UNIT 4 -- Money and Monetary Policy

Ch. 13 -- Money and Banking: What is Money?

(only pp. 253-269)

Ch. 14 -- How Banks Create Money

Ch. 15 -- Monetary Policy

Ch. 16 -- Other Economic Views

(only pp. 317-330)

Suggested Textbook Questions:

Ch. 13: pp. 274-5 1, 2, 4, 5, 6, 7, 8, 12, 13, 15

Ch. 14: pp. 291-2 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 13, 14, 15

Ch. 15: pp. 315-6 1, 2, 3, 4, 8

Ch. 16: pp. 336-7 1, 2, 3, 4, 5, 6, 8

(See answers to Key Questions in textbook. and answers to other questions in this Coursebook)

Suggested Study Guide Questions:

(Please see the Syllabus section "How to Pass Economics ... #3" before doing these problems)

Ch. 13:

Multiple-Choice Questions - pp. 152-154 1, 4, 5, 10, 13, 15, 16, 17, 18, 19, 22

Short Answer/Essay - pp. 156 1, 2, 6, 7, 10, 11, 14,

Ch. 14:

Multiple-Choice Questions - pp. 163-165 1, 2, 3, 4, 5, 6, 8, 9, 10, 11, 13, 14, 17, 18, 19, 20, 21, 22, 24, 25

Problems - pp. 165-166 1, 3, 4 (assume cash NOT part of reserves)

Ch. 15:

Multiple-Choice Questions - pp. 175-177 1, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20, 24, 27, 28, 29, 30

Problems - pp. 177-179 1a, 1b., 1c, 3, 4

Ch 16:

Multiple-Choice Questions - pp. 190-191 1, 2, 3, 4, 6, 7, 8, 9, 10, 12, 15, 16, 17, 19, 20, 21


What is Money? (Money and Banking)

I. Introduction

A. Circular Flow Model of Capitalism

B. Why Monetary Side is Important

II. What Is Money?

A. Examples of Money

B. Functions of Money

1. medium of exchange

a. barter and the double coincidence of wants

b. money, specialization and efficiency

2. measure of value

3. liquid store of value

C. Money Supply

1. M1

a. currency

b. checkable deposits

2. near monies

a. M2

b. M3

D. What is not money?

1. currency and checkable deposits of the gov't and banks

2. income

3. credit cards

E. Why is money "money"?

(What "backs" the money supply?)

1. money as debt

2. value of money

a. acceptability

b. legal tender (fiat money)

c. relative scarcity

III. The Money Market

A. Money Supply

1. M1, M2, M3

2. graphically

B. Money Demand

1. what is it?

2. sources of money demand

a. transactions demand

1) definition

2) transactions demand and interest rates


3) transactions demand and nominal GDP

(directly related)

4) graphically

b. asset demand

1) definition

2) asset demand and interest rates

(inversely related)

3) graphically

c. total money demand

1) graphically

2) nominal GDP and shifts

C. The Money Market

IV. The U.S. Financial System

A. Structure of the Federal Reserve System

1. Board of Governors

2. Federal Open Market Committee (FOMC)

3. Federal Advisory Committee (FAC)

4. The 12 Federal Reserve Banks

a. central banks

b. quasi-public banks

c. banker's banks

5. Commercial Banks

6. Thrift Institutions

B. Functions of The Federal Reserve System (Fed)

1. reserves

2. check collection

3. fiscal agents

4. supervision

5. control of money supply

C. Federal Reserve Independence


How Banks Create Money

I. Goldsmith Banking fractional reserve system of banking

A. Money Creation and Reserves

B. Bank panics and Regulation

II. A Single Bank and a Cash Deposit

A. Balance Sheet of a Bank

1. assets

2. liabilities

3. net worth

B. Reserves

1. total reserves

2. legal (required) reserves and the required reserve ratio

3. excess reserves

C. Cash Deposit

1. balance sheet changes

2. effect on M1

D. Money Creation granting a loan

1. balance sheet changes

2. clearing the check

III. The Banking System: Multiple Deposit Expansion

A. Additional Changes in the Money Supply

B. The Money Multiplier

IV. Limits To Money Creation

A. Required Reserve Ratio

B. Currency Drains

C. Excess Reserves


Monetary Policy

I. Introduction

A. Objectives of Monetary Policy

B. AS and AD

C. Functions of the Fed

D. Monetary Policy Keynesian view

1. excess reserves

2. money supply

3. interest rate

4. investment

5. aggregate expenditures

II. Balance Sheet of the Fed

A. Assets

1. securities

2. loans to commercial banks

3. other

B. Liabilities

1. reserves of commercial banks

2. U.S. treasury deposits

3. federal reserve notes

4. other

III. The Tools of Monetary Policy

A. Three Tools of the Fed over the Money Supply

1. open market operations (OMO)

2. changing the reserve ratio (RR)

3. changing the discount rate (DR)

