Deck 13: The Financial Sector and the Economy

Question 1

What does it mean to say that money is liquid?

Answer 1

Saying that money is liquid means that money can be easily exchanged for another asset or good.

Question 2

What is the interest rate? How does it relate to the buying and selling of financial assets?

Answer 2

The interest rate is the price paid for the use of a financial asset.The interest rate varies to give people the incentive to buy or sell financial assets.Specifically,when the interest rate rises people are more likely to buy a financial asset (lend money)and less likely to sell a financial asset (borrow money).

Question 3

Define financial assets,and explain why every financial asset must correspond to a financial liability.

Answer 3

Financial assets,such as a savings deposit,stocks,and bonds,are assets whose benefit to the owner depends on the issuer of the asset meeting certain obligations.Therefore,when individuals buy a financial asset,the financial institution (the issuer)becomes financially liable to the buyer to meet these obligations.

Question 4

A story often told about the emergence of banks is that banks first emerged from the activities of goldsmiths,who stored gold for a fee.Briefly describe this story.

Question 5

What is a derivative? Why were they created?

Question 6

Explain what is meant by the reserve ratio.Give the formulas for the simple money multiplier and the money multiplier when people hold cash and explain the difference between the two.What would happen to the real world multiplier as people begin to hold a larger fraction of their assets in the form of cash?

Question 7

Describe the difference between a commercial bank and the central bank.

Question 8

Explain how a financial panic can occur.Describe how government actions can contribute to financial stability.Describe the potential problem that may be caused by government guarantees to prevent bank failures.

Question 9

What is money? What are the three functions of money?

Question 10

Why is the financial sector important in macroeconomic debates? Why are macroeconomists concerned with the total amount of flows coming out of and returning to spending?

Question 11

Explain the distinction between a real transaction and a financial transaction (giving examples of each)and explain why for most real transactions,there is a financial transaction that mirrors it.

Question 12

Why is money important from a short-run macroeconomic perspective?

Question 13

The major measures of money are M₁ and M₂.What are the major components of each of these measures? Why do economists focus their attention on M₂?

Question 14

What is the relationship between the real side of the economy (economic activity that results in the creation of real assets)and the financial side of the economy (economic activity that results in the production of financial assets)? Your discussion should cover the following points: How does the production of real assets differ from the production of financial assets? Does the creation of financial assets really contribute to overall economic productivity? Do financial assets make a country richer or poorer? What role do financial assets serve (if any)in facilitating the production of real assets?

Question 15

You are holding two bonds; one matures in 1 year and the other matures in 30 years.What do you expect to happen to the price of each bond when the interest rate rises? For which bond will the effect of a change in interest rates be greater?

Question 16

Explain the difference between the way real assets are created and the way financial assets are created.

Question 17

Explain how banks create money.Compare the effect on the money supply of accepting a cash deposit with that of making a loan.

Question 18

What is money? What is a liquid financial asset? Why do people hold their assets in the form of money?

Question 19

The three functions of money are to serve as: (1)a medium of exchange, (2)a unit of account,and (3)a store of wealth.Briefly explain each of these functions and give an example of each.

Question 20

Why is the financial sector important in macroeconomic debates?

Question 21

What are bank reserves? What is the reserve ratio?

Question 22

Suppose the reserve ratio changes from 10% to 20%,with all else unchanged and banks fully loaned out.Does the money supply in the economy increase or decrease? Why? Use the simple money multiplier to illustrate your answer.

Question 23

"Credit cards make a difference in how much money people hold,but they are not money." Explain this statement.

Question 24

All M₁ assets are included in M₂.We will call those assets that are part of M₂ but not part of M₁,"M₂ assets".You have just received $5,000 that you must hold as either an M₁ asset or an M₂ asset.What are the costs and benefits of holding the $5,000 as an M₁ asset rather than as an M₂ asset? Explain.

