Questions - Johan Lindén, Mälardalens högskola



Chapter 11The Monetary SystemQuestions1.List and explain the three functions of money in a modern economy.Answer: Money is used to conduct market transactions in a modern economy. Money is what people usually use to make and receive payments when buying and selling goods and services. Specifically, money serves three functions:Money is a medium of exchange. Money is the most common medium of exchange. The use of money allows for a convenient, universally acceptable way of buying and selling goods. Money is a store of value. A store of value is an asset that enables people to transfer purchasing power into the future. Money that is received today will be accepted as a form of payment even a decade from now.Money is a unit of account. Money is a universal yardstick that is used for expressing the worth (price) of different goods and services. The cost of a good is measured by the number of dollars it takes to buy the good. 2.How does fiat money differ from commodities like gold and silver that were used as money? Answer: Fiat money is intrinsically worthless but is used as legal tender by government decree. Whereas gold and silver have intrinsic value, fiat or paper money is valuable only because other people will accept it as money. 3.How is the M2 money supply defined? Answer: The money supply or M2 adds together currency in circulation, checking accounts, travelers’ checks, savings accounts, and money market accounts. 4.Recall the discussion in the chapter about the “quantity theory of money.”a.Explain the quantity theory of money. b.Explain how the predictions of the quantity theory of money are borne out by historical data.Answer: a.The quantity theory of money assumes that the ratio of money supply to nominal GDP is constant. This implies that, if money supply grows by 10 percent, then nominal GDP also needs to grow by 10 percent to keep the ratio of money supply divided by nominal GDP constant. It follows that the growth rate of money supply and the growth rate of nominal GDP will be the same.Growth Rate of Money Supply = Growth Rate of Nominal GDPSubstituting the growth rate of money supply for the growth rate of nominal GDP, we find that:Growth Rate of Money Supply = Inflation Rate + Growth Rate of Real GDPRearranging this equation, Rate= Growth Rate of Money Supply – Growth Rate of Real GDPSo, according to the quantity theory of money, inflation is equal to the gap between the growth rate of the money supply and the growth rate of real GDP. When this gap widens, the inflation rate increases.b.Exhibit 11.2 in the text examines data on inflation and the value of the growth rate of money supply minus the growth rate of real GDP from 110 countries over the period 1960–1990. The exhibit shows that a 45-degree line passes through the inflation rate and the value of the growth rate of money supply minus the growth rate of real GDP. The quantity theory of money predicts that inflation should rise one-for-one with the growth rate of money supply minus the growth rate of real GDP. The fact that the data points lie approximately along a 45-degree line with a slope of one confirms the key long-run prediction generated by the quantity theory of money. 5.What are the differences among inflation, deflation, and hyperinflation?Answer: Inflation refers to an increase in an economy’s overall price level, whereas deflation is a decrease of an economy’s overall price level. Hyperinflation refers to a level of inflation so high that a country’s price level doubles within three years.6.What is the most common cause of hyperinflation?Answer: Hyperinflation is always related to extremely rapid growth of the money supply. In almost all cases, such extreme monetary growth is brought about by large government budget deficits. If a government’s tax revenues fall short of its expenditures, it meets its obligations by borrowing more from the public or printing money. Printing more money and using it to buy goods and services increases the money supply in the economy, leading to rapid increases in the price level. 7.What are the costs associated with inflation?Answer: Inflation imposes the following types of costs on consumers and firms. High rates of inflation create logistical costs: Even moderate rates of inflation will necessitate multiple changes to price lists, price tags, and so on over the course of the year. The costs associated with such changes are referred to as “menu costs.” Higher inflation distorts relative prices, reducing economic efficiency: As a consequence of volatile inflation, firms may adjust their prices differently, causing relative prices to fall out of alignment. Distortion of relative prices leads to economic inefficiencies.Inflation often leads to counterproductive policies like price controls: High rates of inflation are a politically sensitive issue, which may prompt governments to enact economically destructive policies such as price controls. As discussed in earlier chapters, price controls can result in supply disruptions, long lines, and expansion of the underground economy. 8.Does inflation have any benefits? Explain.Answer: Yes, inflation does have certain benefits. Government revenue is generated when the government prints money. The government revenue that is obtained from money creation is called seignorage. Seignorage is the difference between the cost of printing paper money and the value of the goods and services that the government can purchase with the newly printed money. Inflation can sometimes stimulate economic activity. If inflation increases when the nominal wage is fixed, a worker’s real wage falls. This increases firms’ willingness to hire more workers. Inflation may therefore give the government a way to stimulate the economy temporarily, which is a useful policy lever during economic slowdowns. In addition, inflation lowers the real interest rate, which increases consumption and investment. 