B. Open Market Operations

1. definition

2. buying securities

a) from commercial banks

b) from the public

3. selling securities

a) to commercial banks

b) to the public

C. Changing the Reserve Ratio

1. raising the reserve ratio

2. lowering the reserve ratio

D. Discount Rate

IV. Monetary Policy, Equilibrium GDP, and the Price Level

A. Keynesian Cause-Effect Chain of Monetary Policy

1. Fed tools

2. excess reserves

3. money supply

4. interest rate

5. investment

6. aggregate expenditures

7. equilibrium GDP

8. effects on UE, IN, and EG

B. Refinements and Feedbacks

1. policy effectiveness

2. feedback effects


V. Effectiveness of Monetary Policy

A. Strengths of Monetary Policy

1. speed and flexibility

2. isolation from political pressure

3. recent successes

B. Shortcomings and Problems

1. less control?

2. cyclical asymmetry

3. changes in velocity

4. the investment impact

5. interest as income


Other Economic Views

I. Comparing Classical and Keynesian Theories

A. Classical View

1. vertical aggregate supply curve

2. stable aggregate demand curve

B. Keynesian View

1. horizontal aggregate supply curve

2. unstable aggregate demand

II. Comparing Monetarist and Keynesian Theories

A. What is Monetarism?

B. Basic Differences

1. Keynesians: instability and intervention

2. Monetarists: stability and laissez faire

C. Basic Equations

1. Keynesian: C + I + G + Xn = GDP

2. Monetarism: M x V = P x Q

D. Velocity: Stable or Unstable?

1. Monetarists: V is stable

2. Keynesians: V is unstable

3. empirical evidence

E. Policy Debates

1. fiscal policy

2. monetary policy: discretion or rules?

a) irregular time lags

b) interest rate: wrong target

c) the monetary rule

3. AD- AS

a) Monetarism

b) Keynesianism


Suggested Textbook Questions


Ch. 13: pp. 274-5 1, 2, 4, 5, 6, 7, 8, 12, 13, 15

131 Describe how rapid inflation can undermine money's ability to perform its three basic functions.

People will only accept money in exchange for goods and services and for the work they perform if they can be reasonably certain that the medium of exchange --money-- will retain its value until they are ready to spend it. In runaway inflations of the thousands or tens of thousands of percent a year, people revert to barter.

Again, drastic inflation greatly reduces money's use as a measure of value, for it is impossible to adjust instantaneously all prices strictly in line with their relative values. Thus, opportunities are afforded to speculators to profit at the expense of the less sophisticated who, eventually, will learn to distrust money's usefulness as a measure of value.

Finally, and most obviously, money's usefulness as a store of value is destroyed in a drastic inflation. The "rule of 70" is instructive here. By dividing the absolute inflation rate into 70, one can estimate how long it takes one's dollar savings to lose half their purchasing power. At 7 percent inflation, the dollar will be worth half as much in ten years.

132 What are the disadvantages of commodity money? What are the advantages of (a) paper money and (b) check money compared with commodity money?

Commodity money can be inconvenient with regard to its portability, its supply, and its safekeeping. For instance, fullbodied copper coins (that is, coins whose value as metal equaled their value as currency) would be very heavy in relation to the purchase of even a week's groceries. Indeed, the coins would outweigh the groceries several times over. And it would take several truckloads of coins to pay for a house. In this regard, being much scarcer, gold and silver have been much more convenient. But there is the problem of storage and safekeeping. For example, the mid19th century depression in the United States ended with the California gold rush of 1849.

The great advantage of paper money and check money is that their supply does not rely on the chance discovery or laborious production of whatever commodity is used as money. The cost of printing paper money is trivial compared to the values that can be printed on them. Writing a check for a billion dollars costs no more than writing one for ten cents. However, the very convenience and ease of producing paper and check money can be their downfall --or the downfall of the economies that use them. Since they can be produced without limit at virtually no cost, sometimes they are. Hyperinflation and economic breakdown may result.

134 Fully evaluate and explain the following statements:

(a) "The invention of money is one of the great achievements of the human race, for without it the enrichment that comes from broadening trade would have been impossible."

(b) "Money is whatever society says it is."

(c) "When prices of everything are going up, it is not because everything is worth more, but because the dollar is worth less."

(d) "The difficult questions concerning paper [money] are ... not about its economy, convenience or ready circulation but about the amount of paper which can be wisely issued or created, and the possibilities of violent convulsions when it gets beyond bounds."

(e) "In most modern industrial economies of the world the debts of government and of commercial banks are used as money."

(a) Without money, trade must occur through barter. And barter requires the "double coincidence of wants," the requirement that a seller find a buyer who not only desires what the seller has to offer but also has to offer what the buyer desires. A wheat grower desiring milk must find a dairy farmer desiring wheat or, at least, a merchant in the middle trading in both wheat and milk. Maybe one can imagine a merchant owning both a grain elevator and refrigerated milk holding tanks. But suppose the wheat farmer desires a new suit or a new combine?

