Chapter 27: Money, Banking, and the Financial Sector



CHAPTER 10: THE FINANCIAL SECTOR AND THE ECONOMYQuestions and Exercises1.Money doesn't have to have any inherent value to function as a medium of exchange. All that's necessary is that everyone believes that other people will accept it in exchange for their goods. This is the social convention that gives money value.2.Money functions as a medium of exchange, a unit of value, and a store of wealth.3.a.Money: Funds held in a checking account are considered money.b.Not money: Foreign currencies are not accepted in exchange for other goods so Brazilian reals do not qualify as money in the United States.c. Not money: Credit cards are a form of instant loan, but they are not considered money because they create a financial liability for their users, rather than for a bank.d. Not money: Only currency held by the public, not currency held by banks, is counted as money.e. Money: Currency held by the public (Federal Reserve notes) is considered money. f. Not money: Gold is neither highly liquid nor generally accepted in exchange for other goods, so it does not fit the definition of money.g.Not money: Coupons are only accepted in exchange for a very specific set of goods, and it cannot be used as a reference in valuing other goods, so it is not considered money4.Money serves as a unit of account when people compare prices between goods.5.Inflation reduces money’s function as a store of wealth because it reduces how much can be purchased with a given amount of money (lowers money’s value). 6.There are three components of M2 that are not components of M1: small-denomination time deposits, savings and money market accounts, and retail money funds. The question asks for two.7.a. State and local government bonds are neither included in M1 nor in?M2. ?b. Checking accounts are included in M1?and must therefore also be included in M2.c. Money market deposit accounts are only included in M2.d. Currency is included in M1?and must therefore also be included in M2.e. Stocks are neither included in M1 nor in?M2.f. Corporate bonds are neither included in M1 nor in?M2.8.a. M1 declines by $150. Nothing happens to M2 as both?cash?and deposits in savings accounts are included in M2.b.Nothing happens to M1?since neither CDs nor money market mutual funds are included in M1.?Nothing happens to M2 as the decrease in the CD and the increase in the money market mutual fund cancel each other?out.c.M1 rises by $50. Nothing happens to M2 as both?cash?and deposits in savings accounts are included in M2.9. Banks earn revenue by lending others money out of deposits given to the bank. They can do so because at any specific day only a fraction of their deposits are withdrawn, and they hold just a fraction of their total deposits as reserves. So if everyone tried to withdraw their deposits at the same time, the bank would not have enough money on hand to let them do so: this could only be done if all borrowers repaid their loans at the same time. (Note: From Don Leet and Scott Houser, Journal of Economic Education, Fall 2003.)10.If individuals hold no cash, the money multiplier is the reciprocal of the reserve requirement. Thus for the following reserve requirements the money multiplier is found by dividing the requirement percentage into 1: 5 percent: (1/0.05) = 2010 percent: (1/0.10) = 1020 percent: (1/0.20) = 525 percent: (1/0.25) = 450 percent: (1/0.50) = 275 percent: (1/0.75) = 1.33100 percent: (1/1) = 111.If the U.S. government were to raise the reserve requirement to 100 percent, the interest rates banks pay to depositors would decrease and possibly even become negative (you’d have to pay to have the bank handle your money), because significant opportunities for profitable loans would be lost, leaving banks with no other way to make revenue.12.a.The bank can initially lend out $100 – (0.05 × 100) = $95.b.There is now an additional ($100 + $95) = $195 in the economy.c.The multiplier is 1/0.05 = 20.d.John’s $100 will ultimately turn into $100 × 20 = $2,000 of money in the economy.13.False. Policy makers do not use the money multiplier to determine the amount of reserves needed to achieve the desired money supply because people hold cash and banks hold excess reserves. These vary significantly, often offsetting the change in the money supply that would have occurred from the Fed’s action. This makes the total money supply endogenous. That is, the money multiplier is the result of a process, not the driving force of money creation. 14.Although financial institutions don't produce any tangible real assets, they are nonetheless considered a vital part of the economy because of their central role in transferring savings into investment and in making the real economy more efficient.15.The two roles of the financial sector are to facilitate trade and transfer savings back into spending.16.a.Expanding spending too quickly might create inflationb.Globalization kept inflation low in the period from 2000 to 2007 because foreign firms could sell products at much lower prices than could domestic firms. 17.a.Transactions motiveb.Precautionary motive c.Speculative motive d. Transactions motive18.People will increase the amount of money they hold, and sell bonds, if they expect interest rates to rise in the future because the price of those bonds will be falling.19.Short-term interest rates are determined in the money market.Questions from Alternative Perspectives1. Austriana.Yes, money could be privately supplied. Economists disagree as to whether the government ought to be the monetary authority. Austrians believe that the monetary system works better the less government is involved.b.Yes, money has been supplied privately. (See the work of Lawrence White and his former student George Selgin.) People knew its value in the same way they know the value of anything—by the information generated in the market by what people would give them in exchange for the money.2. Feminista.Since its inception only a very small percentage of the governors have been women. See: .b.Currently, (as of 2018) about all that one can say about the current members is that they are people with a background in economics (there are currently three women on the board, a historically high number). 