9.What is the federal funds rate? What are the factors that would shift the demand curve for reserves? Answer: The federal funds rate is the interest rate in the federal funds market where banks obtain overnight loans of reserves from one another. The funds that are lent in this market are reserves at the Federal Reserve Bank. The demand curve for reserves plots the net quantity of reserves held by private banks. Because the demand curve relates the quantity of reserves demanded by private banks for each level of the federal funds rate, if some factor other than the federal funds rate changes, the entire demand curve shifts. There are five such factors that can shift the curve:An economic expansion or contraction: The value of reserves will rise in a booming economy because banks will need to make more loans to their customers. This will shift the demand curve to the right. Similarly, in a contracting economy, the demand curve will shift to the left. Changing liquidity needs: If the deposit base is expected to fall very quickly in the near future, for example due to a substantial increase in withdrawals, this will increase the demand for reserves and shift the demand curve to the right.Changing deposit base: A bank in the United States needs to hold 10 percent of its deposits as reserves. So as deposits increase, the demand curve for reserves will shift to the right. Similarly, as the deposit base shrinks, the demand curve for reserves will shift to the left. Changing reserve requirement: In the rare event that the Fed raises the reserve requirement, demand for reserves would increase, and the demand curve for reserves would shift to the right. Conversely, if the Fed lowered the reserve requirement, the demand curve for reserves would shift to the left. Changing interest rate paid by the Fed for having reserves on deposit at the Fed: A change in the modest interest rate that the Fed pays banks on reserves held at the Fed could change the demand for reserves. For example, if the Fed raises this rate, reserves become more beneficial to private banks, shifting the demand curve for reserves to the right. If the Fed lowers this rate, reserves become less valuable, shifting the demand curve for reserves to the left. 10.What is an open market operation? Why does the Federal Reserve conduct open market operations?Answer: An open market operation is an exchange between a private bank and the Federal Reserve. The Fed buys or sells government bonds to private banks in exchange for reserves held by those private banks at the Fed.The Fed uses open market operations when it wants to influence the federal funds rate. Banks need to give the Fed assets in exchange for the reserves held at the Fed. These assets are usually government bonds. When the Fed offers to buy government bonds from private banks, it gives banks more electronic reserves. Similarly, when the Fed sells government bonds to private banks, it reduces the level of electronic reserves that banks hold. Suppose the Fed wants to obtain a particular value for the federal funds rate. It first chooses the federal funds rate and then finds that point on the demand curve that corresponds to that federal funds rate. The Fed makes available the exact level of reserves associated with that point on the demand curve. 11.Why is the Federal Reserve referred to as the “lender of last resort”?Answer: Banks usually meet their liquidity needs by borrowing from each other in the federal funds market. Every morning, the banks assess their liquidity needs for the coming business day and borrow or lend accordingly. During extraordinary times, say during a financial crisis, the federal funds market can “freeze” or break down. Banks with excess reserves may be unwilling to lend out these reserves. When this happens, banks can borrow from the Federal Reserve instead. Banks borrow reserves from the Fed at the “discount window.” Since borrowing from the Fed is more costly than borrowing on the federal funds market, it is a bank’s last resort for borrowing reserves. 12.How does the Federal Reserve influence the long-term real interest rate? Answer: The long-term real interest rate is defined as the long-term nominal interest rate minus the long-term inflation rate. The Fed influences the long-term nominal interest rate through the short-term federal funds rate. A long-term loan is effectively made up of many short-term loans. The nominal interest rate for the long-term loan can be seen as the average of these short-term loans. Because several of the short-term loans are affected by a change in the federal funds rate, the long-term nominal rate moves in the same direction.The long-term expected inflation rate depends on the effect of monetary policy on inflationary expectations. If the inflation expectations don’t change and nominal interest rates fall, then the expected real interest rate falls. Therefore, a fall in the federal funds rate lowers the long-term nominal interest rate and lowers the expected long-term real interest rate. Even when inflation expectations do change, the long-term expected real interest rate often falls in response to a reduction in the federal funds rate.13.What are the two models that are used to describe inflationary expectations? Answer: Adaptive expectations and rational expectations are the two models that are used to describe inflationary expectations. The adaptive expectations model assumes that inflationary expectations are determined by the level of inflation in the recent past. Adaptive expectations are a backward-looking way of describing how inflationary expectations are formed. The rational expectations approach, on the other hand, assumes that people have inflation expectations that incorporate all of the information that is available when the inflation expectations are being formed and use that information in the most sophisticated way possible. If agents have rational expectations, they are masterful forecasters who make the best possible forecast using