Chapter 21The Monetary System

1. Multiple Choice Q1

The money supply includes all of the following EXCEPT

metal coins.

paper currency.

lines of credit accessible with credit cards.

bank balances accessible with debit cards.

Explanation:

The money supply includes currency (paper bills and coins) and demand deposits (balances in

bank accounts accessible by personal check or debit card), but not lines of credit accessible with

credit cards. See Section: Money in the U.S. Economy.

2. Multiple Choice Q2

Chloe takes $100 of currency from her wallet and deposits it into her checking account.

If the bank adds the entire $100 to reserves, the money supply ________, but if the bank lends

out some of the $100, the money supply ________.

increases, increases even more

increases, increases by less

is unchanged, increases

decreases, decreases by less

Explanation:

Depositing money into a bank reduces currency and increases demand deposits by equal amounts.

If the bank keeps this entire deposit as part of its reserves, the $100 deposit has no effect on the

money supply. However, if the bank lends a portion of this deposit—say, $10—that portion now

exists both as a demand deposit and as currency, thereby increasing the money supply. See

Section: Money Creation with Fractional Reserve Banking.

If the reserve ratio is ¼ and the central bank increases the quantity of reserves in the banking

system by $120, the money supply increases by

$90.

$150.

$160.

$480.

Explanation:

The amount of money the banking system generates with each dollar of reserves is called the

money multiplier, which is the reciprocal of the reserve ratio. If the reserve ratio is ¼, the money

multiplier is equal to 4, and a $120 increase in reserves will increase the money supply by . See

Section: Money Creation with Fractional Reserve Banking.

4. Multiple Choice Q4

A bank has capital of $200 and a leverage ratio of 5. If the value of the bank’s assets declines by

10 percent, then its capital will be reduced to

$100.

$150.

$180.

$185.

Explanation:

The leverage ratio is the ratio of the bank’s total assets to bank capital. When assets decline by a

given percentage, the value of capital declines by that amount times the leverage ratio. In this

case, 10 percent times a leverage ratio of 5 means a 50% decline in capital, or $200-(0.5 x $200)

= $100 . See Section: Bank Capital, Leverage, and the Financial Crisis of 2008–2009.
5. Multiple Choice Q5

Which of the following actions by the Federal Reserve would reduce the money supply?

an open-market purchase of government bonds

a reduction in banks’ reserve requirements

an increase in the interest rate paid on reserves

a decrease in the discount rate on Fed lending

Explanation:

An increase in the interest rate paid on reserves would reduce the money supply. The more

interest banks receive on reserves, the more incentive they have to hold on to reserves rather

than make loans, and the lower the reserve ratio. A lower reserve ratio means a lower money

multiplier and, in turn, a lower money supply. See Section: How the Fed Influences the Reserve

Ratio.

6. Multiple Choice Q6

In a system of fractional-reserve banking, even without any action by the central bank, the money

supply declines if households choose to hold ________ currency or if banks choose to hold

________ excess reserves.

more, more

more, less

less, more

less, less

Explanation:

The more money households hold (and thus the less they deposit), the less reserves banks have,

and the less money the banking system can create. Similarly, the more excess reserves banks

choose to hold, the fewer loans they make, and the less money the banking system can create.

See Section: Problems in Controlling the Money Supply.

Indicate whether each of the following function as a medium of exchange, a unit of account, or a

store of value in the U.S. economy. Check all that apply.

Medium of Exchange Unit of Account Store of Value

U.S. penny

Mexican peso

Picasso painting

Plastic credit card

Given your answers to the previous task, indicate whether each of the following is considered

money in the U.S. economy.

Money

Yes No

U.S. penny

Mexican peso

Picasso painting
 Money

Yes No

Plastic credit card

Your uncle repays a $100 loan from Tenth National Bank (TNB) by writing a $100 check from his

TNB checking account. Assume these funds are the only loans and deposits available for your

uncle and the bank.

Complete the following T-accounts for your uncle and TNB before your uncle repays the loan.

Explanation:

A T-account is a simplified accounting statement that shows changes in a bank’s or individual’s

assets and liabilities. When your uncle takes out a loan of $100 from TNB and deposits it into his

checking account, this increases his assets by $100 but also increases his liability by $100 because

the money represents a loan. From the bank’s perspective, the loan increases its assets by $100

but also increases its liability by $100 when your uncle deposits the money into his checking

account. See Section: The Simple Case of 100–Percent-Reserve Banking.