3. InstitutionalistTwo examples include judging the value of someone by the clothes they wear: "Did you see Sue; it looks like she got her clothes at the Salvation Army"; and people’s discussions about how much money they have made on their houses: "My house has gone up $40,000 in value last year." There are many more. 4. Post-Keynesiana.Post-Keynesians believe that the money supply is much more endogenous than is suggested by the textbook presentation. b.Post-Keynesians see the money supply being determined by the supply and demand of banks and depositors for financial instruments, which means that when the Fed changes high-powered money, banks and individuals change their actions so that the Fed’s actions are offset. For example, instead of increasing lending in response to an increase in high-powered money, banks simply increase their excess reserves. Post-Keynesians may believe that the central bank influences the creation of money, but does not determine it, and often has a difficult time influencing it in the way it wants to. 5. Religiousa.In profit sharing the lender has a stronger stake in the business, and the payment he receives depends on how well the business does. b.In an interest paying system, a failed business could be forced to pay back the debt even though the business was not a success. In a profit sharing system, that would not be the case, making it less exploitative.Issues to Ponder1.Money is to the economy as oil is to an engine because money is a financial asset that makes the real economy function smoothly by serving as a medium of exchange, a unit of account, and a store of wealth. Without it, the economy comes to a screeching halt.2.To be considered money, the currencies would have to fulfill the functions of money. They only partially fulfill those functions since they have only limited acceptability as a medium of exchange, store of value, and unit of account. Thus, while these monies partially fulfill the functions of money, we would not consider them full monies.3.a.No, because they are hard to move. In this case, pearl shells were used for small transactions. b.It would lower the value of the stones, causing a general inflation in prices.c.If they could be distinguished, which in this case they could, the new stones would sell at a discount to the older stones, which they did.d.It depends, in some ways money is a marker of individuals’ “gifts to the marketplace.” Oftentimes, however, people assume that wealthy individuals got their money at the expense of others.4. a.As more counterfeit money is printed and not identified as counterfeit, the value of money circulated will decline.b.As businesses become suspicious of currency that is circulated, they will favor cashless transactions such as checks or debit cards, and likely offer benefits for using such payment methods. In this case, the volume of cashless transactions will increase.c.As counterfeiting increases, the U.S. Treasury will likely spend more to introduce additional security measures. The cost of not doing so will be the loss in the purchasing power of circulating money and the loss to businesses that accept identified counterfeit currency.APPENDIX: A CLOSER LOOK AT FINANCIAL ASSETS AND LIABILITIES1.Students gain a financial asset and the government incurs a financial liability.2.It is a financial asset because it has value due to an offsetting liability of the Federal Reserve Bank.3.No. In economic terminology he is saving. Investing is the act of spending the money on real investment goods in economic terminology.4.No, she is not correct. While a loan is a loan, that loan is a financial asset to the one issuing the loan because it has value just as a bond does.5.$2.506.$0.507.At a 6% interest rate, $2,000 five years from now is worth $1,500 today, so take the $2,000 five years from now (assuming you don't really need the money right away). At a 10% interest rate, the $2,000 five years from now is worth about $1,241, so take the $1,400 today. 8.a.Market rates are likely to be above 10 percent because the price of the bond is below face value.b.Its yield is 12.24 percent.c.Its price would rise.9.As interest rates rise, one would have to save less money today to get $100 in ten years, so the present value falls. 10.Substituting into the present value formula PV = $1,060/1.1, we find that the bond is worth $964 now.11.Using the annuity table, we find that a dollar a year for 40 years with a 6 percent interest rate is worth $15.05 now. Thus $100 would be worth $1,505.12.Using the present-value table A29-1, we see that at a 3 percent interest rate, the value today of $1 paid 30 years from now is $0.41, so $200 in 30 years would be worth $82 now.13.Since we're not sure how long your expected lifetime is, we can use the annuity rule which says that the present value of an annuity is the flow of income divided by the interest rate, which in this case would be $200/.09 = $2,222.22. You should be willing to pay no more than $2,222.22 for that annuity. The amount you are willing to pay does depend on your expectations about future changes in the interest rate and about your own life expectancy; if you expected the interest rate to decline in the future, you would be willing to pay more than $2,222.22, whereas if you expect to live for only a few more years, you would be willing to pay less.14.If the interest rate is still 9 percent, the value of a lump sum of $20,000 in 10 years can be calculated using the present-value table in Table A29-1. You should be willing to pay $20,000 × 0.42, or about $8,400 for this offer.15.To find the present value of a perpetuity of $100 per year, use the annuity rule, which says that the present value is equal to the amount of the cash flow divided by the interest rate. Thus the present value will be: $1,000 if the interest rate is 10 percent; $2,000 if the interest rate is 5 percent; $500 if the interest rate is 20 percent.a.Using the same interest rates, the future values of $100 are: $110 in one year and $121 in two years at 10 percent; $105 in one year and $110.25 in two years at 5 percent; and $120 in one year and $144 in two years at 20 percentb.Using the rule of 72, your money will double in: about 7.2 years at 10 percent, about 14.4 years at 5 percent, and about 3.6 years at 20 percent. 16.a.Agree and disagree. Technically, a rise in stock prices does not imply a richer economy. If, however, the rise in stock prices reflects underlying real economic improvement such as finding the cure for cancer or a technological advance, society will be richer not because of the rise in stock prices, but because of the underlying cause of their rise.b.Disagree. If both the real and financial assets are worth $1 million, then they have the same value as long as they are valued at market prices. Just as financial assets bear a risk of no repayment, real assets bear a risk of a fluctuation in prices.c.Disagree. Financial assets facilitate trades that could not otherwise have taken place and thus have enormous value to society.d.Disagree. The value of an asset depends not only on the quantity but also on its price per unit. The price of land per acre in Japan exceeds that in the United States by so much that the total value of land in Japan also exceeds that in the United States.e.Disagree. The stock market valuation depends on the supply and demand for existing stocks. There is, however, a relationship between relative growth in GDP and the rise in stock prices to the extent that growth in stock prices and GDP growth both reflect economic well-being in a country. Also, many of the companies are multinational companies, and where the company is based may not reflect where its value added is generated. ................
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