a sophisticated understanding of the workings of the economy. Problems1.Barter is a method of exchange whereby goods or services are traded directly for other goods or services without the use of money or any other medium of exchange. a.Suppose you need to get your house painted. You register with a barter Web site and want to offer your car cleaning services to someone who will paint your house in return. What are the problems you are likely to encounter?b.Some barter Web sites allow the use of “barter dollars.” The registration fee that you pay to a barter Web site gets converted into barter dollars that can be exchanged with other users to buy goods and services. Would the use of barter dollars resolve the problems you listed in part (a)? Explain. Answer:a.You might find it difficult to find people who need you to wash their car and are also willing to paint your house in return. You may find people who need their car washed but are not necessarily willing to paint your house in return. Or you may find people who are willing to paint your house but do not need their car washed. b.Yes. If you could convert your services into a common currency, you could avoid the problems in part (a). Even if the other person does not want his car washed, you could compensate him with “barter dollars.” You could also wash a car for someone in exchange for barter dollars that you can then use to get your house painted. Using barter dollars would allow mutually beneficial trades to take place. Of course, all of this assumes that many people are using barter dollars. If only a small number of people use barter dollars, then the problems of part (a) will reappear.2. Money makes a variety of economic transactions possible. In the following three situations, determine whether money is involved in the transaction.a.On the island of Yap, exchanges were made by using large circular stone discs carved out of limestone. Since these stones were too large to move, when an exchange occurred, a stone stayed in its place but its ownership would change. Can these stone discs be termed as money? b.In recent years it has become increasingly common to pay with your smartphone. Is your smartphone money? Explain your reasoning. c.In food courts at several malls, it is quite common to use coupons instead of money. This means that you exchange your currency notes for coupons and use them to purchase meals. Can such coupons be considered money?Answer:a.The three key functions of money are: medium of exchange, store of value, and unit of account. Even though these stone disks were large, you could use them for exchange. The ownership of these disks was recorded in oral history, thus fulfilling the first and third component of the exchange. It also possessed inner value as it was made from limestone which was apparently difficult to access on the island of Yap.b.Smartphones are not money! It is a vehicle of transfer. Your smartphone is connected to an online account (typically your credit or debit card). If it is connected to your debit card, when you pay you are directly transferring money from your bank account to the sellers account. However, when you are using your credit card, you are borrowing from your bank to pay the seller and you will have to repay this debt later. Thus, when you settle your debt you will be transferring money.c.This is an interesting one. In a food court, yes, coupons do constitute real money. They are transferrable between the consumers and are not false. However, these can only be exchanged for real money in the confines of the food court within that specific mall, so a consumer cannot buy goods or services using the coupons outside the food court.3. In some parts of the world, salt—the stuff sitting on your kitchen table—was once used as currency. In ancient Ethiopia, for example, blocks of salt were used to purchase goods and pay salaries. The value of the salt block was based on weight, and it was physically transferred as part of the transaction. In part, salt was valuable because of its scarcity and its usefulness: before the introduction of refrigeration, many civilizations used salt to preserve food. a. Discuss how salt did or did not fulfill the three purposes of currency. b.Suppose several new salt mines opened in ancient Ethiopia. How would you expect the rapid infusion of currency into society to affect the economy? Explain. Answer:a.As the problem describes it, salt was a medium of exchange. However, it’s not clear to what degree it was a store of value or a unit of account. Since it could be used and, thus, depleted, the student could argue that it did not store a fixed amount of value. In addition, we don’t know whether it really served as a unit of account; if it was primarily a valuable commodity that everyone wanted, then it was, perhaps, the centerpiece of a barter-based system rather than a true currency. b. If we viewed this as a traditional currency, then we could characterize the opening of new mines as a potential source of hyper-inflation; the value of a given amount of salt would weaken, leading to rising “prices” in salt. Given the context, however, the opening of new mines could make salt useless as a currency—given a new abundance of salt, it may lose almost all of its value in a barter-based system. Either way, the value of salt would be severely weakened—leading, likely, to its abandonment as a currency. 