Special Handout for November 20, 2000

Money and Banking

The following handout contains many questions covering the material that has presented up to this point (and including Chapter 19) in the class. It is meant as a review of the material to supplement the practice questions that are available on the Web at www.ssc.wisc.edu/~ekelly/econ330. After the Thanksgiving Break, we will have a third midterm and a final exam. The Web will provide additional practice questions for the material presented after the Thanksgiving Break.

1. What is money? What do the terms M1, M2, and M3 measure? How do these three terms differ? What criteria is used in determining the monetary aggregate measure to use?

2. What is the general relationship between money and inflation? Why are economists interested in understanding inflation?

3. What is the relationship between money and the interest rate? How does monetary policy potentially affect interest rates?

4. If you see a decrease in the rate of money growth, what might you expect to see happen to

a. real output

b. the inflation rate

c. interest rates

5. Why do we care about recessions?

6. If interest rates fall, how might this change your economic behavior?

7. Are rising interest rates bad for everyone? Explain your answer.

8. Is it better to travel in foreign countries when the dollar is weak or when it is strong?

9. When the dollar is worth more in relation to currencies of other countries, are you more likely to buy American-made or French-made jeans? Are U.S. companies that make jeans happier when the dollar is strong or when it is weak?

10. What is the difference between GDP and GNP?

11. What is a price index? What are some of the limitations of price indices?

12. How does wealth differ from money? How does money differ from income?

13. What is currency? Is currency the same as money?

14. What does the term “medium of exchange” mean? How does money facilitate exchange? How does money affect transaction costs?

15. What does the term “unit of account” mean and how does money serve as a unit of account?

16. What does the term “store of value” mean and how does money serve as a store of value?

17. How does the theoretical definition of money differ from the empirical definition of money? What is a weighted monetary aggregate?

18. In Brazil, a country that has had high levels of inflation in recent years, many transactions are conducted in dollars rather than in the cruzados, the domestic currency. Why?

19. What regulation issues are there with respect to financial markets? What are the goals of regulation within the United States?

20. Some economists suspect that one of the reasons that economies in developing countries grow so slowly is that they do not have well-developed financial markets. Does this argument make sense?

21. Why might you be more willing to loan funds to a neighbor by putting your funds in a savings account earning 6% at the credit union and having the credit union loan her the funds at 12%, rather than directly loaning the funds to her?

22. Suppose you suspect Company A will go bankrupt next year. Would you rather hold bonds issued by the company or equities issued by the company? Why?

23. Why are debt contracts so complex and restrictive?

24. What is adverse selection? What is moral hazard? How might adverse selection occur in the housing market?

25. Describe the free-rider problem with respect to both adverse selection and moral hazard in financial markets.

26. How can a sharp rise in interest rates help provoke a financial crisis?

27. What is the trade-off between specialization of a bank’s loans versus diversification of the bank’s loan holdings? What arguments support specialization? What arguments support diversification?

28. What is interest-rate risk? Why is it more of a problem today than it was 35 or 40 years ago?

29. How do off-balance sheet activities expose a bank to greater risk?

30. Is there a moral hazard problem with regard to the existence of the FDIC? Do the FDIC insurance premiums take into account a bank’s riskiness?

31. What is the “too-big-to-fail” policy? How is such a policy justified? Evaluate this policy.

32. What is regulatory forbearance? Why did the FSLIC engage in this practice?

33. When net worth of a bank is $0, what is the owners’ stake in the bank? Why might this be a concern? How might it affect the bank’s operation? Relate this scenario to the topic of asymmetric information.

34. In the money supply process there are four important sets of actors. Who are they? How does each group affect the money supply process?

35. How can the Federal Reserve provide additional reserves to the banking system? Why might the Federal Reserve want to provide additional reserves to the banking system?

36. Using the simple money multiplier model answer the following question. Suppose the Fed makes a discount loan of $300 to Bank A. If the required reserve ratio is 15%, how will this action on the part of the Fed affect the banking system? Assume there are no currency drains and that excess reserves are kept at zero. Can you show what happens to the banking system using a T-account? Calculate the change in the monetary base.

