The Monetary System

11 The Monetary System CHAPTER CHECKPOINTS

Checkpoint 11.1 Checkpoint 11.3 Checkpoint 11.4 Clicker version Problem 1 Problem 1 Problem 1 Clicker version Problem 2 Problem 2 Problem 2 Clicker version Clicker version Problem 3 Problem 3 Clicker version Clicker version Checkpoint 11.2 Problem 4 Problem 1 Clicker version Problem 2 Clicker version Problem 3 Problem 4

Practice Problem 1 In the United States today, money includes which of the following items? Your Visa card The quarters inside public phones U.S. dollar bills in your wallet The check that you have just written to pay for your rent The loan you took out last August to pay for your school fees CHECKPOINT 11.1

Solution Money is defined as means of payment. Only the quarters inside public phones and U.S. dollar bills in your wallet are money. CHECKPOINT 11.1

Study Plan Problem In the United States today, money includes ___________. A. Your Visa card, the quarters inside public phones, and the U.S. dollar bills in your wallet. B. The U.S. dollar bills in your wallet and your Visa card, but not quarters inside public phones. C. The quarters inside public phones, the U.S. dollar bills in your wallet, the check you wrote to pay the rent, and the loan you took out to cover the school fees. D. The U.S. dollar bills in your wallet and the quarters inside the public phones, but not your Visa card. CHECKPOINT 11.1

Practice Problem 2 In November 2004, Currency held by individuals and businesses was $699.8 billion Traveler’s checks were $7.6 billion Checkable deposits owned by individuals and businesses were $654.7 billion Savings deposits were $3,494.8 billion Small time deposits were $810.3 billion Money market funds and other deposits were $713.3 billion. Calculate M1 and M2 in November 2004. CHECKPOINT 11.1

Solution M1 is the sum of Currency held by individuals and businesses, $699.8 billion, Traveler’s checks, $7.6 billion, and Checkable deposits owned by individuals and businesses, $654.7 billion. M1 = ($699.8 + $7.6 + $654.7 ) billion = $1,362.1 billion. CHECKPOINT 11.1

M2 is the sum of M1, $1,362.1 Savings deposits, $3,494.8 billion Small time deposits, $810.3 billion Money market funds and other deposits, $713.3 billion M2 = ($1,362.1 + $3,494.8 + $810.3 + $713.3) billion M2 = $6,380.5 billion. CHECKPOINT 11.1

Practice Problem 1 What are the institutions that make up the U.S. banking system? CHECKPOINT 11.2

Solution The institutions that make up the U.S. banking system are The Fed Commercial banks Thrift institutions Money market funds CHECKPOINT 11.2

Study Plan Problem The institutions that make up the U.S. banking system are ______. A. the Fed and money market funds B. thrift institutions, the Fed, money market funds, and commercial banks C. New York Stock Exchange, the Fed, and banks D. the New York Stock Exchange and the U.S. Treasury E. the Fed and commercial banks CHECKPOINT 11.2

Practice Problem 2 What is a bank’s balancing act? CHECKPOINT 11.2

Solution A bank makes a profit by borrowing from depositors at a low interest rate and lending at a higher interest rate. The bank must hold enough reserves to meet depositors’ withdrawals. The bank’s balancing act is to balance the risk of loans (profits for stockholders) against the security for depositors. CHECKPOINT 11.2

Study Plan Problem What is a bank’s balancing act? A bank must balance _______ against _____. A. security for depositors; profit for stockholders B. high-risk loans; lending to business and home buyers C. lending to business and home buyers; profit for stockholders D. cash assets; securities E. long-term loans; long-term deposits CHECKPOINT 11.2

Practice Problem 3 A bank has the deposits and assets set out in the table. Calculate the bank’s Total deposits Deposits that are part of M1 Deposits that are part of M2 CHECKPOINT 11.2 • The bank’s deposits and assets • $320 in checkable deposits • $896 in savings deposits • $840 in small time deposits • $990 in loans to businesses • $400 in outstanding credit card balances • $634 in government securities • $2 in currency • $30 in its reserve account at the Fed.

