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Cllnftu T3d A common unit for measuring the value of every good or service in the economy is known as a(n) -' - 5. (Fiat Money) Most economists believe that the better fiat money serves as a store of value, the more acceptable it is. What does this statement mean? How could people lose faith in money? 6. (The Value of Money) When the value of money was based on its gold content, new discoveries of gold were frequently followed by periods of inflation. Explain. 13-2 Explain what is meant by a fractional reserve banking system. (Depository Institutions) What is a depository institution and what types of depository institutions are found in the United States? How do they act as intermediaries between savers and borrowers? Why do they play this role? 8. (Depository Institutions) Explain why a bank typically holds only a fraction of its deposit liabilities as reserves. In light of this arrangement, why is it important that depositors have confidence in their bank's health? 13-3 Describe the Fed, summarize its mandated objectives, and outline some of its other goals. (Federal Reserve System) What are the main powers and responsibilities of the Federal Reserve System? What are its two mandates and some of its other goals? 13-4 Describe subPrime mortgages and the role they played in the financial crisis of 2008. (Subprime Mortgages) What are subprime mortgages and what role did they play in the financial crisis of 2008? 11. (Bank Deregulation) Some economists argue that deregulating the interest rates that could be paid on deposits combined with deposit insurance led to the insolvency of many depository institutions during the 1980s. On what basis do they make such an argument? CHAPTER 14 14-1 Interpret why using a debit card is like using cash, but using a credit card is not. (Credit vs. Debit Cards) Explain why using a debit card is just like using cash, while using a credit card is different. 14-2 (Monetary Aggregates) Calculate M1 and M2 using the following information: Large-denomination time deposits, Currency and coin held by the non-banking public, Checkable deposits, Small-denomination time deposits, Traveler's checks, Savings deposits, Money market mutual fund accounts. 14-3 Explain why a bank is in a better position to lend your savings than you are. (Bank Expertise) Why are banks in a better position to make loans than would be a typical saver? Describe a bank's expertise in this area. (Reserve Accounts) Suppose that a bank's customer deposits $4,000 in her checking account. The required reserve ratio is 0.2. What are the required reserves on this new deposit? What is the largest loan that the bank can make on the basis of the new deposit? If the bank chooses to hold reserves of $3,000 on the new deposit, what are the excess reserves? 14-4 (Money Creation) Describe how banks create money. (Money Creation) Suppose Bank A, which faces a reserve requirement of 0.10, receives a $1,000 cash deposit from a customer. a. Assuming no excess reserves, how much should the bank lend? Show your answer on Bank A's balance sheet. b. If the loan is redeposited in Bank B, show the changes in Bank B's balance sheet. c. Repeat for Banks C, D, and E. d. Using the simple money multiplier, calculate the total change in the money supply. e. How does holding 5 percent excess reserves affect the total change? (Money Multiplier) Suppose the Federal Reserve lowers the reserve ratio from 0.10 to 0.05. How does this affect the money multiplier? What are the multipliers for ratios of 0.15 and 0.20? (Money Creation) Show how each initial transaction affects a bank's assets, liabilities, and reserves. 14-5 (Money Creation) Show how specific transactions like deposit, loans, defaults, and open-market operations affect bank assets, liabilities, reserves, and the money supply. Summarize the Fed’s tools of monetary policy. (Monetary Tools) What tools does the Fed have to pursue monetary policy? Which is used most? Suppose the money supply is $500 billion, and the Fed wants to increase it by $100 billion. a. What should it do? b. How would changing the reserve ratio affect this? Why might the Fed be reluctant? (Money Demand and Interest Rates) Explain how money demand and supply determine the interest rate. a. What is your average money balance during a pay period? b. How would changes like income or spending patterns affect this? Plot the supply and demand for money and explain the interest rate determination. 15-2 (Money and Aggregate Demand) How does an increase in money supply affect aggregate demand? How do different factors like investment demand, consumption propensities, and bank reserves influence this? 15-3 Describe how monetary policy impacts aggregate output and short/long-run equilibrium. Use diagrams if necessary. How does altering the money supply affect interest rates, investment, and GDP? Discuss the importance of velocity in monetary policy. a. Calculate velocity using given data; what happens if the price level or money supply changes? b. Explain the quantity theory of money and how it relates to changes in money supply and nominal GDP. 15-4 (Great Recession Policies) Summarize the Fed's policies during and after the Great Recession. How did it use the money supply and interest rates to stimulate the economy? What is quantitative easing, and why was it used? How do these policies reflect in the Fed’s balance sheet? 16-1 (Active vs. Passive Policy) Explain the difference between active and passive monetary policy approaches. How do expectations and wage adjustments influence these strategies? Discuss the roles each approach plays in stabilizing the economy.