37. Suppose the Federal Reserve purchases $400 worth of U.S. Treasury bills from Bank B. What will be the effect on the banking system? Suppose the required reserve ratio is 5%. Assume there are no currency drains and that excess reserves are not held by banks. What happens to the level of deposits in the banking system? Illustrate what happens using a T-account. What is the change in deposits do to this action by the Fed?

38. The Federal Reserve purchases $400 worth of T-bills from Bank B. Suppose the required reserve ratio is 5% and there are no currency drains or excess reserves. What happens to the level of reserves in the banking system due to the Fed’s purchase? Illustrate what happens using T-accounts. Calculate the change in deposits using the simple multiple deposit model?

39. The First National Bank receives an extra $100 of reserves, but decides not to loan any of these reserves out. How much deposit creation takes place for the entire banking system?

40. If a bank depositor withdraws $100 of currency from his account, what happens to reserves and checkable deposits?

41. When the Fed engages in open market sales does it affect the level of reserves differently if the purchaser keeps the proceeds from the sale as currency or as deposits? Explain your answer.

42. How does the more complex money multiplier model allow for currency drains? How does the more complex money multiplier model allow for excess reserves?

43. What is the relationship between the money multiplier and the various variables that determine that multiplier? What variables are directly related to the money multiplier? What variables are inversely related to the money multiplier?

44. What variables are positively related to the money supply? What variables are negatively related to the money supply?

45. During the Great Depression years of 1930-1933 the {C/D} ratio rose dramatically. What do you think happened to the money supply and why? Why do you think the {C/D} ratio rose so rapidly?

46. What would you predict will happen to the money supply if the Fed increases its required reserve ratio on checkable deposits? What would it mean if the required reserve ratio had a value of one? Explain your answer fully for both questions.

47. If the Fed sells $2 billion of bonds and banks reduce their discount loans by $2 billion, predict what will happen to the money supply.

48. If banks borrow an additional $4 million from the Fed and also reduce {ER/D}, what will happen to the money supply?

49. What factors influence the level of the {C/D} ratio? In what way do these factors influence {C/D}?

50. In periods when there has been a sharp increase in illegal activities (e.g., during Prohibition or today with respect to drug laws), what has happened to the level of the {C/D} ratio? Why? Does this make the Fed’s control of the money supply more difficult? Why or why not?

51. What factors determine the level of the {ER/D} ratio? Which of these factors is positively related to this ratio and which of these factors is negatively related to this ratio?

52. Discuss the following statement: “Self-preservation can be self-destructive during a banking panic.”

53. Should the discount rate be tied to a market rate of interest so that the spread is a constant rather than a variable? Why or why not?

54. During Christmas time, when the public’s holdings of currency increase, what defensive open market operations typically occur? Why?

55. If float decreases below its normal level, why might the manager of domestic operations consider it more desirable to use repurchase agreements to affect the monetary base rather than an outright purchase of bonds?

56. Discuss the following: “The only way the Fed can affect the level of discount loans is by adjusting the discount rate.”

57. If the Fed did not administer the discount window to limit borrowing, what do you predict would happen to the money supply if the discount rate were several percentage points below the federal funds rate?

58. Discuss the following: “Discounting is no longer needed because the presence of the FDIC eliminates the possibility of bank panics.”

59. What are the goals of monetary policy? Can these goals be attained simultaneously? Why or why not?

60. What is a monetary target? What do we mean by intermediate and operating targets? Why does the Fed use operating targets rather than focusing on monetary goals when they execute monetary policy?

61. Can the Fed choose both an interest rate and a monetary aggregate target at the same time? Why or why not? Illustrate your answer with appropriate graphs. What factors should be considered in choosing the appropriate target?

62. In selecting an intermediate target we are interested in measurability, controllability, and ability to predictably affect goals. Comment on how both monetary and interest rate targets measure up with regard to these criteria.

63. If the Fed has an interest rate target, why will an increase in money demand lead to a rise in the money supply?