And so far all we have been talking about is local trade. Suppose the dairy farmer desires oriental spices --to use an example from the beginning of trade after the ending of the Dark Ages in Europe. The dairy farmer could hardly ship the milk to the Orient, so a buyer must be found in Europe who desires milk and who has something our dairy farmer can trade for oriental spices. And how are the terms of trade to be determined in the absence of money? Is a quart of milk worth an ounce of pepper? Or how much of what the dairy farmer got locally for milk is worth an ounce of pepper? As one can see, without a measure of value the complications are enormous.

(b) Money must be acceptable in exchange. That is its fundamental requirement. A person will accept payment in whatever is called money only if that person knows that the money can subsequently be used in exchange for something else. If the money is easily, cheaply producible by a monetary authority, it will only be acceptable if the conviction exists that the authority will keep the rate of increase below the hyperinflationary level. If the money is a commodity such as cigarettes in a prisonerofwar camp, the commodity will be acceptable as money not only because of its intrinsic value, but also, again, because there is no fear of the supply suddenly increasing to a hyperinflationary level. Note that checks are our primary medium of exchange, although they have not been deemed legal tender by government.

(c) The quotation is accurate. The great advantage of paper money is that its supply does not rely on the chance discovery or laborious production of whatever commodity is used as money. The cost of printing paper money is trivial compared to the values that can be printed on it. However, the very convenience and ease of producing paper money can be their downfall or the downfall of the economies that use it. Since it can be produced without limit at virtually no cost, sometimes it is. Hyperinflation and economic breakdown may result. However, this is not a fault of paper money in itself: Colonial Pennsylvania issued paper money completely unbacked by gold and silver for fortyfour years, from 1723 to 1767, without any inflation at all.

(d) The quotation is correct. Paper money is issued by the central government in payment for goods and services. In essence, such government (or central bank) paper money is identical to an I.O.U. issued by an individual in acknowledgement of a debt owing for goods and services. The difference is that the central government or its bank never pays off such debts! All that you can get in payment for a dollar bill with which the government paid for your services is another identical dollar bill.

(e) All accounts (saving and checking) in the commercial banks are money owed by these banks to their customers, who own these deposits. Since checks drawn on checking accounts are accepted as money (since they demand payment out of these checking accounts), it follows that the debts of the commercial banks are used as money. Paper money is merely the circulating debt of the government.

135 (Key Question) What items constitute the M1 money supply? What is the most important component of the M1 money supply? Why is the face value of a coin greater than its intrinsic value? Distinguish between M2 and M3. What are nearmonies? Of what significance are they? What arguments can you make for including savings deposits in a definition of money?

Answers to Key Questions appear in the text.

136 What "backs" the money supply in the United States? What determines the value of money? Who is responsible for maintaining the value of money? Why is it important to be able to alter the money supply? What is meant by (a) "sound money" and (b) a"52cent dollar"?

There is no concrete backing to the money supply in the United States. Paper money, which has no intrinsic value, has value only because people are willing to accept it in exchange for goods and services, including their labor services as employees. And people are willing to accept paper as money because they know that everyone else is also willing to do so. If people knew the monetary authorities were issuing new banknotes at a rate far in excess of the worn out notes being withdrawn from circulation, the acceptability of paper as money would diminish. People would start to worry about whether the banknotes would be worth much shortly after they received them. The fact that banknotes are legal tender merely adds to their acceptability. Checks are not legal tender, but people accept them willingly from people they have decided are trustworthy.

The Board of Governors of the Federal Reserve System (the Fed) is responsible for managing the United States' money supply so that money retains its value.

The money supply must increase in response to the increasing productive capacity of the nation. If it does not, rather than prices dropping, production will decrease and unemployment will increase. On the other hand, if commercial bank lending is increasing the money supply at an inflationary rate, the Fed must act to slow this rate of increase.

(a) "Sound money" is money that retains its purchasing power over an extended period. In this regard, the Swiss franc and the West German Deutsche mark are "sounder" currencies than the dollar.

(b) A "52cent dollar" is one that is now worth only 52 cents in relation to a previous year. The dollar of 1978 was a 52cent dollar in relation to the dollar of 1967, the dollar's purchasing power having been cut almost in half in the intervening eleven years.

13-7 (Key Question) Suppose the price level and value of the dollar in year 1 are 1.0 and $1.00, respectively. If the price level rises to 1.25 in year 2, what is the new value of the dollar? If instead the price level had fallen to .50, what would have been the value of the dollar? What generalization can you draw from your answer?

Answers to Key Questions appear in the text.

138 (Key Question) What is the basic determinant of (a) the transactions demand and (b) the asset demand for money? Explain how these two demands might be combined graphically to determine total money demand. How is the equilibrium interest rate determined in the money market? How might (a) the expanded use of credit cards, (b) a shortening of worker pay periods, and (c) an increase in nominal GDP affect the transactions demand for money and the equilibrium interest rate?

