CHAPTER 29

SOLUTIONS TO TEXT PROBLEMS:

The three functions of money are: (1) medium of exchange; (2) unit of account; and (3)
store of value. Money is used as a medium of exchange because money is the item
people use to purchase goods and services. Money is used as a unit of account because it
is the yardstick people use to post prices and record debts. Money is used as a store of
value because it is an item people use to transfer purchasing power from the present to
the future.

2.

The primary responsibilities of the Federal Reserve are to regulate banks, ensuring the
health of the banking system, and to control the quantity of money that is made available
in the economy. If the Fed wants to increase the supply of money, it usually does so by
creating dollars and using them to purchase government bonds from the public in the
nations bond markets.

3.

Banks create money when they make loans and hold a fraction of the amount of the loans
in reserves, resulting in an expansion of both money and credit in the economy. If the
Fed wanted to use all three of its tools to decrease the money supply, it would: (1) sell
government bonds from its portfolio in the open market to reduce the number of dollars
in circulation; (2) increase reserve requirements to reduce the money created by banks;
and (3) increase the discount rate to discourage banks from borrowing reserves from the
Fed.

Questions for Review

Money is different from other assets in the economy because it is the most liquid asset
available. Other assets vary widely in their liquidity.

2.

Commodity money is money with intrinsic value, like gold, which can be used for
purposes other than as a medium of exchange. Fiat money is money without intrinsic
value; it has no value other than its use as a medium of exchange. Our economy today
uses fiat money.

3.

Demand deposits are balances in bank accounts that depositors can access on demand
simply by writing a check. They should be included in the stock of money because they
can be as a medium of exchange.

4.

The Federal Open Market Committee (FOMC) is responsible for setting monetary policy
in the United States. The FOMC consists of the seven members of the Federal Reserve
Board of Governors and five of the 12 presidents of Federal Reserve Banks. Members of
the Board of Governors are appointed by the president of the United States and confirmed
1

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by the U.S. Senate. The presidents of the Federal Reserve Banks are chosen by each
banks board of directors.
5.

If the Fed wants to increase the supply of money with open-market operations, it
purchases U.S. government bonds from the public on the open market. The purchase
increases the number of dollars in the hands of the public, thus raising the money supply.

6.

Banks do not hold 100 percent reserves because it is more profitable to use the reserves to
make loans, which earn interest, instead of leaving the money as reserves, which earn no
interest. The amount of reserves banks hold is related to the amount of money the
banking system creates through the money multiplier. The smaller the fraction of reserves
banks hold, the larger the money multiplier, since each dollar of reserves is used to create
more money.

7.

The discount rate is the interest rate on loans that the Federal Reserve makes to banks. If
the Fed raises the discount rate, fewer banks will borrow from the Fed, so banks' reserves
will be lower, and thus the money supply will be lower.

8.

Reserve requirements are regulations on the minimum amount of reserves that banks
must hold against deposits. An increase in reserve requirements raises the reserve ratio,
lowers the money multiplier, and decreases the money supply.

9.

The Fed cannot control the money supply perfectly because: (1) the Fed does not control
the amount of money that households choose to hold as deposits in banks; and (2) the Fed
does not control the amount that bankers choose to lend. The actions of households and
banks affect the money supply in ways the Fed cannot perfectly control or predict.

Problems and Applications

a.

A U.S. penny is money in the U.S. economy because it is used as a medium of

b.

A Mexican peso is not money in the U.S. economy, because it is not used as a
medium of exchange, and prices are not given in terms of pesos, so it is not a unit
of account. It could serve as a store of value, though.

c.

A Picasso painting is not money, because you cannot exchange it for goods or
services, and prices are not given in terms of Picasso paintings. It does, however,
serve as a store of value.

d.

A plastic credit card is similar to money, but represents deferred payment, rather
that immediate payment. So credit cards do not fully represent the medium of
exchange function of money, nor are they really stores of value, since they

Chapter 29/The Monetary System 3

represent short-term loans rather than being an asset like currency.

3.

a.

It would be difficult to run the economy using the "Swopper's Column" instead of
money because it requires finding a double coincidence of wants. Money works
efficiently because it requires satisfying people's needs on just one side of each
transaction; you buy something for money and sell something else for money.
With money, you do not have to buy something from someone who wants an item
you're selling.

b.

The "Swopper's Column" probably exists so that people can avoid paying taxes on
things they buy and sell.

For an asset to be useful as a medium of exchange, it must be widely accepted (so all
transactions can be made in terms of it), recognized easily as money (so people can
perform transactions easily and quickly), divisible (so people can provide change), and
difficult to counterfeit (so people will not print their own money). That is why nearly all
countries use paper money with fancy designs for larger denominations and coins for
smaller denominations.
For an asset to be useful as a store of value, it must be something that maintains its value
over time and something that can be used directly to buy goods and services or sold when
money is needed. In addition to currency, financial assets (like stocks and bonds) and
physical assets (like real estate and art) make good stores of value.

