24.4 Review and Practice


In this chapter we investigated the money supply and looked at how it is determined. Money is anything that serves as a medium of exchange. Whatever serves as money also functions as a unit of account and as a store of value. Money may or may not have intrinsic value. In the United States, the total of currency in circulation, traveler’s checks, and checkable deposits equals M1. A broader measure of the money supply is M2, which includes M1 plus assets that are highly liquid, but less liquid than those in M1.

Banks create money when they issue loans. The ability of banks to issue loans is controlled by their reserves. Reserves consist of cash in bank vaults and bank deposits with the Fed. Banks operate in a fractional reserve system; that is, they maintain reserves equal to only a small fraction of their deposit liabilities. Banks are heavily regulated to protect individual depositors and to prevent crises of confidence. Deposit insurance protects individual depositors.

A central bank serves as a bank for banks, a regulator of banks, a manager of the money supply, a bank for a nation’s government, and a supporter of financial markets generally. In the financial crisis that rocked the United States and much of the world in 2008, the Fed played a central role in keeping bank and nonbank institutions afloat and in keeping credit available. The Federal Reserve System (Fed) is the central bank for the United States. The Fed is governed by a Board of Governors whose members are appointed by the president of the United States, subject to confirmation by the Senate.

The Fed can lend to banks and other institutions through the discount window and other credit facilities, change reserve requirements, and engage in purchases and sales of federal government bonds in the open market. Decisions to buy or sell bonds are made by the Federal Open Market Committee (FOMC); the Fed’s open-market operations represent its primary tool for influencing the money supply. Purchases of bonds by the Fed initially increase the reserves of banks. With excess reserves on hand, banks will attempt to increase their loans, and in the process the money supply will change by an amount less than or equal to the deposit multiplier times the change in reserves. Similarly, the Fed can reduce the money supply by selling bonds.

Concept Problems

  1. Airlines have “frequent flier” clubs in which customers accumulate miles according to the number of miles they have flown with the airline. Frequent flier miles can then be used to purchase other flights, to rent cars, or to stay in some hotels. Are frequent flier miles money?
  2. Debit cards allow an individual to transfer funds directly in a checkable account to a merchant without writing a check. How is this different from the way credit cards work? Are either credit cards or debit cards money? Explain.
  3. Many colleges sell special cards that students can use to purchase everything from textbooks or meals in the cafeteria to use of washing machines in the dorm. Students deposit money in their cards; as they use their cards for purchases, electronic scanners remove money from the cards. To replenish a card’s money, a student makes a cash deposit that is credited to the card. Would these cards count as part of the money supply?
  4. A smart card, also known as an electronic purse, is a plastic card that can be loaded with a monetary value. Its developers argue that, once widely accepted, it could replace the use of currency in vending machines, parking meters, and elsewhere. Suppose smart cards came into widespread use. Present your views on the following issues:

    1. Would you count balances in the purses as part of the money supply? If so, would they be part of M1? M2?
    2. Should any institution be permitted to issue them, or should they be restricted to banks?
    3. Should the issuers be subject to reserve requirements?
    4. Suppose they were issued by banks. How do you think the use of such purses would affect the money supply? Explain your answer carefully.
  5. Which of the following items is part of M1? M2?

    1. $0.27 cents that has accumulated under a couch cushion.
    2. Your $2,000 line of credit with your Visa account.
    3. The $210 balance in your checking account.
    4. $417 in your savings account.
    5. 10 shares of stock your uncle gave you on your 18th birthday, which are now worth $520.
    6. $200 in traveler’s checks you have purchased for your spring-break trip.
  6. In the Middle Ages, goldsmiths took in customers’ deposits (gold coins) and issued receipts that functioned much like checks do today. People used the receipts as a medium of exchange. Goldsmiths also issued loans by writing additional receipts against which they were holding no gold to borrowers. Were goldsmiths engaging in fractional reserve banking? Why do you think that customers turned their gold over to goldsmiths? Who benefited from the goldsmiths’ action? Why did such a system generally work? When would it have been likely to fail?
  7. A $1,000 deposit in Acme Bank has increased reserves by $1,000. A loan officer at Acme reasons as follows: “The reserve requirement is 10%. That means that the $1,000 in new reserves can back $10,000 in checkable deposits. Therefore I’ll loan an additional $10,000.” Is there any problem with the loan officer’s reasoning? Explain.
  8. When the Fed buys and sells bonds through open-market operations, the money supply changes, but there is no effect on the money supply when individuals buy and sell bonds. Explain.

Numerical Problems

  1. Consider the following example of bartering:

    1 10-ounce T-bone steak can be traded for 5 soft drinks.

    1 soft drink can be traded for 10 apples.

    100 apples can be traded for a T-shirt.

    5 T-shirts can be exchanged for 1 textbook.

    It takes 4 textbooks to get 1 VCR.

    1. How many 10-ounce T-bone steaks could you exchange for 1 textbook? How many soft drinks? How many apples?
    2. State the price of T-shirts in terms of apples, textbooks, and soft drinks.
    3. Why do you think we use money as a unit of account?
  2. Assume that the banking system is loaned up and that any open-market purchase by the Fed directly increases reserves in the banks. If the required reserve ratio is 0.2, by how much could the money supply expand if the Fed purchased $2 billion worth of bonds?
  3. Suppose the Fed sells $5 million worth of bonds to Econobank.

    1. What happens to the reserves of the bank?
    2. What happens to the money supply in the economy as a whole if the reserve requirement is 10%, all payments are made by check, and there is no net drain into currency?
    3. How would your answer in part b be affected if you knew that some people involved in the money creation process kept some of their funds as cash?
  4. If half the banks in the nation borrow additional reserves totaling $10 million at the Fed discount window, and at the same time the other half of the banks reduce their excess reserves by a total of $10 million, what is likely to happen to the money supply? Explain.
  5. Suppose a bank with a 10% reserve requirement has $10 million in reserves and $100 million in checkable deposits, and a major corporation makes a deposit of $1 million.

    1. Explain how the deposit affects the bank’s reserves and checkable deposits.
    2. By how much can the bank increase its lending?
  6. Suppose a bank with a 25% reserve requirement has $50 million in reserves and $200 million in checkable deposits, and one of the bank’s depositors, a major corporation, writes a check to another corporation for $5 million. The check is deposited in another bank.

    1. Explain how the withdrawal affects the bank’s reserves and checkable deposits.
    2. By how much will the bank have to reduce its lending?
  7. Suppose the bank in problem 6 faces a 20% reserve requirement. The customer writes the same check. How will this affect your answers?
  8. Now consider an economy in which the central bank has just purchased $8 billion worth of government bonds from banks in the economy. What would be the effect of this purchase on the money supply in the country, assuming reserve requirements of:

    1. 10%.
    2. 15%.
    3. 20%.
    4. 25%.
  9. Now consider the same economy, and the central bank sells $8 billion worth of government bonds to local banks. State the likely effects on the money supply under reserve requirements of:

    1. 10%.
    2. 15%.
    3. 20%.
    4. 25%.
  10. How would the purchase of $8 billion of bonds by the central bank from local banks be likely to affect interest rates? How about the effect on interest rates of the sale of $8 billion worth of bonds? Explain your answers carefully.

This is a derivative of Principles of Economics by a publisher who has requested that they and the original author not receive attribution, which was originally released and is used under CC BY-NC-SA. This work, unless otherwise expressly stated, is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.