Answers to Key Questions appear in the text.

1312 What is the major responsibility of the Board of Governors? Discuss the major characteristics of the Federal Reserve Banks. Of what significance is the fact that the Federal Reserve Banks are quasipublic? Do you think the Fed should be an independent institution?

The major responsibility of the Board of Governors is to exercise general supervision and control over the operation of the money and banking system of the United States. This is done in large part through increasing or decreasing (or restraining the growth of) the money supply, depending on whether the Board's main concern of the moment is unemployment or inflation.

The Fed is composed of twelve regional banks that together function as a central bank, though the Federal Reserve Bank of New York is by far the most important. The Fed is quasipublic: The twelve regional banks are owned by the commercial banks in their region, but the policies the Fed's twelve banks pursue is set by the Board of Governors, which is appointed by the government. The twelve Fed banks are bankers' banks. The Fed banks accept deposits and make loans to the member banks and thrifts in their regions. Finally, the Fed banks issue currency, the banknotes of the nation's money supply.

Their being quasipublic prevents the Fed banks from seeking profit. They follow the policies set by the Board of Governors, which are designed with the wellbeing of the economy in mind. The Fed does not compete for business with the commercial banks. In fact, the Fed rarely deals with the public: the Fed deals with the government and the commercial banks.

If the Fed were not independent of government, it would be subject to political pressure, resulting in more of a political business cycle than there is already. It is hard to imagine a restrictive monetary policy in the months leading up to a Presidential election, if the President could tell the Fed what to do. On the other hand, the restrictive monetary policy could be wrong. For example, quite respectable economists with no political axe to grind disagree with the Fed's tight money policy of the 1980s. But it is the very independence of the Fed that allows it to ignore all outside advice, whether from the President, the Congress, or even professors of economics.

1313 What are the two basic functions of commercial banks and thrift institutions? State and briefly discuss the major functions of the Federal Reserve System.

The two basic functions of commercial banks and thrifts are to hold the deposits of households and businesses and to make loans to the public, thereby increasing the money supply.

The major functions of the Fed are to exercise general supervision and control over the banking system of the United States and to control the growth of the money supply in the best interests of the nation. The latter is done mainly through openmarket operations. The Fed acts as bankers' banks to the commercial banks, making loans to them and issuing paper currency.

"Routine" functions of the Fed include: providing facilities for the collection of checks; acting as fiscal agent for the federal government; and supervising the overall operation of commercial banks.

13-15 (Last Word) Over the years the Federal Reserve Banks have printed about $235 billion more in currency than American households, businesses, and financial institutions now hold. Where is this "missing" money? Why is it there?

This missing money is outside of the country. It originally left the country to pay for imports of goods and services purchased by Americans from producers abroad. Now it is in circulation outside the country, especially in countries whose currencies are not very stable. For example, it is estimated that Russians hold about $20 billion worth of U.S. dollars. Transactions are conducted in dollars inside Russia, because Russians fear that when they accept the Russian ruble, it may lose its value very quickly. The same is true in other countries with high rates of inflation. The dollar is also used in international transactions, both legal and illegal, where it is acceptable because of its stability.

Ch. 14: pp. 291-2 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 13, 14, 15

141 Why must a balance sheet always balance? What are the major assets and claims on a commercial bank's balance sheet?

A balance sheet is a statement of assets and claims (or liabilities and net worth). It must balance because every asset is claimed by someone, so that assets (the lefthand side) = liabilities + net worth (the righthand side).

The major assets of a bank are: cash (including cash reserves held by the Fed), its property, the loans it has made, and the securities it holds over and above general loans. Its liabilities are the deposits of its customers. The difference between the assets and liabilities is the bank's net worth, which is shown on the liabilities side, thus ensuring that the balance sheet balances.

142 (Key Question) Why are commercial banks required to have reserves? Explain why reserves are assets to commercial banks but liabilities to the Federal Reserve Banks. What are excess reserves? How do you calculate the amount of excess reserves held by a bank? What is their significance?

Answers to Key Questions appear in the text.

143 "Whenever currency is deposited into a commercial bank, cash goes out of circulation and, as a result, the supply of money is reduced." Do you agree? Explain.

Students should not agree. The M1 money supply consists of currency outside of the banks (cash in the hands of the public) and checking account deposits of the public in the commercial banks. The deposit of currency into a checking account in a bank has changed the form of the money supply but not the amount.

144 (Key Question) "When a commercial bank makes loans, it creates money; when loans are repaid, money is destroyed." Explain.

Answers to Key Questions appear in the text.

145 Explain why a single commercial bank can safely lend only an amount equal to its excess reserves but the commercial banking system can lend by a multiple of its excess reserves. Why is the multiple by which the banking system can lend equal to the reciprocal of its reserve ratio?