Sample Paper For Above instruction
The concept of a common unit for measuring the value of goods and services in an economy is fundamental to understanding monetary economics. This unit, often identified as money, allows individuals and institutions to compare the worth of different goods and services, facilitating trade and economic calculation. Among various forms of money, fiat money—currency that has no intrinsic value but is established as legal tender by government decree—is the most prevalent in modern economies (Mankiw, 2021). The acceptability of fiat money hinges on the confidence of the public in its stability and value preservation. Essentially, the more effectively fiat money functions as a store of value, the more people trust it, and consequently, the more acceptable it becomes for transactions (Issing, 2005).
However, this trust can be fragile. People may lose faith in money due to inflation, loss of confidence in government policies, or economic instability. For instance, inflation erodes the purchasing power of money, leading individuals to seek alternative stores of value such as real estate or foreign currency (Borio & Lowe, 2004). Hyperinflation episodes, like Zimbabwe in the late 2000s, demonstrate how rapidly confidence can deteriorate, causing money to become worthless and disrupting economic activity.
The classical gold standard exemplifies a monetary system where the value of money was based on gold content. When new gold discoveries increased the supply of gold, they frequently led to periods of inflation. This occurs because an increase in gold supply increased the backing for currency, leading to an increase in the overall money supply, which in turn raised price levels (Thomas, 2016). The system's inability to flexibly adjust to gold discoveries often caused economic instability, illustrating the limitations of a commodity-backed system.
A fractional reserve banking system forms the backbone of modern banking. In this system, depository institutions such as commercial banks, savings banks, and credit unions accept deposits and are required to hold only a fraction of these deposits as reserves—either as cash in their vaults or on deposit at the central bank (Mishkin, 2019). The remainder can be loaned out, which enables banks to create money by expanding credit. These institutions serve as intermediaries between savers, who deposit funds, and borrowers, who seek loans. This process of intermediation allocates funds efficiently, promotes economic growth, and provides liquidity to the economy.
Banks typically keep only a fraction of their deposits as reserves to optimize profitability. Holding excess reserves means that banks forgo potential interest earnings from loans. Nonetheless, maintaining adequate reserves is crucial because trust in a bank’s financial health reduces the risk of bank runs—a situation where multiple depositors withdraw their funds simultaneously out of concern about insolvency. Confidence is vital because a bank’s insolvency can trigger a chain reaction, leading to broader financial instability.
The Federal Reserve (Fed) plays a critical role in monetary policy. It operates with the main objectives of promoting maximum employment, stabilizing prices, and moderating long-term interest rates (Board of Governors of the Federal Reserve System, 2022). These mandates aim to foster economic stability and growth. Additionally, the Fed seeks to maintain financial stability, regulate and supervise banking institutions, and provide financial services to the government and the public.
Subprime mortgages were loans extended to borrowers with poor credit histories or high debt-to-income ratios. These higher-risk loans played a pivotal role in the 2008 financial crisis. Financial institutions packaged subprime loans into mortgage-backed securities (MBS), which were sold to investors globally. When housing prices declined, many borrowers defaulted, causing the value of these securities to plummet and destabilizing financial markets. The crisis revealed how lax lending standards, coupled with complicated financial products and inadequate regulation, contributed to systemic risk.
