MACROECONOMICS

The Monetary System: What it is and How it Works

QUESTIONS FOR REVIEW & PROBLEMS AND APPLICATIONS

GROUPS 3 :
Gery Alesandro Simbolon NIM:
2207511043
Ni Wayan Widarbayanti NIM:
2207511045
Ning Ai Satyawati NIM:
2207511046
Hilda Nurhidayanti NIM:
2207511073
Ni Komang Tri Widyastuti NIM:
2207511081

LECTURERS
Prof. Dr. I Komang Gde Bendesa, M.A.D.E.

FACULTY OF ECONOMICS AND BUSINESS

MACROECONOMICS 2022/2023
UDAYANA UNIVERSITY
2023
Question For Review:
1.
a. First off, money serves as a store of value. If I work today and make $25, I
should save it rather than spending it since it will remain valuable until
tomorrow, next week, or even next year. Holding money is really a more
efficient way to store value than holding other valuables like grain, which
could rot. Money is not a perfect store of value, but it is an effective one.
Over time, inflation gradually reduces the value of money's purchasing
power.
b. Second: Money is a unit of account. You can think of money as a yardstick-
the device we use to measure value in economic transactions. If you are
shopping for a new computer, the price could be quoted in terms of t-shirts,
bicycles, or corn. So, for instance, your new computer might cost you 100
to 150 bushels of corn at today's prices, but you would find it most helpful
if the price were set in terms of money because it is a common measure of
value across the economy
c. Thirdly, a medium of exchange is money. This indicates that accepting cash
as payment is commonplace. I am sure that the cashier will take my payment
when I go to the grocery shop. The phrase "This note is legal tender for all
debts, public and private" is printed on every piece of U.S. paper money.
This indicates that the U.S. government defends my ability to use dollars as
payment.

2. Commodity money's value, on the other hand, is based on the material it

was manufactured with, such as gold or silver. Fiat money, therefore, does
not have intrinsic value, while commodity money often does. Changes in
public confidence in a government issuing fiat money may be enough to
make the fiat currency worthless.

3. The Federal Reserve uses open market operations to change the federal
funds rate and affect other interest rates. The main monetary policy tool used
by the central bank is called open market operations (or "OMOs"). The
central bank purchases bonds in order to cut interest rates. Bond purchases
increase the money supply by adding funds to the money market. Without
the influence of an outside market, buyers and sellers can freely exchange
goods. Changes in supply and demand impact the prices of products and
services.

4. Banks create money during their normal operations of accepting deposits

and making loans. In this example we'll use M1 as our definition of money.
(M1 = currency in our pockets and balances in our checking accounts.)
When a bank makes a loan, it creates money.

5. The Fed controls the supply of money by increasing or decreasing the

monetary base. The monetary base is related to the size of the Fed's balance
sheet; specifically, it is currency in circulation plus the deposit balances that
depository institutions hold with the Federal Reserve.
6. Afraid of humongous withdrawals, financial institutions would be more
careful and raise the amount of money held in deposits, thereby raising the
reserve ratio. Increases in the currency and reserve deposit ratios reduce the
money multiplier and decline in the money supply.
APPLICATION AND PROBLEM
1. What are the functions of money? Which of the functions do the
following items satisfy? Which do they not satisfy?
Answer:
a. A credit card
Because it is accepted as payment for goods and services, a credit
card can be used as a medium of exchange. With the potential for
debt accumulation, a credit card could be seen of as a (negative)
store of value. An automobile, for instance, does not cost 5 VISA
cards, hence a credit card is not a unit of account.
b. A painting by Rembrandt
A Rembrandt painting is a store of value only. It is not a medium of
exchange or a unit of account.
c. A subway token.
A subway token, within a subway system, satisfies all three
functions of money. Yet outside the subway system, it is not widely
used as a unit of account or a medium of exchange, so it is not a form
of money.
2. Explain how each of the following events affects the monetary base, the
money multiplier, and the money supply.
Answer:
a. When the Fed buys bonds, the dollars that it pays to the public for the
bonds increase the monetary base, and this in turn increases the money
supply. The money multiplier is not affected, assuming no change in the
reserve-deposit ratio or the currency-deposit ratio.
b. When the Fed increases the interest rate, it pays banks to hold
reserves. This gives banks an incentive to hold more reserves relative to
deposits. The increase in the reserve-deposit ratio will decrease the
money multiplier. The decline in the money multiplier will lead to a
decrease in the money supply. Since banks are holding more reserves
(because they are making fewer loans), the monetary base will increase.
c. If the Fed reduces its lending to banks through the Term Auction
Facility, then the monetary base will decrease, and this in turn will
decreases the money supply. The money multiplier is not affected,
assuming no change in the reserve-deposit ratio or the currency-deposit
ratio.
d. If consumers lose confidence in ATMs and prefer to hold more cash,
then the currency-deposit ratio will increase, and this will reduce the
money multiplier. The money supply will fall because banks have fewer
reserves to lend. The monetary base will increase because people are
holding more currency but will decrease because banks are holding
fewer reserves. The net effect on the monetary base is
 zero.
d. If the Fed drops newly minted $100 bills from a helicopter, then this will
increase the monetary base and the money supply. If any of the currency
ends up in the bank, then there will be a further increase in the money
supply. If people end up holding more currency relative to deposits, then the
money multiplier would fall.