When a bank grants a loan, it can expect that the borrower will not leave the proceeds of the loan sitting idle in his or her account. Most people borrow to spend. Therefore the lending bank can expect that checks will be written against the loan and that the bank will shortly lose reserves to other banks, as the checks are presented for payment, to the full extent of the loan. In short, when a bank grants loans to the full extent of its excess reserves, it can shortly expect to lose these excess reserves to other banks. From this it can be seen why a bank cannot safely lend more than its excess reserves. If it did, it would soon find that its cash reserves were below its legal reserve requirement.

From the above it can be seen why the commercial banking system can safely lend a multiple of its excess reserves. Whereas one bank loses reserves to other banks, the system does not. With a legal cash reserve requirement of, say, 20 percent, Bank "B" on receiving as a new deposit the $100 loaned by Bank "A" (the excess reserves of Bank "A"), may safely lend $80 (80 percent of $100). Bank "C", on receiving as a new deposit the $80 loan of Bank "B", loans 80 percent of that, namely $64. Note that the $100 initial excess reserves of the banking system have already resulted in the money supply increasing by $244 (= $100 + $80 + $64). The money supply will continue to increase, at a diminishing rate (Bank "D" will increase the money supply by $51.20 in loaning this amount), until the total increase in the money supply is $500.

The algebra underlying the monetary multiplier is that of an infinite geometric progression. Designating the fixed fraction of the previous number as b (0.8 in our case) and k as the sum of the progression, we have:

k = 1 + b + b2 + b3 + ....... +bn

Solving this for a very large n, we get: k = 1/(1b)

In our example, the multiplier, k is 1/(1 0.8) = 1/.2 = 5. And 5 is the reciprocal of the reserve ratio of 20 percent or 0.2..

146 Assume that Jones deposits $500 in currency into her demand deposit in the First National Bank. A halfhour later Smith negotiates a loan for $750 at this bank. By how much and in what direction has the money supply changed? Explain.

The loan of $750 to Smith increases the money supply by $750, and that is the only change. The deposit of $500 by Jones does not change the money supply. Whether Jones' $500 is in her purse or in her demand deposit, the $500 are still part of the money supply.

147 Suppose the National Bank of Commerce has excess reserves of $8,000 and outstanding demand deposits of $150,000. If the reserve ratio is 20 percent, what is the size of the bank's actual reserves?

Required reserves = 20 percent of $150,000 = $30,000

Therefore, required reserves = $30,000; Excess reserves = $ 8,000; Actual reserves = $38,000.

148 (Key Question) Suppose the Continental Bank has the following simplified balance sheet. The reserve ratio is 20 percent.

Assets Liabilities and net worth

(1) (2) (1) (2)

Reserves $22,000 _____ _____ Demand deposits $100,000 _____ _____

Securities 38,000 _____ _____

Loans 40,000 _____ _____

(a) What is the maximum amount of new loans which this bank can make? Show in column 1 how the bank's balance sheet will appear after the bank has loaned this additional amount.

(b) By how much has the supply of money changed? Explain.

(c) How will the bank's balance sheet appear after checks drawn for the entire amount of the new loans have been cleared against this bank? Show this new balance sheet in column 2.

(d) Answer questions a, b, and c on the assumption that the reserve ratio is 15 percent.

Answers to Key Questions appear in the text.

149 The Third National Bank has reserves of $20,000 and demand deposits of $100,000. The reserve ratio is 20 percent. Households deposit $5,000 in currency into the bank which is added to reserves. How much excess reserves does the bank now have?

Demand deposits have risen to $105,000. Twenty percent of this is $21,000, which is its required reserves. The bank's actual reserves have risen to $25,000. Therefore, its excess reserves are $4,000 ($25,000 $21,000).

1410 Suppose again that the Third National Bank has reserves of $20,000 and demand deposits of $100,000. The reserve ratio is 20 percent. The bank now sells $5,000 in securities to the Federal Reserve Bank in its district, receiving a $5,000 increase in reserves in return. How much excess reserves does the bank now have? Why does your answer differ (yes, it does!) from the answer to question 9?

The bank now has excess reserves of $5,000 (rather than $4,000) because in this case the demand deposits on the liabilities side of its balance sheet did not change. In the former case, $1,000 of new cash reserves were needed against the $5,000 increase in demand deposits. In the present case, nothing occurred on the liabilities side of the balance sheet. The sale of the securities to the Fed caused changes on the assets side only --one asset (securities) was exchanged for another (reserves).

1411 Suppose a bank discovers its reserves will temporarily fall slightly short of those legally required. How might it remedy this situation through the Federal funds market? Next, assume the bank finds that its reserves will be substantially and permanently deficient. What remedy is available to this bank? Hint: Recall your answer to question 4.

Banks can borrow temporarily from other banks that have temporary excess reserves. These funds are transferred from one bank's reserve account to the other and allow the lending bank to earn interest on otherwise idle excess reserve funds for an overnight period, while replenishing the reserves of the deficient bank.

If a bank finds that its reserves are substantially deficient, it should suspend lending and gradually build up its reserves as borrowers repay loans made by the bank earlier.

