Deck 10: The Financial Sector and the Economy

Question 1

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?

Answer 1

M1 is a measure of money that consists of currency in the hands of the public, checking account balances, and traveler's checks.
M2 is a measure of money that consists of all the types of money in M1 plus savings deposits, small-denomination time deposits, and money market mutual fund shares.Economic research has shown that M2 is the measure of money that is most closely correlated with the price level and economic activity.

Question 2

What does it mean to say that money is liquid?

Answer 2

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

Question 3

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

Answer 3

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 4

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 5

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

Question 6

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

Question 7

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

Question 8

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

Question 9

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 10

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 11

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 12

Why is the financial sector important in macroeconomic debates?

Question 13

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 14

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 15

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 16

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

Question 17

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

Question 18

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

Question 19

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

Question 20

What are M1 and M2?

Question 21

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

Question 22

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

Question 23

Calculate the 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

Question 24

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 25

If a central bank increases the money supply, and in the process generates fear of a country defaulting on its bonds, what would happen to the interest rate?

Question 26

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% .
(b) The reserve ratio is 20%.

Question 27

Which function of money is in each of the following cases demonstrating?
(1) You pay $15 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 $3.00.
(6) Bill Gates net worth is around $90 billion.

Question 28

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 29

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 30

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 31

What are bank reserves? What is the reserve ratio?

Question 32

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.) 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.
(c.) As stock prices begin to tumble, investors sell stock and increase their cash holdings.

Question 33

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 34

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.