Chapter 10

MONEY, BANKING, AND FINANCE

Macroeconomics in Context (Goodwin, et al.)

Chapter Overview
In this chapter, you will be introduced to a standard treatment of money and the banking
system as well as the role that banks play in our financial system. You will get an
overview of the relationship between money and the average price level, and will learn
about the role and functions of money, different types of money, and the concept of
liquidity as it applies to money. The chapter explores various types of banks and the role
they play in money creation. The functions of finance are introduced along with
nonbank financial institutions, financialization, and speculative bubbles. The final
section of the chapter presents the theory of financial instability. The appendix provides
a brief overview of the 2008 financial crisis and regulatory reforms to prevent future
crises.

Objectives
After reading and reviewing this chapter, you should be able to:

1. Describe the consequences of inflation and deflation.

2. Describe the functions and types of money.
3. Describe the measures of the money supply and explain the liquidity continuum.
4. Explain the basic workings of private banks including the use of balance sheets.
5. Explain how banks create money.
6. Describe the categories and functions of nonbank financial institutions.
7. Explain the concept of “financialization” and provide examples.
8. Explain the concept of “speculative bubble” and illustrate it with concrete examples.
9. Describe Minsky’s theory of financial instability to explain the occurrence of financial
crisis and understand the role of regulation in managing instability.

Key Terms
monetary policy M2
barter financial intermediary
deflation economic liability
liquidity bank reserves
fractional reserve system
credit money
required reserves
commodity money
exchange value excess reserves
intrinsic value portfolio investment
gold standard leverage
fiat money non-bank financial institution
collective investment vehicle
M1
hedge fund
Chapter 10 – Money, Banking, and Finance 1
 pension fund shadow banking
insurance company subprime mortgage
securities broker securitization
mortgage broker moral hazard

Active Review

Fill in the Blank

1. The fact that money can be immediately used in exchange, whereas valuable
jewelry cannot, illustrates the fact that money is very __________________.

2. The measure of the money supply that includes currency in circulation,

checking accounts, saving accounts, share accounts, and money market
accounts is called __________________.

3. When the aggregate price level falls economists use the term ____________
to describe the situation.

4. When something contains intrinsic value and also serves as a medium of

exchange it is known as ____________________.

5. The __________ definition of the money supply is broad enough to include

retail money market funds, certificates of deposit, savings and share accounts,
as well as checkable deposits and currency.

6. A medium of exchange that is valuable because a government says that it has

value is known as _______________.

7. Institutions that accept funds and provide loans are known as

_________________________.

8. Vault cash and deposits at the Federal Reserve both count towards
_____________, a term that describes funds not lent out or invested by a
private bank.

9. When banks are only required to hold a fraction of their deposits on reserve
they are part of _________________________.

10. The portion of bank reserves that a bank must keep on reserve are known as
_______________________.

11. The portion of bank reserves that banks are permitted to lend or invest are
known as _______________________.

Chapter 10 – Money, Banking, and Finance 2

 12. The use of debt to increase the potential rate of return on one’s own
investment is called __________________.

13. One alternative to saving money in a bank is to use a

______________________ , which is a category of pooled funds.

14. A _______________ is a type of pooled fund that often engages in highly

speculative investments and is generally restricted to wealthy clients.

15. An agent responsible for finding a buyer for sellers of different securities is
known as a ____________________.

16. The theory that unregulated markets will always produce instability and crisis is
referred to as the _________________.

17. In Minsky’s theory, the three financial profiles that account for the different
margins of safety are _________________, _________________, and
_________________.

18. (Appendix) The process of pooling various kinds of loans, slicing and sorting them
according to their risk levels, and repackaging them into financial instruments is
known as _________________________.

19. (Appendix) Mortgages given to people with poor credit are known as
_______________________.

20. (Appendix) The availability of government bailouts for large firms can encourage
excessive risk-taking, a phenomenon known as ______________________

21. (Appendix) The major financial reform passed in the wake of the 2007-9 crisis was
the _________________ bill.

