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© 2013 Pearson

© 2013 Pearson

© 2013 Pearson

The Monetary System

27

CHECKPOINTS

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© 2013 Pearson

Problem 1

Problem 2

Problem 1

Problem 2

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Problem 3

Problem 1

Problem 2

Problem 3

Checkpoint 27.1

Checkpoint 27.2

Checkpoint 27.3

Problem 4

Problem 4

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In the news

In the news

Problem 3

In the news

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© 2013 Pearson

Problem 1

Problem 2

Problem 3

Checkpoint 27.4

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In the news

© 2013 Pearson

Practice Problem 1

In the United States today, money includes which of the
following items?



Your Visa card



The quarters inside vending machines



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 27.1

© 2013 Pearson

Solution

Money is defined as means of payment.

Only the quarters inside vending machines and U.S.
dollar bills in your wallet are money.

CHECKPOINT 27.1

© 2013 Pearson

Study Plan Problem


In the United States today, money includes
___________.


CHECKPOINT 27.1

A.
Your Visa card, the quarters inside vending machines,
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 vending machines.

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 vending machines, but not your Visa card.

© 2013 Pearson

Practice Problem 2

In January 2011,




Currency held by individuals and businesses was $920

billion




Traveler’s checks were $5 billion




Checkable deposits owned by individuals and businesses

were $926 billion




Savings deposits were $5,378 billion




Small time deposits were $905 billion




Money market funds and other deposits were $705

billion.

Calculate M1 and M2 in January 2011.

CHECKPOINT 27.1

© 2013 Pearson

Solution

M1 is the sum of



Currency held by individuals and businesses, $920

billion,



Traveler’s checks, $5 billion, and



Checkable deposits owned by individuals and

businesses, $926 billion.

M1 = ($920 + $5 + $926 ) billion = $1,851 billion.

CHECKPOINT 27.1

© 2013 Pearson

M2 is the sum of



M1, $1,851




Savings deposits, $5,378 billion




Small time deposits, $905 billion




Money market funds and other deposits, $705 billion

M2 = ($1,851 + $5,378 + $905 + $705) billion

M2 = $8,839 billion.

CHECKPOINT 27.1

© 2013 Pearson

Practice Problem 3

In August 2011,




M1 was $2,108 billion




M2 was $9,545 billion




Checkable deposits owned by individuals and businesses

were $1,127 billion




Time deposits were $810 billion




Money market funds and other deposits were $716

billion.

Calculate currency and traveler’s checks held by individuals
and businesses and calculate savings deposits.

CHECKPOINT 27.1

© 2013 Pearson

Solution

Currency and traveler’s checks equals M1 ($2,108 billion)
minus checkable deposits owned by individuals and
businesses ($1,127 billion).

Currency and traveler’s checks held by individuals and
businesses is $981 billion.

Saving deposits equals M2 ($9,545 billion) minus M1
($12,108 billion) minus time deposits ($810 billion) minus
money market funds and other deposits ($716 billion).

Saving deposits are $5,911 billion.

CHECKPOINT 27.1

© 2013 Pearson

In the news

The cell phone as wallet: Will the trend catch on?

In the next few years, you'll be able to pull out your cell
phone and wave it over a scanner to make a payment. The
convenience of whipping out your phone as a payment
mechanism is driving the transition.

Source: CTVNews.ca, September 24, 2011

As people use their cell phones to make payments, will
currency disappear?

How will the components of M1 change?

Will debit cards disappear?

CHECKPOINT 27.1

© 2013 Pearson

Solution

Most people will probably carry less currency, but it won’t
disappear because currency is used in the underground
economy.

Most of M1 will be checkable deposits.

Cell phones and debit cards will be perfect substitutes, so
debit cards will probably disappear.

CHECKPOINT 27.1

© 2013 Pearson

Practice Problem 1

What are the institutions that make up the U.S. banking
system?

CHECKPOINT 27.2

© 2013 Pearson

Solution

The institutions that make up the U.S. banking system are


The Fed


Commercial banks


Thrift institutions


Money market funds

CHECKPOINT 27.2

© 2013 Pearson

Study Plan Problem


The institutions that make up the U.S. banking
system are ______.