1413 (Key Question) Suppose the simplified consolidated balance sheet shown below is for the commercial banking system. All figures are in billions. The reserve ratio is 25 percent.

Assets Liabilities and net worth
(1) (1)

Reserves $ 52 _____ Demand deposits $200 _____
Securities 48 _____
Loans 100 _____

(a) How much excess reserves does the commercial banking system have? What is the maximum amount the banking system might lend? Show in column 1 how the consolidated balance sheet would look after this amount has been lent. What is the monetary multiplier?

(b) Answer question 13a assuming that the reserve ratio is 20 percent. Explain the resulting difference in the lending ability of the commercial banking system. What is the new monetary multiplier?

Answers to Key Questions appear in the text.

14-14 What are banking "leakages"? How might they affect the moneycreating potential of the banking system? Be specific.

Banking leakages are reductions in the money available to banks in each successive round of moneysupply creation that occurs as banks lend money deposited with them. The first leakage is governmentordained: The banks are required to keep a certain percentage of their deposits as cash reserves. Thus, when Bank "A" receives a deposit of $100 it may only loan, say, $80. And when the $80 is deposited in Bank "B," it, too, may only loan 80 percent, or $64; and so on. The $20 Bank "A" must retain is a leakage, as is the $16 that Bank "B" must retain. If these and all other leakages did not exist, the monetary multiplier would be infinite, for the initial deposit would be continuously relent without any part being retained in the system.

There are, in fact, two other leakages. The first is called "currency drains." If those who borrow from a bank take part of the loan in cash and they or others retain it as additional cash in hand, then less than the amount of the loan will be redeposited in other banks in the system. For instance, Bank "B" would not be able to lend $80, but only, say, $40 if only $50 of the $100 loan was deposited in it.

The third leakage is "excess reserves" that are not loaned out; that is, that are retained by a bank in excess of the legal reserve required by law. Since reserves earn no interest for the bank, it is not usual for a bank to hold excess reserves, but when it does happen (presumably because the bank is not satisfied that it can lend safely), the monetary multiplier is diminished.

1415 Explain why there is a need for the Federal Reserve System to control the money supply.

Without the Fed, in a boom the commercial banks would lend as much as they could, subject only to the legal reserve requirement. This could well increase the inflationary pressures that might already be building. Therefore, the Fed has the means to decrease the money supply (or its rate of increase) and thus the inflationary lending ability of the commercial banks.

Again, in a recession, without the Fed, the commercial banks might well be disinclined to lend because they fear loans will not be repaid. The banking system thus would fail to provide the liquidity needed for recovery.

Ch. 15: pp. 315-6 1, 2, 3, 4, 8

151 Use commercial bank and Federal Reserve Bank balance sheets to demonstrate the impact of each of the following transactions on commercial bank reserves:

(a) Federal Reserve Banks purchase securities from private businesses and consumers.

(b) Commercial banks borrow from the Federal Reserve Banks.

(c) The Board of Governors reduces the reserve ratio.

In the tables below, columns "a" through "c" show the changes caused by the answers to the questions. It is assumed the initial reserve ratio is 20 percent. Thus, as the first column shows, the commercial banks are initially completely loaned up. The answers are not cumulated: We return to the first column each time to show the resulting change in column a, b, or c. If you would rather not use numbers, it would be acceptable to substitute with + or - signs, using symbols to represent numbers. For example, part (a) could read "the Fed purchases Ôx dollars' worth of securities," and instead of the $2 billion changes on the balance sheet, you would indicate + x .

(a) It is assumed the Fed buys $2 billion worth of securities. This increases demand deposits and commercial bank reserves by $2 billion. With demand deposits of $202 billion, required reserves are $40.4 billion, (= 20 percent of $202 billion). Therefore, excess reserves are $1.6 billion (= $42 billion $40.4 billion) and the banking system can increase the money supply (by making loans) by $8 billion more (= $1.6 billion x 5).

(b) It is assumed the commercial banks borrow $1 billion from the Fed. The commercial banks may now increase the money supply (through making loans) by $5 billion (= $1 billion x 5).

(c) Changing the reserve ratio, in itself, does not change the balance sheets. However, if we assume the reserve ratio has been decreased from 20 percent to 19 percent, required reserves are now $38 billion (= 19 percent of $200 billion) and the commercial banks can now increase the money supply (through making loans) by $10.53 billion [= $2 billion x (1/0.19)]. Proof: 19 percent of $210.53 billion is $40 billion.

a b c
Reserves $40 $42 $41 $40
Securities 60 60 60 60
Loans 102 102 102 102

Liabilities and net worth:
Demand deposits 200 $202 $200 $200
Loans from the Fed

Reserve Banks 2 2 3 2

a b c
Securities $283 $285 $283 $283
Loans to commercial banks 2 2 3 2

Liabilities and net worth:
Reserves of commercial banks $40 42 41 40
Treasury deposits 5 5 5 5
Federal Reserve Notes 225 225 225 225
Other liabilities and net worth 15 15 15 15

152 (Key Question) In the table below you will find simplified consolidated balance sheets for the commercial banking system and the twelve Federal Reserve Banks. In columns 1 through 3, indicate how the balance sheets would read after each of the three ensuing transactions is completed. Do not cumulate your answers; that is, analyze each transaction separately, starting in each case from the given figures. All accounts are in billions of dollars.

