Tutorial 7

The Monetary System

I. Term

1. liquidity
2. commodity money
3. fiat money
4. demand deposits
5. central bank
6. money supply
7. monetary policy
8. reserves
9. fractional-reserve banking
10. reserve ratio
11. money multiplier
12. open-market operations
13. discount rate

II. Short-answer questions

1. What distinguishes money from other assets in the economy?

2. What is commodity money? What is fiat money? Which kind do we use?
3. What are demand deposits and why should they be included in the stock of
money?
4. Who is responsible for setting monetary policy in the United States? If the Fed
wants to increase the money supply with open-market operations, what does it
do?
5. Why don’t banks hold 100 percent reserves? How is the amount of reserves
banks hold related to the amount of money the banking system creates?
6. What is the discount rate? What happens to the money supply when the Fed
raises the discount rate?
7. What are reserve requirements? What happens to the money supply when the
Fed raises reserve requirements?
8. Why can’t the Fed control the money supply perfectly?

III. Practice problems

1. Which of the following is money in the U.S. economy? Which are not?
Explain your answers by discussing each of the three functions of money.
a. a U.S. penny
b. a Mexican peso
c. a Picasso painting
d. a plastic credit card
2. Beleaguered State Bank (BSB) holds $250 million in deposits and maintains a
reserve ratio of 10 percent.
a. Show a T-account for BSB.
b. Now suppose that BSB’s largest depositor withdraws $10 million in
cash from her account. If BSB decides to restore its reserve ratio by
reducing the amount of loans outstanding, show its new T-account.
 c. Explain what effect BSB’s action will have on other banks.
d. Why might it be difficult for BSB to take the action described in part
(b)? Discuss another way for BSB to return to its original reserve ratio.
3. You take $100 you had kept under your mattress and deposit it in your bank
account. If this $100 stays in the banking system as reserves and if banks hold
reserves equal to 10 percent of deposits, by how much does the total amount
of deposits in the banking system increase? By how much does the money
supply increase?
4. Suppose that the T-account for First National Bank is as follows:
Assets Liabilities
Reserves $100,000 Deposits $500,000
Loans 400,000
a. If the Fed requires banks to hold 5 percent of deposits as reserves, how
much in excess reserves does First National now hold?
b. Assume that all other banks hold only the required amount of reserves.
If First National decides to reduce its reserves to only the required
amount, by how much would the economy’s money supply increase?
5. Suppose that the reserve requirement for checking deposits is 10 percent and
that banks do not hold any excess reserves.
a. If the Fed sells $1 million of government bonds, what is the effect on
the economy’s reserves and money supply?
b. Now suppose the Fed lowers the reserve requirement to 5 percent, but
banks choose to hold another 5 percent of deposits as excess reserves.
Why might banks do so? What is the overall change in the money
multiplier and the money supply as a result of these actions?
6. Assume that the reserve requirement is 20 percent. Also assume that banks do
not hold excess reserves and there is no cash held by the public. The Federal
Reserve decides that it wants to expand the money supply by $40 million
dollars.
a. If the Fed is using open-market operations, will it buy or sell bonds?
b. What quantities of bonds does the Fed need to buy or sell to
accomplish the goal? Explain your reasoning.
7. The economy of Elmendyn contains 2,000 $1 bills.
a. If people hold all money as currency, what is the quantity of money?
b. If people hold all money as demand deposits and banks maintain 100
percent reserves, what is the quantity of money?
c. If people hold equal amounts of currency and demand deposits and
banks maintain 100 percent reserves, what is the quantity of money?
d. If people hold all money as demand deposits and banks maintain a
reserve ratio of 10 percent, what is the quantity of money?

IV. Multiple-Choice Questions

1. Which of the following is not a function of money?

a. unit of account
b. store of value
c. hedge against inflation
d. medium of exchange

2. An example of fiat money is

 a. Gold.
b. Paper dollars.
c. Solid silver coins.
d. Cigarettes in a prisoner-of-war camp.

3. Commodity money
a. Has no intrinsic value.
b. Has intrinsic value.
c. Is used exclusively in the United States.
d. Is used as reserves to back fiat money.

4. Required reserves of banks are a fixed percentage of their

a. Loans.
b. Assets.
c. Deposits.
d. Government bonds.

5. If the reserve ratio is 25 percent, the value of the money multiplier is

a. 0.25.
b. 4.
c. 5.
d. 25.
e. None of the above.

6. Which of the following policy actions by the Fed is likely to increase the money
supply?
a. Reducing reserve requirements.
b. Selling government bonds.
c. Increasing the discount rate.
d. Increasing interest on reserves.
e. All of these will increase the money supply.

7. Suppose Joe changes his $1,000 demand deposit from Bank A to Bank B. If the
reserve requirement is 10 percent, what is the potential change in demand deposits
as a result of Joe’s action?
a. $1,000
b. $9,000
c. $10,000
d. $0

8. A decrease in the reserve requirement causes

a. Reserves to rise.
b. Reserves to fall.
c. The money multiplier to rise.
d. The money multiplier to fall.
e. None of the above.

9. The discount rate is

a. The interest rate the Fed pays on reserves.
b. The interest rate the Fed charges on loans to banks.
 c. The interest rate banks pay on the public’s deposits.
d. The interest rate the public pays when borrowing from banks.
e. The interest rate paid by banks at the Term Auction Facility.

10. Which of the following policy combinations would consistently work to increase
the money supply?
a. sell government bonds, decrease reserve requirements, decrease the discount
rate
b. sell government bonds, increase reserve requirements, increase the discount
rate
c. buy government bonds, increase reserve requirements, decrease the discount
rate
d. buy government bonds, decrease reserve requirements, decrease the discount
rate
e. None of the above.

11. Suppose all banks maintain a 100 percent reserve ratio. If an individual deposits
$1,000 of currency in a bank,
a. The money supply is unaffected.
b. The money supply increase by more than $1,000.
c. The money supply increase by less than $1,000.
d. The money supply decrease by more than $1,000.
e. The money supply decrease by less than $1,000.

12. If the Fed engages in an open-market purchase, and at the same time, it raises
reserve requirements,
a. The money supply should rise.
b. The money supply should fall.
c. The money supply should remain unchanged.
d. We cannot be certain what will happen to the money supply.

13. The Fed’s tools of monetary control are

a. Government expenditures, taxation, reserve requirements, and interest rates.
b. The money supply, government purchases, and taxation.
c. Coin, currency, demand deposits, and commodity money.
d. Open-market operations, lending to banks, reserve requirements, and paying
interest on reserves.
e. Fiat, commodity, and deposit money.

14. If banks increase their holdings of excess reserves

a. The money multiplier and the money supply decrease.
b. The money multiplier and the money supply increase.
c. The money multiplier decreases and the money supply increases.
d. The money multiplier increases and the money supply decreases.