Bank deregulation in the 1980s, particularly concerning interest rate controls and deposit insurance, is argued to have led to increased insolvencies. Deregulation allowed banks to offer higher interest rates, creating a competitive environment that increased the likelihood of risky lending and investments. Deposit insurance mitigated the risk for depositors but incentivized banks to take on excessive risks, knowing their deposits were protected, which contributed to narrow safety margins and failures when risks materialized (Benston, 2006).
Using debit and credit cards exhibits different implications for the transaction process. A debit card functions like cash because it deducts directly from the cardholder’s checking account, providing immediate settlement. Conversely, credit cards involve borrowing from a credit issuer, creating a delayed payment obligation, and are not equivalent to cash in transaction terms. This distinction influences consumer behavior and the regulatory environment surrounding these payment methods.
Calculating monetary aggregates such as M1 and M2 involves summing specific types of money and near-money assets. M1 includes currency and coin in circulation plus checkable deposits, reflecting the most liquid forms of money. M2 encompasses M1 plus savings deposits, small-denomination time deposits, and money market mutual funds, representing broader money available for use in the economy (Mishkin, 2019). These aggregates help policymakers gauge liquidity conditions and inform monetary policy decisions.
Banks are better positioned than individual savers to lend funds because they possess expertise in evaluating creditworthiness, managing risks, and pricing loans appropriately. They also have access to central bank facilities and can diversify risk across many borrowers, which mitigates individual risk and ensures a steady flow of credit to the economy (Kennedy, 2013).
When a bank receives a deposit under reserve requirements, it must hold a certain percentage as reserves. For example, with a 0.2 reserve ratio on a $4,000 deposit, the required reserves are $800. The bank can lend the remaining amount, which in this case is $3,200, provided it holds the required reserves. If the bank opts to hold $3,000 in reserves, the excess reserves are $2,200, which can be used for further lending or kept as a buffer against unexpected withdrawals.
Banks create money through a process called fractional reserve banking. When a bank receives a deposit, it holds a fraction as reserves and lends out the rest. The loaned funds are then redeposited in the banking system, enabling subsequent lending. Assuming a reserve requirement of 0.10 and an initial deposit of $1,000, the bank lends $900, which is redeposited in another bank, allowing further loans, and so on, amplifying the money supply in the economy (Mishkin, 2019). The total potential increase in the money supply can be calculated using the money multiplier, which is the reciprocal of the reserve ratio.
The Federal Reserve’s tools for monetary policy include open market operations, reserve requirements, and the discount rate. Of these, open market operations are most frequently employed; they involve buying or selling government securities to influence the money supply and interest rates (Board of Governors of the Federal Reserve System, 2022). For example, to expand the money supply, the Fed purchases securities, increasing bank reserves and encouraging lending.
When the Fed aims to increase the money supply by $100 billion with a reserve ratio of 0.25, it can buy securities in open market operations, which injects liquidity into the banking system. Alternatively, it can reduce the reserve requirement, which raises the money multiplier, allowing banks to lend more (Mishkin, 2019). The Fed may be reluctant to lower reserve requirements extensively due to concerns over financial stability and the reduced ability to control inflation.
Interest rates are primarily determined by the interaction of money demand and money supply. An increased demand for money raises interest rates, while an increased money supply tends to lower them, assuming other factors are constant. Consumers and firms adjust their balances and borrowing based on these rates, influencing overall economic activity (Mankiw, 2021).
During an economic expansion, the demand for money increases as people undertake more transactions. If the Fed does not offset this increased demand, interest rates tend to rise, potentially dampening growth. Conversely, if the Fed increases the money supply, it can offset the rise in money demand, maintaining stable interest rates and promoting further growth. This dynamic is depicted in supply and demand diagrams where the equilibrium interest rate adjusts to the shifts in liquidity preferences.
An increase in the money supply, holding other factors constant, shifts the supply curve rightward, leading to a lower interest rate and higher aggregate demand in the short run. Over the long term, higher aggregate demand can lead to increased output or rising prices depending on the economy's capacity. Short-term adjustments are influenced by monetary policy, while long-run effects depend on productivity and supply-side factors (Blanchard, 2017).