(1) (2) (3)
Reserves $33 ____ ____ ____
Securities 60 ____ ____ ____
Loans 60 ____ ____ ____

Liabilities and net worth:
Demand deposits 150 ____ ____ ____
Loans from the Federal
Reserve Banks 3 ____ ____ ____

(1) (2) (3)
Securities $60 ____ ____ ____
Loans to commercial banks 3 ____ ____ ____

Liabilities and net worth:
Reserves of com. banks $ ____ ____ ____
Treasury deposits 3 ____ ____ ____
Federal Reserve Notes 27 ____ ____ _____

(a) Suppose a decline in the discount rate prompts commercial banks to borrow an additional $1 billion from the Federal Reserve Banks. Show the new balancesheet figures in column 1.

(b) The Federal Reserve Banks sell $3 billion in securities to the public, who pay for the bonds with checks. Show the new balancesheet figures in column 2.

(c) The Federal Reserve Banks buy $2 billion of securities from commercial banks. Show the new balancesheet figures in column 3.

(d) Now review each of the above three transactions, asking yourself these three questions: (1) What change, if any, took place in the money supply as a direct and immediate result of each transaction? (2) What increase or decrease in commercial banks' reserves took place in each transaction? (3) Assuming a reserve ratio of 20 percent, what change in the moneycreating potential of the commercial banking system occurred as a result of each transaction?

Answers to Key Questions appear in the text.

153 (Key Question) Suppose you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp and prolonged inflationary trend. What changes in (a) the reserve ratio, (b) the discount rate, and (c) openmarket operations would you recommend? Explain in each case how the change you advocate would affect commercial bank reserves, the money supply, interest rates, and aggregate demand.

Answers to Key Questions appear in the text.

154 (Key Question) What is the basic objective of monetary policy? Describe the causeeffect chain through which monetary policy is made effective. Using Figure 152 as a point of reference, discuss how (a) the shapes of the demand for money and investmentdemand curves and (b) the size of the MPC influence the effectiveness of monetary policy. How do feedback effects influence the effectiveness of monetary policy?

Answers to Key Questions appear in the text.

158 (Key Question) Suppose the Federal Reserve decides to engage in a tight money policy as a way to reduce demandpull inflation. Use the aggregate demandaggregate supply model to show the intent of this policy for a closed economy. Next, introduce the open economy and explain how changes in the international value of the dollar might affect the location of your aggregate demand curve.

Answers to Key Questions appear in the text.

Ch. 16: pp. 336-7 1, 2, 3, 4, 5, 6, 8

16-1 (Key Question) Use the aggregate demand-aggregate supply model to compare classical and Keynesian interpretations of (a) the aggregate supply curve, and (b) the stability of the aggregate demand curve. Which model do you think is more realistic?

Answers to Key Questions appear in the text.

162 Explain: "The debate between Keynesians and monetarists is an important facet of the larger controversy over the role of government in our lives."

Believing the capitalist economy --and investment in particular-- to be inherently unstable, Keynesians stress the need for government intervention through active countercyclical fiscal and monetary policies. Moreover, Keynesians point out that many product and labor markets are not perfectly competitive, resulting in prices and wages that are inflexible downward. Thus, downward pressures in the economy affect output and employment rather than the price level. Again, these facts call for government intervention.

The monetarists, on the other hand, claim that markets are very competitive --or would be if the government kept its regulating hands off. Moreover, the monetarists believe that the government makes matters even worse with its ill-timed attempts to push the economy in a countercyclical direction with its discretionary fiscal and monetary policies.

The monetarists believe in as little government as possible, and certainly in no significant stabilization role for government, for its attempts to play a role simply add to or even create the instability. Keynesians believe government is necessary, indeed essential, to overcome capitalism's weaknesses --weaknesses that are inherent and not fostered by government itself.

163 State and explain the basic equations of Keynesianism and monetarism. "Translate" the Keynesian equation into the monetarist equation.

The basic Keynesian equation is: Ca + Ig + Xn + G = GDP This means that, in equilibrium, the lefthand side, aggregate expenditures, equals the righthand side, nominal domestic output.

The basic monetarist equation is the equation of exchange: MV = PQ

To the monetarists, total spending is the supply of money multiplied by its velocity, that is, MV. Thus, MV is the monetarists' way of expressing the equilibrium level of Ca + Ig + Xn + G in the Keynesian analysis. Also, since MV is the total spent on final goods and services in a year, it is necessarily equal to nominal GDP. But since nominal GDP is the physical output of goods and services (Q) multiplied by their prices (P), GDP = PQ.