Solution Total deposits are $320 + $896 + $840 = $2,056. CHECKPOINT 11.2 • The bank’s deposits and assets • $320 in checkable deposits • $896 in savings deposits • $840 in small time deposits • $990 in loans to businesses • $400 in outstanding credit card balances • $634 in government securities • $2 in currency • $30 in its reserve account at the Fed.

Deposits that are part of M1 are checkable deposits, $320. CHECKPOINT 11.2 • The bank’s deposits and assets • $320 in checkable deposits • $896 in savings deposits • $840 in small time deposits • $990 in loans to businesses • $400 in outstanding credit card balances • $634 in government securities • $2 in currency • $30 in its reserve account at the Fed.

Deposits that are part of M2 are checkable deposits, savings deposits, and small time deposits. Deposits that are part of M2 total $2,056. CHECKPOINT 11.2 • The bank’s deposits and assets • $320 in checkable deposits • $896 in savings deposits • $840 in small time deposits • $990 in loans to businesses • $400 in outstanding credit card balances • $634 in government securities • $2 in currency • $30 in its reserve account at the Fed.

Practice Problem 4 A bank has the deposits and assets set out in the table. Calculate the bank’s Loans Securities Reserves CHECKPOINT 11.2 • The bank’s deposits and assets • $320 in checkable deposits • $896 in savings deposits • $840 in small time deposits • $990 in loans to businesses • $400 in outstanding credit card balances • $634 in government securities • $2 in currency • $30 in its reserve account at the Fed.

Solution Loans are loans to businesses and outstanding credit card balances. Loans equal $990 + $400 = $1,390. CHECKPOINT 11.2 • The bank’s deposits and assets • $320 in checkable deposits • $896 in savings deposits • $840 in small time deposits • $990 in loans to businesses • $400 in outstanding credit card balances • $634 in government securities • $2 in currency • $30 in its reserve account at the Fed.

Securities are $634. CHECKPOINT 11.2 • The bank’s deposits and assets • $320 in checkable deposits • $896 in savings deposits • $840 in small time deposits • $990 in loans to businesses • $400 in outstanding credit card balances • $634 in government securities • $2 in currency • $30 in its reserve account at the Fed.

The bank’s reserves are its reserve account at the Fed and the bank’s currency in its vaults and ATMS. Reserves are$30 + $2 = $32. CHECKPOINT 11.2 • The bank’s deposits and assets • $320 in checkable deposits • $896 in savings deposits • $840 in small time deposits • $990 in loans to businesses • $400 in outstanding credit card balances • $634 in government securities • $2 in currency • $30 in its reserve account at the Fed.

Practice Problem 1 What is the Fed and what is the FOMC? CHECKPOINT 11.3

Solution The Federal Reserve (Fed) is the central bank in the United States. The central bank in the United States is a public authority that provides banking services to banks and the U.S. government and that regulates the quantity of money and the banking system. The FOMC is the Federal Open Market Committee. The FOMC is the Fed’s main policy-making committee. CHECKPOINT 11.3

Study Plan Problem The Fed is _______and the FOMC is _______. A. the U.S. central bank; the New York Federal Reserve B. a federation of commercial banks; its management committee C. the U.S. central bank; the Fed’s main policy-making committee D. the world’s central bank; the Fed’s chairman and the U.S. president CHECKPOINT 11.3

Practice Problem 2 Who is the Fed’s chief executive? What are the Fed’s main policy tools? CHECKPOINT 11.3

Solution The Fed’s chief executive is the Chairman of the Board of Governors, currently Ben Bernanke. The Fed’s main policy tools are required reserve ratios, the discount rate, and open market operations. CHECKPOINT 11.3

Study Plan Problem What are the Fed’s main policy tools? A. Discount rate, interest rates, and open market operations B. Open market operations and required reserve ratios C. The monetary base and the discount rate D. Required reserve ratios, discount rate, and open market operations E. The monetary base and open market operations CHECKPOINT 11.3

Practice Problem 3 What is the monetary base? CHECKPOINT 11.3

Solution The monetary base is the sum of Coins Federal Reserve notes (dollar bills) Banks’ reserves at the Fed CHECKPOINT 11.3