Complete the following T-accounts for your uncle and TNB after your uncle repays the loan.
Explanation:

A T-account is a simplified accounting statement that shows changes in a bank’s or individual’s

assets and liabilities. When your uncle repays a $100 loan from Tenth National Bank by writing a

check from his TNB checking account, the result is a change in the assets and liabilities of both

your uncle and TNB to $0. See Section: The Simple Case of 100–Percent-Reserve Banking.

True or False: Your uncle’s wealth has changed.

True

False

Explanation:

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. See Section: The Meaning of Money.

Beleaguered State Bank (BSB) holds $250 million in deposits and maintains a reserve ratio of 10

percent.

Now suppose that BSB’s largest depositor withdraws $10 million in cash from her account. BSB

decides to restore its reserve ratio by reducing the amount of loans outstanding.
Because BSB is cutting back on its loans, other banks will find they have too little reserves,

causing them to decrease their loans

Explanation:

Because BSB is cutting back on its loans, other banks will find themselves short of reserves, and

they may also cut back on their loans. See Section: Money Creation with Fractional Reserve

Banking.

BSB may find it difficult to cut back on its loans immediately because it cannot force people to pay

off loans.

Which of the following ways represent an alternative for BSB to return to its original reserve

ratio? Check all that apply.

Lend money

Attract additional deposits

Borrow money from another bank

Borrow money from the Fed

Explanation:

Because BSB cannot force people to pay off loans, BSB may find it difficult to cut back on its loans

immediately since it can only stop making new loans. Therefore, for a time, it might find itself with

more loans than it wants. As alternatives, it could try to attract additional deposits to get

additional reserves or borrow from another bank or from the Fed. See Sections: Money Creation
with Fractional Reserve Banking; and How the Fed Influences the Quantity of Reserves.
10. Problems and Applications Q4

You take $100 you had kept under your mattress and deposit it in your bank account. Suppose

this $100 stays in the banking system as reserves and banks hold reserves equal to 10 percent of

deposits.

$1000
The total amount of deposits in the banking system increases by , and the money
$900
supply increases by
11. Problems and Applications Q5

Happy Bank starts with $200 in bank capital. It then takes in $800 in deposits. It keeps 12.5

percent (1/8th) of deposits in reserve. It uses the rest of its assets to make bank loans.

Complete the following balance sheet for Happy Bank.

The Federal Reserve conducts a $10 million open-market purchase of government bonds.
13. Problems and Applications Q7

Assume that the reserve requirement is 5 percent.

True or False: All other things equal, the money supply will expand more if the Federal Reserve

buys $2,000 worth of bonds than if someone deposits in a bank $2,000 that she had been hiding

in her cookie jar.

True

False
Explanation:

The money supply will expand more if the Fed buys $2,000 worth of bonds. Both deposits will lead

to monetary expansions, but the Fed’s deposit is new money, whereas the $2,000 from the cookie

jar is already part of the money supply. See Section: The Money Multiplier.

.
14. Problems and Applications Q8

Suppose that the reserve requirement for checking deposits is 10 percent and that banks do not

hold any excess reserves.

Explanation:

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 supply. See Sections: The Money Multiplier; and How the Fed Influences the Quantity of

Reserves.
15. Problems and Applications Q9

Assume that the banking system has total reserves of $100 billion. Assume also that required

reserves are 10 percent of checking deposits and that banks hold no excess reserves and

households hold no currency.

10
The money multiplier is .

$1000
The money supply is billion.

Suppose the Fed raises required reserves to 20 percent of deposits.

5 $500
The new money multiplier is , and the money supply__decrease_ to

billion.
16. Problems and Applications Q10

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 using open-market operations.

The economy of Elmendyn contains 2,000 $1 bills.

For each of the following scenarios, determine the quantity of money in this economy.

Quantity of Money

Scenario

$2,000 $1,818 $3,636 $10,000 $20,000

People hold all money as currency.

People hold all money as demand deposits, and banks maintain

People hold equal amounts of currency and demand deposits,

and banks maintain 100 percent reserves.

People hold all money as demand deposits, and banks maintain

a reserve ratio of 10 percent.

People hold equal amounts of currency and demand deposits,

and banks maintain a reserve ratio of 10 percent.