True or False

22. When a government finances its expenditures by printing money rather

than collecting taxes, this can lead to “too much money chasing too few
goods” and hyperinflation.

23. Coins and paper money have in some periods been commodity money and in
other periods fiat money.

24. Nelson takes a $100 bill he had in his wallet and deposits it into his
checking account. Thus, M1 increases by $100.

25. (Appendix) High mortgage rates contributed to the development of the housing
bubble.
Chapter 10 – Money, Banking, and Finance 3
 Short Answer

26. Why is inflation harmful to an economy?

27. Why is deflation harmful to an economy?

28. What are the three roles of money? And what are two types of money?

29. Identify the components of M1 and M2.

30. Explain the difference between required reserves and excess reserves.

31. Explain the difference between a commercial bank and an investment bank.

32. What was the Glass-Steagall Act? Why was it originally passed? Why have some
economists argued that elements of the Act should be restored?

33. How does Minsky’s theory explain the occurrence of financial instability in the economic
system?

34. (Appendix) What were some of the factors leading to the housing bubble?

35. (Appendix) What were the major fiscal and monetary policy responses to the crisis?

Chapter 10 – Money, Banking, and Finance 4

Problems

1. Jane Doe has the following assets.

$100 in her wallet

$800 in her checking account
$1,000 in her savings account
A $300 outstanding credit card bill.
$3,000 in a small certificate of deposit
A car worth $5,000.
A house, worth $200,000.

a. Identify which are in M1, which are in M2, or in neither M1 nor M2.

b. Suppose she takes the $100 in her wallet and deposits it in her checking account.
What is the change in M1 and M2?

c. Suppose she takes $400 from her checking account and purchases a certificate of
deposit. What is the change in M1 and M2?

2. Assume a required reserve ratio of 0.10 to complete the following.

Assets Liabilities & Net Worth

Reserves $ 150 million Deposits $ 500 million

Loans $ 250 million Bank Capital $ 25 million
Bonds $ 125 million

TOTAL: 525 Million TOTAL: $ 525 Million

a) Calculate the initial required reserves for this bank.

b) Calculate the initial excess reserves for this bank.
c) Convert all of the excess reserves into loans. Construct the new balance sheet.

Chapter 10 – Money, Banking, and Finance 5

 Self Test

1. Which of the following is not a reason why an unexpected episode of inflation is

harmful to an economy?

A. It wipes out the value of people’s savings.

B. It hurts people on fixed incomes, such as retired people who receive non-indexed
pensions.
C. It redistributes wealth from debtors to creditors.
D. It creates menu costs.
E. It creates uncertainty, which makes financial planning for the future more
difficult.

2. Hyperinflation …

A. is often defined as any annual inflation rate higher than 10 percent.

B. describes the German economy after World War II.
C. can be become so severe that people resort to barter.
D. means that people tend to save money much more aggressively.
E. none of these statements is accurate.

3. According to the textbook, why is deflation harmful to an economy?

A. It redistributes wealth from debtors to creditors.

B. creates menu costs.
C. It creates uncertainty, which makes financial planning for the future more
difficult.
D. It can lead to cutbacks in borrowing and spending, which can slow down the
economy.
E. All of the above.

4. Which of the following is NOT a function of money?

A. A hedge against inflation.

B. A unit of account.
C. A store of value.
D. A medium of exchange.
E. All of these are functions of money.

5. Which of the following is NOT a type of money described in the textbook?

A. Fishhooks as money.
B. Fiat money.
C. Commodity money.
D. Silver coins as money.
E. All of these are types described in the text.
Chapter 10 – Money, Banking, and Finance 6
 6. “Fiat money” refers to …

A. Older U.S. coins that contain a high (90%) silver content.

B. A creative alternative to modern money (such as cigarettes in a prisoner of war
camp.)
C. Money that is valuable because a government says it has value.
D. Paper money backed by gold or other precious metals.
E. None of these is fiat money.

