Econ 364

Intermediate Macroeconomic Theory

In Class Exercise – Money and The FED

Answers in RED

1. Who invented money?  Explain.

 Nobody.  Money evolved spontaneously because of the problems with barter.  It makes exchange much easier (don't have to have double coincidence of wants), etc.

2. What is the difference between commodity money and fiat money?

 Commodity money emerges as money because of its physical characteristics (everyone in a given society values those characteristics for some reason); fiat money is paper money with a legal stamp or signature on it.  It is not the physical characteristics that make it money, it is the legal stamp or signature.

3. What three groups affect the money supply?

The public - by deciding how much currency they hold vs. deposit.

Depository institutions - by deciding how many reserves they hold.

The FED - by manipulating the reserves in the system that banks have or don't have.

4. What is a fractional reserve banking system (FRBS)?

Depository institutions (such as banks) only have to hold a fraction of their deposits on hand.

5. In a FRBS, by how much can a SINGLE bank increase the money supply?  Explain.

 By its excess reserves, which they can loan out (creating "new" credit).

6. By how much, in theory, can the entire system potentially increase the money supply?  Explain why.

 By taking the initial excess reserves from a deposit and multiplying it by the simple money multiplier (1/required reserve ratio).

7. How do the reserve-deposit ratio and the currency-deposit ratio affect the money multiplier?  Explain.

If the reserve-deposit ratio increases, that means that banks are holding more of their reserves and not loaning them out, therefore the multiplier effect will go down.  If the currency-deposit ratio increases, that means the public is holding more of its money out of depository institutions (not depositing it), therefore the multiplier effect will go down.

8. Explain three ways the FED attempts to control the money supply?

a.  Open market operations -- by buying and selling government bonds.  If the sells a bond to a bank, the bank will pay for it with money, which the FED retires into the black hole.  The money supply decreases.  If the FED buys a bond, it pays with money that comes out of the black hole and the money supply increases.

  Remember that the FED manipulates or targets the federal funds rate by using open market operations.

b.  Changing the discount rate -- if the FED increases the discount rate, banks are less likely to borrow from the FED, therefore have less to loan to the public, the money supply goes down.  If the FED decreases the discount rate, banks are more likely to borrow from the FED, therefore they have more money to loan to the public, and the money supply increases.

c.  Changing the required reserve ratio -- if the FED increases this ratio, banks must hold more money as required reserves, the loan less out, the money supply decreases.  If the FED decreases this ratio, banks can loan more money out, increasing the money supply.  This is rarely used by the FED because it is so powerful.

9. What intermediate target has the FED been using lately?

The Federal Funds Rate -- the interest rate banks charge each other for short-term (usually overnight) loans.