CHECKPOINT 27.2

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

© 2013 Pearson

Practice Problem 2

What is a bank’s balancing act?

CHECKPOINT 27.2

© 2013 Pearson

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 27.2

© 2013 Pearson

Study Plan Problem

What is a bank’s balancing act? A bank must
balance _______ against _____.


CHECKPOINT 27.2

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

© 2013 Pearson

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 27.2

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.


© 2013 Pearson

Solution

Total deposits are

$320 + $896 + $840 = $2,056.

CHECKPOINT 27.2

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.


© 2013 Pearson

Deposits that are part of M1
are checkable deposits,
$320.

CHECKPOINT 27.2

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.


© 2013 Pearson

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 27.2

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.


© 2013 Pearson

Practice Problem 4

A bank has the deposits and
assets set out in the table.

Calculate the bank’s




Loans




Securities




Reserves



CHECKPOINT 27.2

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.


© 2013 Pearson

Solution

Loans are loans to
businesses and outstanding
credit card balances.

Loans equal

$990 + $400 = $1,390.

CHECKPOINT 27.2

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.


© 2013 Pearson

Securities are $634.

CHECKPOINT 27.2

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.


© 2013 Pearson

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 27.2

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.


© 2013 Pearson

In the news

Regulators close Georgia bank in 95th failure for the
year

Regulators shut down Atlanta
-
based Georgian Bank. On
July 24, 2009, Georgian Bank has $2 billion in assets and

$2 billion in deposits. By 29 September, 2009, Georgian
Bank had lost about $2 billion in home loans and other
assets.

Source:
USA Today
, September 30, 2009

Explain how Georgian Bank’s balancing act failed.

CHECKPOINT 27.2

© 2013 Pearson

Solution

In July, Georgian Bank’s $2 billion of assets (home loans
and securities) balanced its deposits of $2 billion.

The bank expected to make a profit on its assets that
exceeded the interest it paid to depositors.

The financial crisis increased the risk on all financial assets.

The bank was now holding assets that were more risky
than it had planned to hold.

CHECKPOINT 27.2

© 2013 Pearson

As people defaulted on their home loans and the value of
securities fell, the value of Georgian Bank’s assets crashed
to about minus $2 billion.


With fewer assets than deposits, regulators had no choice
other than close the bank and sell its assets and deposits.

The bank failed to balance risk against profit.

CHECKPOINT 27.2

© 2013 Pearson

Practice Problem 1

What is the Fed and what is the FOMC?

CHECKPOINT 27.3

© 2013 Pearson

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 27.3

© 2013 Pearson

Study Plan Problem


The Fed is _______and the FOMC is _______.


CHECKPOINT 27.3

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

© 2013 Pearson

Practice Problem 2

Who is the Fed’s chief executive?

What are the Fed’s main policy tools?

CHECKPOINT 27.3

© 2013 Pearson

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 27.3

© 2013 Pearson

Study Plan Problem

What are the Fed’s main policy tools?


CHECKPOINT 27.3

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

© 2013 Pearson

Practice Problem 3

What is the monetary base?

CHECKPOINT 27.3

© 2013 Pearson

Solution

The monetary base is the sum of




Coins




Federal Reserve notes (dollar bills)




Banks’ reserves at the Fed

CHECKPOINT 27.3

© 2013 Pearson

Study Plan Problem


The monetary base is ______.


CHECKPOINT 27.3

A.
the sum of U.S. government securities and loans made
by the Fed to commercial banks

B.
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

© 2013 Pearson

Practice Problem 4

Suppose that at the end of December 2009,




The monetary base in the United States was $700

billion.




Federal Reserve notes were $650 billion.




Banks’ reserves at the Fed were $20 billion.

Calculate the quantity of coins.