3. An economy has a monetary base of 1,000 $1 bills. Calculate the money supply
in scenarios (a)–(d) and then answer part (e).
Answer:
a) If all money is held as currency, then the money supply is equal to the monetary
base. The money supply will be $1,000.
b) If all money is held as deposits, but banks hold 100 percent of deposits on reserve,
then there are no loans. The money supply will be $1,000.
c) If all money is held as deposits and banks hold 20 percent of deposits on reserve,
then the reserve deposit ratio is 0.20. The currency deposit ratio is 0, and the money
multiplier will be 1/0.2, or 5. The money supply will be $5,000.
d) If people hold an equal amount of currency and deposits, then the currency
deposit ratio is 1. The reserve–deposit ratio is 0.2 and the money multiplier is (1 +
1)/ (1 + 0.2) = 1.67. The money supply will be $1,666.67.
e) The money supply is proportional to the monetary base and is given by M = m ×
B, where M is the money supply, m is the money multiplier, and B is the monetary
base. Since m is a constant number defined by the currency deposit ratio and the
reserve deposit ratio, a 10 percent increase in the monetary base B will lead to a 10
percent increase in the money supply M.

4. The money supply fell from 1929 to 1933 because both the currency- deposit
ratio and reserve- deposit ratio increased. Use the model of the money supply and
the data in the table below to answer the following hypothetical questions about this
episode.
Answer:

a. In order to determine what will happen to the supply of money m if the

current deposit ratio has increased but the reserve deposit ratio has remained
the same. It is required to calculate the
b. money multiplier and then put the value in the money supply equation M
= mB.

Now,

m = (cr1933 + 1) / (cr1933 + rr1929)

= (0.41 + 1) / (0.41 + 0.14)

= 2.56

Calculating the money supply under these conditions in 1933:

M1933 = 2.56 * 8.4

M1933 = 21.504

Thus, under the current condition, the supply of money have decreased from 1929
level of 26.5 to 21.504 in 1933.

b) In order to determine what will happen to the supply of money m if the current
deposit ratio has increased but the reserve deposit ratio has remained the same. It is
required to calculate the money multiplier and then put the value in the money
supply equation M = mB.

m = (cr1929 + 1) / (cr1929 + rr1933)

= (0.17 + 1) / (0.17 + 0.21)

= 3.09

Calculating the money supply under these conditions in 1933:

M1933 = mB1933

Putting the value of m and the 1933 value for B

M1933 = 3.09 * 8.4

M1933 = 25.96

Thus, under the current condition, the supply of money have decreased from 1929
level of 26.5 to 25.96 in 1933.

c) From the calculations given above, the decline in the currency deposit ratio was
responsible for the drop in the money multiplier and therefore, it is responsible for
the fall in the supply of money.

5. To increase tax revenue, the U.S. government in 1932 imposed a 2-cent tax on
checks written on bank account deposits. (In today’s dollars, this tax would amount
to about 34 cents per check.)
Answer:
a. This tax probably decreased the ratio of currency in circulation to deposits. The
tax would have increased the cost to consumers of writing checks, meaning they
would spend less from their checkable accounts, choosing instead to leave a larger
portion of their cash in the bank vault.
b. Under a fractional reserve banking system, this tax would ultimately contract the
money supply. As consumers spend less, they would reduce the velocity of money,
which would lead to a decrease in the M1 money stock.
c. If decreasing the money supply did indeed contribute to falling production and
rising unemployment then this policy was a bad idea at the time. By making money
harder to spend (consumers are less willing to write checks because of the tax) the
government ultimately decreased aggregate expenditures.
 7. Give an example of a bank balance sheet with a leverage ratio of 10. If the
value of the bank’s assets rises by 5 percent, what happens to the value of
the owners’ equity in this bank? How large a decline in the value of bank
assets would it take to reduce this bank’s capital to zero?
Answer:

Leverage ratio

Leverage ratio is one of the mandatory statutory ratio imposed by the central bank
of a country over its commercial banks to ensure the short term and solvency of
the bank, this ratio is a part of basel 3 norms.

Leverage ratio = tier 1 capital/ total assets = C/A :

20 = C/A

C= 20A

If we increase Assets by 2% :

20 = C/A(1.02)

C= 20.4A

Increase in capital= (20.4-20)/20=2% :

Lets plugin C= 0

0/ A =20

As we can see to wipe out the capital fully asset needs to be = zero