7. Which of the following is the most liquid?

A. A $20 bill in your pocket

B. A gold necklace
C. Three shares of Microsoft stock
D. A certificate of deposit (CD) in your bank.
E. A new Toyota Prius automobile

8. Which of these sequences best captures the liquidity continuum?

A. Checking accounts, precious metal, real estate, share of stock

B. Checking accounts, precious metal, share of stock, real estate
C. Checking accounts, share of stock, precious metal, real estate
D. Checking accounts, share of stock, real estate, precious metal
E. Precious metal, checking accounts, share of stock, real estate

9. Which of the following is not one of the characteristics necessary for commodity
money to be used as money?

A. It must be durable.
B. It must be portable.
C. It must be generally acceptable.
D. It must be differentiated.
E. It must be scarce.

10. Which of the following is not included as “money” in M1?

A. Currency in circulation
B. Checkable deposits
C. Money in savings account
D. The use of a credit card
E. The use of debit cards that take funds from a checking account

Chapter 10 – Money, Banking, and Finance 7

11. Which of the following is NOT a component of the M2 definition of the money supply?
A. Certificates of deposit
B. Checking account deposits
C. Retail money market funds
D. Savings account
E. All of these are components of the M2 definition of the money supply.

12. Which of these would be an INCORRECT use a balance sheet for a private bank?

A. A “government bonds” entry listed as an asset.

B. A “deposits” entry listed as a liability.
C. A “loans” entry listed as an asset.
D. Both (b) and (c) are incorrect.
E. All three of (a), (b), AND (c) are correct entries.

13. Which of these is NOT an example of a bank type described in the textbook?

A. Goldman Sachs investment bank

B. Washington Mutual Savings and Loan
C. Service Federal Credit Union
D. The Federal Reserve
E. All of these are examples of bank types described in the textbook.

14. The Glass-Steagall Act …

A. was passed in 2009 to prevent future financial crises.
B. was strengthened in 1999 to increase financial regulation.
C. was passed in the late 1980s in response to the Savings & Loan crisis.
D. was passed in the 1930s to increase financial regulation.
E. None of these is correct.

15. Which of these is NOT an example of leverage?

A. An investment bank increases its liabilities to speculate on derivatives.

B. A local entrepreneur borrows heavily to finance the cost of starting a new business.
C. General Motors issues new stock to raise funds for a new factory.
D. Microsoft issues commercial bonds to finance production of a new product.
E. All of these are examples of leverage.

16. A hedge fund is an example of …

A. a financial intermediary
B. a nonbank financial institution
C. an investment bank
D. a pension fund
E. None of these.

Chapter 10 – Money, Banking, and Finance 8

17. Nonbank institutions …

A. have been growing in importance in our financial system.

B. often provide much more attractive alternatives to traditional savings accounts.
C. are typically subject to less government regulation than traditional banks.
D. include pension funds and insurance companies.
E. All of these statements are accurate.

18. Speculative bubbles …

A. generally form for psychological and economic reasons.

B. are an important source of economic growth.
C. generally occur due to a general lack of liquidity.
D. are generally associated with tight credit conditions.
E. None of these statements is true.

19. The ‘efficient market hypothesis is based on all the following assumptions except:

A. Individuals are rational decision-makers.

B. Markets are perfectly competitive.
C. Individual decision-making is influenced by their expectations.
D. Individuals possess complete information about the market price of assets.
E. (a) and (c)

20. According to Minsky, during an economic expansion

A. financial firms move from speculative financing to hedge financing.

B. financial firms become more confident and take higher risks.
C. financial firms move from hedge financing to Ponzi financing.
D. financial firms become stronger.
E. Both (b) and (c).