Study Plan Problem The monetary base is ______. the sum of U.S. government securities and loans made by the Fed to commercial banks excess reserves held by the commercial banks C. the sum of gold and U.S. currency held by U.S. citizens but not U.S. currency held foreigners D. money held by the regional federal reserve banks E. the sum of coins, Federal reserve notes, and banks’ reserves at the Fed CHECKPOINT 11.3

Practice Problem 4 Suppose that in the United States at the end of December 2009, The monetary base was $700 billion. Federal Reserve notes were $650 billion. Banks’ reserves at the Fed were $20 billion. Calculate the quantity of coins. CHECKPOINT 11.3

Solution The monetary base is the sum of coins, Federal Reserve notes, banks’ reserves at the Fed. Quantity of coins = Monetary base – Federal Reserve notes – Banks’ reserves at the Fed. At the end of December 2009, the monetary base was $700 billion, Federal Reserve notes were $650 billion, and banks’ reserves at the Fed were $20 billion. Quantity of coins = $700 billion – $650 billion – $20 billion = $30 billion. CHECKPOINT 11.4

Practice Problem 1 How do banks create new deposits by making loans? What factors limit the amount of deposits and loans that banks can create? CHECKPOINT 11.4

Solution Banks can make loans when they have excess reserves—reserves in excess of those required. When a bank makes a loan, it creates a new deposit for the person who receives the loan. The bank uses its excess reserves to create new deposits. The amount of loans that the bank can make, and therefore the amount of new deposits that it can create, is limited by the monetary base, the desired reserve ratio, and the currency drain ratio. CHECKPOINT 11.4

Practice Problem 2 If the Fed makes an open market purchase of $1 million of securities, who can sell the securities to the Fed? What initial changes occur in the economy if the Fed buys from a bank? CHECKPOINT 11.4

Solution The Fed buys securities from banks or the public, but not the government. The initial change is an increase in the monetary base of $1 million. Ownership of the securities passes from the bank to the Fed and the Fed’s assets increase by $1 million. The Fed pays for the securities by increasing the bank’s reserves at the Fed by $1 million. CHECKPOINT 11.4

The Fed’s liabilities increase by $1 million. The bank’s assets are the same, but their composition has changed. The bank has $1 million more in reserves and $1 million less in securities. CHECKPOINT 11.4

Study Plan Problem If the Fed makes an open market purchase of $1 million of securities, who can sell the securities to the Fed? A. The government or the public B. Only the public C. The banks or the government D. The banks or the public E. The banks, the public, or the government CHECKPOINT 11.4

Study Plan Problem When the Fed makes an open market purchase from a bank, the monetary base _____. The bank’s deposit with the Fed _____. The bank’s total assets _____, reserves ______ and securities _____. A. decreases; decreases; are the same; decrease; increase B. increases; increases; decrease; increase; decrease C. increases; increases; increase; decrease; increase D. increases; increases; are the same; increase; decrease E. decreases; decreases; decrease; decrease; increase CHECKPOINT 11.4

Practice Problem 3 If the Fed makes an open market purchase of $1 million of securities, what is the process by which the quantity of money changes? What factors determine how much the quantity of money changes? CHECKPOINT 11.4

Solution When the Fed buys securities from a bank, the bank’s reserves increase by $1 million, but its deposits do not change, so the bank has excess reserves. The bank makes loans and creates new deposits (new money). The required reserve ratio and the currency drain ratio determine the increase in the quantity of money. The larger the required reserve ratio or the currency drain ratio, the smaller is the increase in the quantity of money. CHECKPOINT 11.4

Study Plan Problem If the Fed makes an open market purchase , the larger the ______, the smaller is the increase in the quantity of money. A. open market purchase or the currency drain ratio B. currency drain ratio or smaller the required reserve ratio C. required reserve ratio or the smaller the currency drain ratio D. open market purchase or the smaller the required reserve ratio and the currency drain ratio E. larger the required reserve ratio or the currencydrain ratio CHECKPOINT 11.4

The Monetary System