164 In 1994 the money supply (M1) was approximately $1150 billion and the nominal GDP was about $6737 billion. What was the velocity of money in 1994? Figure 164 indicates that velocity increased steadily between the mid1940s and 1982 and then leveled off and declined. Can you think of reasons to explain these trends?

Velocity equals nominal GDP divided by the money supply. Therefore, in 1994, velocity equaled 5.86. The interest rate rise from the mid40s to 1982 caused the velocity of money to rise; money balances declined as the opportunity cost of holding money in lieu of bonds increased. The leveling off of velocity after 1982 is related to the decline in interest rates after that date. Moreover, the fear grew that maybe interest rates had bottomed. In such a case, buying, say, a 6percent long term bond shortly before interest rates rose, say, to 8 percent would entail a loss to the 6percent bond buyer --a loss in interest earned if the bond were held to maturity, or an immediate capital loss if the bond were sold before maturity, because no one would pay the full face value of a 6percent bond if the going rate were now 8 percent. In these circumstances, people can see the advantages of cash over bonds: The velocity drops since M1 grows relatively to GDP.

An alternative --or perhaps complementary-- explanation of the velocity trends shown in Figure 164 has to do with institutional factors. Shorter pay periods, greater use of credit cards, and more rapid means of making payments tended to increase velocity between 1945 and 1982 by enabling people to reduce their amount of money holdings relative to GDP. Conversely, bank deregulation and the emergence of interestbearing checking accounts may have contributed to the post1982 decline in velocity. To the extent that some people "parked" funds in interestbearing M1 accounts, M1 rose sharply in relationship to nominal GDP. And because velocity for M1 is found by dividing GDP by M1, this means that velocity declined.

16-5 (Key Question) What is the transmission mechanism for monetary policy according to (a) Keynesians and (b) monetarists? What significance do the two schools of thought apply to money and monetary policy as a determinant of economic activity? According to monetarism, what happens when the actual supply of money exceeds the amount of money which the public wants to hold?

Answers to Key Questions appear in the text.

166 Why do monetarists recommend that a "monetary rule" be substituted for discretionary monetary policy? Explain: "One cannot assess what monetary policy is doing by just looking at interest rates." Indicate how an attempt to stabilize interest rates can be destabilizing to the economy.

The monetarist monetary rule is that the money supply should be increased at a constant rate, that is, at the same rate as the rate of growth of potential real GDP. The monetarists recommend this rule to eliminate what they believe to be the major cause of instability in the economy, the so-called countercyclical monetary policy. They believe if the money supply keeps increasing at the steady rate of the rule, there can be no longlasting recession.

The quotation implies that, for instance, monetary policy could be easy but interest rates could still be rising, because a fastgrowing economy was increasing the demand for money even faster than the monetary authorities were allowing it to be supplied. Also, interest rates could be rising because the monetary policy was too easy; the easy money policy could be contributing to demandpull inflation, leading lenders to demand a higher return on their loans in the expectation that they would be repaid in devalued dollars. In other words, high interest rates could mean either contractionary or expansionary monetary policy.

The last sentence gives an indication of how an attempt to stabilize interest rates can destabilize the economy. If the economy were booming, the demand for money would be rising. Unless the monetary authorities fully accommodated this demand, interest rates would tend to rise. But fully accommodating the demand for more money to stabilize interest rates could destabilize the economy by adding to the demandpull inflation already starting.

168 Explain why monetarists assert fiscal policy is weak and ineffective. What specific assumptions do (a) monetarists and (b) strict Keynesians make with respect to the shapes of the demand for money and investmentdemand curves? Why are the differences significant?

Monetarists have little use for fiscal policy because of the crowdingout effect. A budgetary deficit financed by borrowing from the public means the government is competing with business for funds: Government borrowing increases the demand for money, drives up the interest rate, and thus crowds out much private investment that would have been profitable at the previous lower interest rate. G merely replaces I, and the net effect of the easy fiscal policy on aggregate expenditures is unpredictable and, in any event, small. They also argue that if a deficit is financed by the Fed purchasing bonds, i.e., using expansionary monetary policy, then it is monetary policy, not fiscal policy, that is actually accomplishing the expansionary effect on the economy.

(a) Monetarists believe the investmentdemand curve is relatively flat and the demand for money curve relatively steep.

(b) Keynesians believe the investmentdemand curve is relatively steep and the demand for money curve relatively flat.

If the monetarists are right, then when the relatively steep demand for money curve is shifted to the right by even a small amount of government borrowing, the interest rate will rise sharply. This, projected on to a relatively flat investmentdemand curve, will cause a sharp contraction in investment, making the expansionary fiscal policy ineffective.

However, if the Keynesians are right, then the relatively flat demand for money curve results in only a small increase in the interest rate in response to government borrowing. And with a relatively steep investmentdemand curve, the result will be only a small decline in investment and little crowding out.