CHECKPOINT 27.3

© 2013 Pearson

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 27.3

© 2013 Pearson

In the news

Risky assets: Counting to a trillion

Prior to the September 15, 2008, … the Fed held less than
$1 trillion in assets, most of which were in U.S. government
securities. By mid
-
December, 2008, the Fed’s balance sheet
had more than doubled to over $2.3 trillion. Much of the
increase was in mortgage
-
backed securities. The massive
expansion began when the Fed rolled out its lending
program

sending banks cash in exchange for risky assets.

Source: CNNMoney, September 29, 2009

What are the Fed’s policy tools and which policy tool did the
Fed use to increase its assets to $2.3 trillion in 2008?

CHECKPOINT 27.3

© 2013 Pearson

Solution

The Fed’s policy tools are the required reserve ratio,
discount rate, open market operations, and extraordinary
crisis measures.

The Fed used an extraordinary crisis measure called credit
easing.

The Fed’s lending program took banks’ own risky assets to
increase their reserve deposits at the Fed.

CHECKPOINT 27.3

© 2013 Pearson

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 27.4

© 2013 Pearson

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 27.4

© 2013 Pearson

Practice Problem 2

If the Fed makes an open market sale of $1 million of
securities, who can buy the securities to the Fed?

What initial changes occur in the economy if the Fed sells
to a bank?

CHECKPOINT 27.4

© 2013 Pearson

Solution

The Fed sells securities to banks or the public, but not the
government.

The initial change is an decrease in the monetary base of
$1 million.

Ownership of the securities passes from the Fed to the
bank and the Fed’s assets decrease by $1 million.

The bank pays for the securities by decreasing its
reserves at the Fed by $1 million.

CHECKPOINT 27.4

© 2013 Pearson

The Fed’s liabilities decrease by $1 million.

The bank’s assets are the same, but their composition has
changed.

The bank has $1 million less in reserves and $1 million
more in securities.


CHECKPOINT 27.4

© 2013 Pearson

Study Plan Problem


If the Fed makes an open market purchase of $1
million of securities, who can sell the securities to the
Fed?


CHECKPOINT 27.4

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

© 2013 Pearson

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 _____.


CHECKPOINT 27.4

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

© 2013 Pearson

Practice Problem 3

If the Fed makes an open market sale 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 27.4

© 2013 Pearson

Solution

When the Fed sells securities to a bank, the bank’s
reserves decrease by $1 million, but its deposits do not
change, so the bank is short of reserves.

The bank calls in loans and deposits decrease by the
same amount.

The desired reserve ratio and the currency drain ratio
determine the decrease in the quantity of money.

The larger the desired reserve ratio or the currency drain
ratio, the smaller is the decrease in the quantity of money.

CHECKPOINT 27.4

© 2013 Pearson

Study Plan Problem

If the Fed makes an open market sale , the larger the
______, the smaller is the decrease in the quantity of
money.


CHECKPOINT 27.4

A.
open market sale or the currency drain ratio

B.
currency drain ratio or smaller the desired reserve ratio

C.
desired reserve ratio or the smaller the
currency drain
ratio

D.
open market sale or the smaller the desired reserve
ratio and the currency drain ratio

E.
the desired reserve ratio or the currency

drain ratio

© 2013 Pearson

In the news

Fed doubles monetary base

During the fourth quarter of 2008, the Fed doubled the
monetary base, but the quantity of money (M2) increased by
only 5 percent.

Source: Federal Reserve

Why did the quantity of M2 not increase by much more than
5 percent?

What would have happened to the quantity of M2 if the Fed
had kept the monetary base constant?

CHECKPOINT 27.4

© 2013 Pearson

Solution

The quantity of M2 equals the money multiplier,

(1 +
C/D
) divided by (
R/D

+
C/D
), multiplied by the
monetary base.

(
R/D
is the banks’ desired reserve ratio and
C/D
is the
currency drain ratio).

The quantity of M2 didn’t increase by more because the
banks increased their desired reserve ratio,
R/D
, which
decreased the money multiplier.

If the Fed had not increased the monetary base, the
quantity of M2 would have decreased because the money
multiplier decreased.

CHECKPOINT 27.4