4.Bitcoins are defined as a “peer-to-peer decentralized digital currency.” The supply of bitcoins is not controlled by the government or any other central agency. The value of each bitcoin is determined on the basis of supply and demand and is defined in terms of dollars. New bitcoins can be generated through a process called “mining.” However, new bitcoins will not be created once there are a total of 21 million bitcoins in existence. Some commentators feel that bitcoins can eventually replace most of the major currencies in the world. Would you agree? Explain your answer. Answer: The bitcoin in its present form is not likely to replace any of the major currencies of the world. Bitcoin deposits, unlike bank deposits, are not insured by the government. Also, the value of a bitcoin is highly volatile, so bitcoins may not serve as a reliable store of value. Source: and that the chairperson of the Federal Reserve announced that, as of the following day, all currency in circulation in the United States would be worth 10 times its face denomination. For example, a $10 bill would be worth $100; a $100 bill would be worth $1,000, etc. Furthermore, the balances in all checking and savings accounts are to be multiplied by 10. So, if you have $500 in your checking account, as of the following day, your balance would be $5,000, etc.Would you actually be 10 times better off on the day the announcement took effect? Why or why not?Answer: Many people would not really be any “richer” on the day the announcement took effect. This is due to the fact that, as soon as the nominal value of the currency increased by a factor of ten, many prices would increase by (approximately) a factor of ten. Hence, a bottle of soda that cost $1.50 before the change would cost $15 very shortly afterward; a $700 IPad would now cost $7,000, etc. The increase might take longer for some goods than for others, but sooner or later, all prices would increase by a factor of ten.In terms of the goods whose prices can change quickly in response to the chairperson’s announcement, you are no better off than before the change in currency and deposit denomination. Money’s ultimate value is the goods and services for which it can be exchanged. For many goods, this will not have changed when the money stock and prices have increased by the same factor.However, this does not mean that all people will be unaffected by the change. If the prices of some of the goods you buy cannot increase in response to the announcement, then you are definitely richer, and the seller of the goods is definitely poorer. This would be especially true with regard to some loan arrangements. For example, if you have a $200,000 mortgage on a home at an interest rate of 4 percent, then you owe $8,000 each year, which is stipulated in the mortgage contract. This amount cannot change in response to the Fed’s announcement. After that announcement, that $8,000 obligation will not change, but $8,000 in nominal terms buys considerably less in real terms than it did before the announcement. Hence, the bank is definitely poorer, while the borrower is definitely richer.However, the prices of the majority of goods and services will increase by a factor of ten fairly quickly, and eventually, the prices of all goods and services will increase by that factor.6.According to the BBC, inflation in the country of Zimbabwe reached an annualized rate of 231,000,000 percent in October of 2008. Prices got so high that in January of 2009 the country’s central bank—the Reserve Bank of Zimbabwe—introduced a $100 trillion bill.(Sources: ; )Read the summary of Zimbabwe’s experience with hyperinflation in Wikipedia (). How does the history of hyperinflation in the country illustrate the points made in the chapter regarding the root causes, costs, and benefits of inflation? What were some of the adaptations that citizens of the country used to cope with the situation?Answer: The chapter stresses that, in accordance with the quantity theory of money, the root cause of inflation is a rate of increase in the money supply that exceeds the rate of growth of real GDP. This was certainly the case in Zimbabwe. According to the article, Zimbabwe was printing money aggressively in order to fund its involvement in foreign wars, as well as to pay higher salaries to military and political officials. Costs to the Zimbabwe economy were also in line with those detailed in the chapter. Businesses faced such severe logistical problems and uncertainty that many ceased to function. People were forced to spend significant time and effort simply to carry out routine errands. Basically, the country’s economy faced such chaos that it simply collapsed. Also mentioned in the chapter are the undesirable political consequences that can follow from inflation, as the government introduces counterproductive policies to cope with the situation. These reached an extreme in Zimbabwe, where the government introduced higher and higher denomination banknotes, stifled political opponents, and tried to declare price increases “illegal,” the ultimate form of price controls!The only beneficiary of Zimbabwe’s hyperinflation (temporarily, at least) was the government of dictator Robert Mugabe, which did reap the seignorage mentioned in the chapter. Wikipedia mentions several of the adaptations that evolved to meet the crisis: initially, redenomination of the currency; later, the use of foreign currencies—especially the U.S. dollar; and the flourishing of an underground economy in U.S. dollars.7.The following table shows the cost of producing dollar notes of various denominations. As you can see in the table, it costs only 12.7 cents to produce a $100 bill. Suppose the government decides that it will print new notes to fund its fiscal deficit as well as all its ongoing expenditures. What would be the effects of such a policy?Note DenominationCost of Production$1 and $25.4 cents per note$511.5 cents per note$1010.9 cents per note$20 $5012.2 cents per note 19.4 cents per note$10015.5 cents per noteAnswer: Printing paper money has small direct cost to the Bureau of Engraving and Printing and gives the government money to spend. But printing too much money can backfire. If a currency has a very high rate of inflation, nobody will want to hold it, not even the country’s own citizens. People will start to switch to other less inflationary currencies. Consequently, printing too much money will cause a currency to lose value sharply. However, there may a lag between when a government prints and spends the money, and when