4.

a.

If there were an easy way to make limestone wheels, the people on Yap would
make additional wheels as long as the monetary value of the wheels was greater
than the cost of producing the wheels. The result would be that people would
make their own money, so there would be too much money produced. Most
likely, people would stop accepting the wheels as money and switch to some other
asset as a medium of exchange.

b.

If someone in the United States discovered an easy way to counterfeit hundreddollar bills, they could flood the country with counterfeit currency, thus reducing
its value. The result might be a switch to a different type of currency.

5.

Many answers are possible.

6.

When your uncle repays a $100 loan from Tenth National Bank (TNB) by writing a check
from his TNB checking account, the result is a change in the assets and liabilities of both

Chapter 29/The Monetary System 4

your uncle and TNB, as shown in these T-accounts:

Liabilities
$100 Loans

$100

$0 Loans

$0

Tenth National Bank

Liabilities
$100 Deposits

$100

$0 Deposits

$0

By paying off the loan, your uncle simply eliminated the outstanding loan using the assets
in his checking account. Your uncle's wealth has not changed; he simply has fewer assets
and fewer liabilities.
7.

a.

Here is BSB's T-account:

Reserves
Loans
b.

Beleaguered State Bank

$250
million

$225
million

When BSB's largest depositor withdraws $10 million in cash and BSB reduces its
loans outstanding to maintain the same reserve ratio, its T-account is now:

Reserves
Loans

Beleaguered State Bank

$240
million

$216
million

c.

Since BSB is cutting back on its loans, other banks will find themselves short of
reserves and they may also cut back on their loans as well.

d.

BSB may find it difficult to cut back on its loans immediately, since it cannot
force people to pay off loans. Instead, it can stop making new loans. But for a

Chapter 29/The Monetary System 5

time it might find itself with more loans than it wants. It could try to attract
additional deposits to get additional reserves, or borrow from another bank or
from the Fed.
8.

If you take $100 that you held as currency and put it into the banking system, then the
total amount of deposits in the banking system increases by $1,000, since a reserve ratio
of 10 percent means the money multiplier is 1/.10 = 10. Thus the money supply increases
by $900, since deposits increase by $1,000 but currency declines by $100.

9.

With a required reserve ratio of 10 percent, the money multiplier could be as high as
1/.10 = 10, if banks hold no excess reserves and people do not keep some additional
currency. So the maximum increase in the money supply from a $10 million openmarket purchase is $100 million. The smallest possible increase is $10 million if all of
the money is held by banks as excess reserves.

10.

a.

If the required reserve ratio is 5 percent, then First National Bank's required
reserves are $500,000 x .05 = $25,000. Since the banks total reserves are
$100,000, it has excess reserves of $75,000.

b.

With a required reserve ratio of 5 percent, the money multiplier is 1/.05 = 20. If
First National lends out its excess reserves of $75,000, the money supply will
eventually increase by $75,000 x 20 = $1,500,000.

a.

With a required reserve ratio of 10 percent and no excess reserves, the money
multiplier is 1/.10 = 10. If the Fed sells $1 million of bonds, reserves will decline
by $1 million and the money supply will contract by 10 x $1 million = $10
million.

b.

Banks might wish to hold excess reserves if they need to hold the reserves for
their day-to-day operations, such as paying other banks for customers'
transactions, making change, cashing paychecks, and so on. If banks increase
excess reserves such that there is no overall change in the total reserve ratio, then
the money multiplier does not change and there is no effect on the money stock.

a.

With banks holding only required reserves of 10 percent, the money multiplier is
1/.10 = 10. Since reserves are $100 billion, the money stock is 10 x $100 billion
= $1,000 billion.

b.

If the required reserve ratio is raised to 20 percent, the money multiplier declines
to 1/.20 = 5. With reserves of $100 billion, the money stock would decline to
$500 billion, a decline of $500 billion. Reserves would be unchanged.

a.

If people hold all money as currency, the quantity of money is $2,000.

b.

If people hold all money as demand deposits at banks with 100 percent reserves,
the quantity of money is $2,000.

11.

12.

13.

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c.

If people have $1,000 in currency and $1,000 in demand deposits, the quantity of
money is $2,000.

d.

If banks have a reserve ratio of 10 percent, the money multiplier is 1/.10 = 10. So
if people hold all money as demand deposits, the quantity of money is 10 x
$2,000 = $20,000.

e.

If people hold equal amounts of currency (C) and demand deposits (D) and the
money multiplier for reserves is 10, then two equations must be satisfied:
(1) C = D, so that people have equal amounts of currency and demand deposits;
and (2) 10 x ($2,000 - C) = D, so that the money multiplier (10) times the number
of dollar bills that are not being held by people ($2,000 - C) equals the amount of
demand deposits (D). Using the first equation in the second gives 10 x ($2,000 D) = D, or $20,000 - 10 D = D, or $20,000 = 11 D, so D = $1,818.18. Then C =
$1,818.18. The quantity of money is C + D = $3,636.36.