To close an expansionary gap, the Fed should contract the money supply, which can be achieved through open-market sales of securities. This action raises interest rates, reduces investment and consumption, and shifts aggregate demand downward, bringing output back to potential (Mankiw, 2021). Such policies must be carefully calibrated to avoid causing a recession.
The stability of the velocity of money is crucial for effective monetary policy. If velocity is stable, changes in the money supply directly translate into changes in nominal GDP through the Equation of Exchange (MV = PY). For example, if real GDP is 3,000 units, the price level is $4, and the money supply is $1,500, then velocity equals (1,500 × 4) / 3,000 = 2. If the price level drops to $3, with the same money supply and output, velocity becomes (1,500 × 3) / 3,000 = 1.5, indicating a decline in velocity. Variations in velocity complicate monetary policy, as changes in the money supply may not produce predictable effects on nominal GDP (Friedman, 1956).
The Quantity Theory of Money assumes that velocity is stable over time, implying that changes in the money supply lead directly to proportional changes in nominal GDP. An increase in the money supply by 5% with stable velocity would increase nominal GDP by roughly the same percentage, assuming other factors are constant. Conversely, if velocity decreases by 5%, the change in nominal GDP would be less pronounced, highlighting the importance of velocity stability for predicting monetary policy outcomes (Friedman, 1956).
During the Great Recession, the Fed implemented unprecedented measures, including lowering interest rates near zero, engaging in quantitative easing (QE), and purchasing large quantities of financial assets to stabilize markets and promote economic recovery (Bernanke, 2015). Quantitative easing involved the Fed buying long-term securities to inject liquidity directly into the financial system, aiming to lower long-term interest rates and spur investment. These policies increased the Fed’s balance sheet significantly but did not lead to runaway inflation because of slack in the economy and the velocity's decline, offsetting the monetary expansion.
Active monetary policy involves deliberate actions by the Fed to stabilize or steer the economy, such as adjusting the money supply or interest rates. Passive policy, on the other hand, relies on the economy’s natural adjusting mechanisms, where the central bank intervenes minimally, allowing market forces to determine economic variables. Expectations about inflation and wage adjustments influence the effectiveness and timing of these policies (Cecchetti & Schoenholtz, 2018). The debate centers on which approach better stabilizes the economy without causing excessive volatility.
The valuation and function of money serve as the foundation of modern economic systems. A common unit, namely money, facilitates the measurement of value, enabling efficient exchange and allocation of resources. Fiat money, underpinning contemporary economies, derives its value primarily from government decree and public confidence (Mankiw, 2021). The durability of this confidence is crucial; loss of faith can result from inflation, as the real value of money declines, or from systemic crises, which erode trust in the monetary system. Such events can lead to hyperinflations or bank runs, severely impairing economic stability (Borio & Lowe, 2004).
Historically, systems like the gold standard anchored the value of money to a tangible commodity. Gold discoveries, by increasing the gold supply, often caused inflationary episodes due to an expansion of the monetary base. This exemplifies the constraints of commodity-backed monetary systems, which lack flexibility in responding to economic shocks and adjustments in demand (Thomas, 2016).
Modern banking relies on the fractional reserve banking system, whereby depository institutions hold only a fraction of their deposits as reserves and lend out the rest. This system enhances liquidity and credit availability but also necessitates confidence from depositors, as bank failures can occur if reserves are insufficient. In the U.S., commercial banks, savings institutions, and credit unions operate as depository institutions, facilitating capital flow from savers to borrowers, thus fueling economic growth (Mishkin, 2019).
The Federal Reserve’s primary objectives are inflation control, maximum employment, and moderate long-term interest rates—goals that underpin its monetary policy operations. Through tools like open market operations, reserve requirements, and the discount rate, the Fed influences the money supply and credit conditions. During crises, such as in 2008, the Fed’s facilitation of subprime mortgage lending, often with lax underwriting standards, contributed to systemic vulnerabilities. When housing prices fell, defaults soared, leading to a collapse in securities tied to these mortgages, which precipitated the financial crisis (Gorton, 2010).
Bank deregulation in the 1980s,