inflation becomes a serious problem. So initially at least, government benefits, but eventually, everyone, including the government, won’t be able to get many goods and services in exchange for the newly printed currency.Data taken from: 8. Up until the late nineteenth century, it was quite common to use gold and silver coins as a medium of exchange. When governments needed money, often it would mint the coins again and replace some of the gold or silver with iron. What would have been the effect of such a policy? Answers:Eventually this led to inflation. People soon found out that the gold amount in the coin was less than it used to be and, therefore, prices increased proportionately. However, typically by that time the government that needed the money, has already used those funds to purchase the goods it needed. If a government did this too often, people would become less trusting of the coins in circulation and may have resorted to gold coins printed by a country where the coins were more stable. 9.From 2001 to 2006, Japan’s central bank, the Bank of Japan (BOJ), engaged in a monetary policy program called quantitative easing. The BOJ increased the quantity of the excess reserves that commercial banks held with the central bank by?buying assets from?these commercial banks. Use a graph to show how this policy is likely to have affected the overnight call rate. The overnight call rate in Japan is similar to the federal funds rate in the United States. Answer: The federal funds rate is a short-term nominal interest rate at which banks lend to each other in the federal funds market. The overnight call rate is Japan’s federal funds rate. When the BOJ increases the level of reserves held at commercial banks, it buys assets like government bonds from these banks. In turn, it gives private banks electronic reserves. This shifts the supply curve for reserves from S1 to S2. Assuming that the demand for reserves remains the same, the overnight call rate will fall from R1 to R2. Through its quantitative easing program, the BOJ had intended to lower the overnight call rate to close to 0 percent. 10. During the financial crisis of 2007-2008, many central banks, including the Federal Reserve and the Bank of Japan, lowered their federal funds rate (or the non-U.S. equivalent) to around zero. The Bank of Japan took an additional, unusual measure: it introduced a negative short-term interest rate on excess reserves. Faced with a negative interest rate, banks must pay to lend their excess reserves to other banks. How would this policy change the incentives of banks? Based on what we learned in this chapter, why might a central bank choose to lower interest rates on reserves below zero?Answer:If banks now have to pay to lend their excess reserves to other banks, they’re better off reducing their excess reserves and lending that money to consumers. Thus, the demand for reserves will shift to the left, leading to a lower federal funds rate—and, ultimately, lower nominal and real long-term interest rates. We’ve seen that, in times of economic downturns, central banks lower interest rates as a stimulus-allowing companies to more easily take out loans and hire employees, allowing individual consumers to spend more money. However, if the interest rates are already close to zero, the bank would be limited in its policy options. With limited maneuverability, central banks might be tempted to take the extreme measure of using negative interest rates—here, on excess reserves—to further manipulate the federal funds market and continue to stimulate the economy. 11.12. The chapter discusses different models of how people form their expectations regarding inflation. Consider the following two investors, who are trying to forecast what inflation will be for next year. Sean reasons as follows: “Inflation was 2.5 percent last year. Therefore, I think it is likely to be 2.5 percent this year.” Carlos, on the other hand, thinks this way: “The economy has recovered from recession sufficiently that inflationary pressures are likely to build. Likewise, a weaker dollar means that imports are going to be more expensive. I don’t think the Fed will risk slowing the recovery and raising unemployment by raising interest rates to fight inflation. So, in light of all these factors, I expect inflation to increase to 5 percent next year.”Using the terminology mentioned in the chapter, explain how you would best describe how each investor is forming his expectations of inflation. Which description better fits your own forecasts of inflation?Answer: Sean is typical of those who formulate their forecasts using adaptive expectations. This involves using past patterns or trends to project what is likely to happen in the future. Carlos, however, is forming his opinion based on what economists call rational expectations. In this approach, expectations are formed not just based on the past, but on all information available at the time. So in forming expectations of inflation, an investor considers such things as the state of the macroeconomy as a whole, various monetary policies, the behavior of exchange rates, etc.Adaptive expectations are necessarily backward looking. They assume that the past is the best guide to the future. Economic history is replete with examples where this has not been the case. Dramatic unexpected events can occur, past trends abruptly reverse, and patterns that have been reliable guides in the past can suddenly disappear. All of this makes adaptive expectations a problematic way to formulate forecasts.Rational expectations, on the other hand, require a level of rationality and objectivity that few people can actually achieve. Moreover, the sheer volume of information involved and the degree of sophistication necessary to understand and process that information are beyond the ability of most people.Of course, student answers to the last part of the question will vary. ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download