect
on the quantity of money is nil. But over time the quantity of money
increases because banks gain more (excess) reserves, which are then
loaned and then deposited, thereby creating additional deposits and
increasing the quantity of money.
Page 201
1.
(page 603 in Economics)
What are the main influences on the quantity of real money that
people and businesses plan to hold?
The quantity of real money demanded depends on four factors: the
price level, the nominal interest rate, real GDP, and financial
innovation. An increase in the price level increases the nominal
demand for money but the quantity of real money demanded is
independent of the price level. An increase in the nominal interest
rate decreases the quantity of real money demanded, because the
nominal interest rate is the opportunity cost of holding money. An
increase in real GDP increases the demand for real money, because
more real GDP implies more transactions and an increase in the
demand for money to finance the transactions. And, financial
innovations that make it less costly to get by with less money on
hand decreases the demand for money.
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WHAT IS ECONOMICS?
2.
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How does a change in the nominal interest rate change the
quantity of money demanded?
Illustrate the effect by using
the demand for money curve.
An increase in the nominal
interest rate decreases the
quantity of real money demanded.
The slope of the demand for
money curve shows how the
quantity of real money demanded
depends on the nominal interest
rate. An increase in the nominal
interest rate results in a
movement upward along the demand
for money curve; a decrease in
the nominal interest rate
results in a movement downward
along the demand for money curve
as illustrated by the arrow in
Figure 8.1.
3.
How does a change in real GDP change the demand for money?
Illustrate the effect by using
the demand for money curve.
A change in real GDP changes the
demand for money. An increase in
real GDP increases the demand
for money and shifts the demand
for curve for real money
rightward from MD0 to MD1, as
shown in Figure 8.2.
4.
How has financial innovation
changed the demand for M1 and
the demand for M2?
Financial innovations, such as
increased use of credit cards
and the spread of ATMs, have
generally decreased the demand
for M1. New interest bearing
accounts during the 1970s and
1980s increased the demand for
M2, but the later financial
innovations have decreased the demand for M2.
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5.
How is money market equilibrium determined in the short run and
in the long run?
In the short run, the nominal interest rate adjusts to restore
equilibrium to the money market. When the quantity of money demanded
equals the quantity supplied, the nominal interest rate is at its
equilibrium level. In the long run, supply and demand in the
loanable funds market determines the real interest rate. The nominal
interest rate equals the equilibrium real interest rate plus the
expected inflation rate. Real GDP equals potential GDP. So the only
variable that can adjust in the long run is the price level. In the
long run the price level adjusts so that the money market is in
equilibrium.
Page 203
1.
(page 605 in Economics)
What is the quantity theory of money?
The quantity theory of money is the proposition that in the long run
an increase in the quantity of money creates an equal percentage
increase in the price level.
2.
How is the velocity of circulation calculated?
The velocity of circulation is the average number of times a dollar
of money is used annually to buy of the goods and services that make
up GDP. The velocity of circulation equals (nominal) GDP divided by
the quantity of money.
3.
What is the equation of exchange? Can it be wrong?
The equation of exchange is the formula that MV = PY, where M is the
quantity of money, V is the velocity of circulation, P is the price
level, and Y is real GDP. The equation of exchange is always true by
definition because the velocity of circulation is defined as PY/M.
4.
Does the quantity theory correctly predict the effects of money
growth on inflation?
The long-run historical and international evidence on the
relationship between money growth and the inflation rate support the
quantity theory. The data suggest a marked tendency for nations with
high money growth rates to have high inflation rates. Thus the longrun cause of inflation is growth in the quantity of money.
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