Question 25

Suppose that American Citizen Bank receives $10,000 in new money in the form of a checking account.Calculate the amount of money the banking system can create under each of the following scenarios:
(a)The reserve ratio is 10% and people hold no cash outside the banking system.
(b)The reserve ratio is 20% and people hold no cash outside of the banking system.
(c)The reserve ratio is 10% and the cash-to-deposit ratio is 10%.
(d)The reserve ratio is 10% and the cash-to-deposit ratio is 20%.
(e)The reserve ratio is 20% and the cash-to-deposit ratio is 20%.
For each of the scenarios (a)-(e),the total amount of new money that the banking system can create is found by using the following formula:
New Money = Initial deposit × the money multiplier
The key to getting the correct values in each case is the appropriate calculation of the money multiplier.For parts (a)& (b)the simple money multiplier formula (1/r)should be used.For parts (c)-(e)the money multiplier formula ((1 + c)/(r + c))should be used.

Question 26

If the reserve ratio is 10%,what is the value of the simple money multiplier? If bank reserves are $10,000,what is the total quantity of demand deposits those reserves can support (assuming the simple money multiplier is the appropriate multiplier to use)?

Question 27

John Deere deposits $1,000 into Lawnmowers Community National Bank.Suppose banks hold reserves of 10% and people hold no currency outside of banks.What will be the amount of new money the banking system can create as a result of John's deposit?

Question 28

A bank's financial success depends on how well it accomplishes its two main tasks: asset management and liability management.Briefly explain what these two terms mean in the context of bank management.

Question 29

Demonstrate equilibrium in the money market.Why does the demand curves have the slopes as you have drawn them? How does an increase in the demand for money affect the short-term interest rate?

Question 30

Assuming individuals hold no cash (all cash is in bank vaults as reserves),calculate the simple money multiplier and the money supply from the following reserve requirements and deposits in the system.
(a)reserve ratio = 5%; deposits = $10,000
(b)reserve ratio = 10%; deposits = $10,000
(c)reserve ratio = 10%; deposits = $20,000
Now assume individuals hold 25% of their money in the form of cash.Calculate the simple money multiplier and the money supply for situations a-c above.

Question 31

What are M₁ and M₂?

Question 32

Bill Sikes deposits $2,000 into Dickens Bank.Suppose banks hold reserves of 15% and the cash-to-deposit ratio is 10%.What will be the amount of new money the banking system can create as a result of Bill's deposit?

Question 33

State whether the following illustrates the speculative,precautionary or transactions motive for holding money.
a.A bond broker holds cash for the possibility of buying a bond whose price is expected to rise.
b.John's mother tells him to keep $10 in his pocket any time he goes out in case he needs to put gas in the car.
c.As stock prices begin to tumble,investors sell stock and increase their cash holdings.
c.Julio withdraws $100 from the bank to buy vegetables at the local organic farm market.
d.Mary takes out $50 from the bank to buy lunches during the week.

Question 34

What are three reasons people hold money? Be sure to mention the three motives.

Question 35

Give the formulas for and explain the difference between the simple money multiplier and the money multiplier when people hold cash.

Question 36

Economists use the terms save and invest in a way that is somewhat different from their common language usage.Explain the special meaning of these terms as used by economists.

Question 37

Why is it not the case that changes in reserves are certain to cause changes in the money supply?

Question 38

What does it mean to say that policymakers cannot apply the money multiplier to determine the level of money in the economy? Does that mean the money multiplier equation is not true?

Question 39

Which function of money is in each of the following cases demonstrating?
(1)You pay $10 for a movie ticket.
(2)You deposit your tax refund check in your saving account.
(3)A restaurant manager sets the prices of meals she serves in dollars.
(4)A restaurant manager keeps $5,000 worth of cash in a safety deposit box.
(5)McDonald's announces that a Big-Mac now costs only $1.00.
(6)Bill Gates net worth is around $50 billion.