Chapter 10 – Money, Banking, and Finance 9

 Answers to Active Review Questions

1. liquid
2. M1
3. deflation
4. commodity money
5. M2
6. fiat money
7. financial intermediaries
8. bank reserves
9. fractional reserve system
10. required reserves
11. excess reserves
12. leverage
13. collective investment vehicle
14. hedge fund
15. securities broker
16. financial instability hypothesis
17. hedge, speculative, and Ponzi
18. securitization
19. sub-prime mortgages
20. moral hazard
21. Dodd-Frank
22. True.
23. True.
24. False, M1 remains unchanged. There has just been a change in the composition of M1,
but the size of M1 remains the same.
25. False. It was low mortgage rates that feed the growth of the housing bubble.
26. Inflation is harmful because: it wipes out the value of people’s savings; it hurts people
on fixed incomes; it redistributes wealth from creditors to debtors; it creates menu
costs; and it creates uncertainty, making financial planning for the future more
difficult.
27. Deflation is a problem because: it redistributes wealth from debtors to creditors, it
creates menu costs; it creates uncertainty, making financial planning for the future more
difficult; and it can lead to cutbacks in borrowing and spending, which can slow down
the economy.
28. The three roles of money are: medium of exchange, store of value, and unit of
account. Two types of money are commodity money and fiat money. Commodity
money is a good that is used as money that is also valuable in itself. Fiat money
is a medium of exchange used as money because the government declares it as
such and people accept it.
29. M1 consists of currency in circulation, checkable deposits, and other liquid accounts,
such as savings, shares, and money market.
M2 consists of all of M1, plus savings accounts, and other funds such as small
certificates of deposit and retail money market funds.
30. Banks generate much of their profit from the use of other peoples’ money. Checking
account deposits entrusted to banks are also known as “demand deposits” because
the depositors have access to their money whenever they want. Consequently banks
Chapter 10 – Money, Banking, and Finance 10
 are obligated to hold a minimal portion of these deposits in liquid reserves. This
portion is a percentage (set by the Federal Reserve in the U.S.) of total deposits and
is known as required reserves. All of the reserves a bank has beyond this category
of required reserves are referred to as excess reserves.
31. Commercial banks provide retail services to individuals and businesses. These are
the institutions that we typically associate with checking accounts and lending.
Investment banks are institutions that focus on underwriting and issuing securities.
They do not provide traditional banking functions.
32. The Glass-Steagall Act was a 1933 legislative attempt to provide greater stability
for the banking system through increased government regulation. It contained a
number of provisions including the separation of commercial banking from
investment banking. Some economists have argued that a “firewall” such as the one
provided by Glass-Steagall should be restored between institutions that are
federally insured (by the FDIC) and investment banks because of differences in
risk-taking across the two types of banks.
33. Minsky’s theory argues that uncertainty about the future and expectations of market
participants play a key role in determining the value of assets. When the economy is
just recovering from a crisis investors will be cautious and maintain large safety
margins. However, as the economy gains strength, investors will become more
optimistic and pursue risky activities, which weakens the financial system and
makes it more credit-dependent and vulnerable to crisis.
34. Factors leading to the housing bubble included a period of low interest rates,
unprecedented expansion of credit including sub-prime mortgages, and speculation
in the housing market driving prices even higher.
35. After the immediate responses of bailouts for endangered financial institutions, the
Federal government instituted large-scale stimulus spending to prevent a collapse in
aggregate demand and to promote economic recovery. At the same time, the
Federal Reserve engaged in an extraordinarily expansionary monetary policy,
purchasing hundreds of billions of dollars’ worth both of Treasury bonds
(traditional expansionary policy) and other financial assets (“quantitative easing”).

Answers to Problems

1.
a. The following are in M1, M2, or neither:

$100 in her wallet = M1

$800 in her checking account = M1
$1,000 in her savings account = M2
A $300 outstanding credit card bill = Neither
$3,000 in a small certificate of deposit = M2
A car worth $5,000 = Neither
A house, worth $200,000 = Neither
Chapter 10 – Money, Banking, and Finance 11
 b. M1 and M2 remain unchanged, since both cash and checking account deposits are
counted in both M1 and M2.

c. M1 decreases by $400, and M2 remains unchanged.

2.
a. Required Reserves = reserve ratio * deposits
= (0.10) * 500 million
= $ 50 million

b. Excess Reserves = total reserves – required reserves

= 150 million – 50 million
= $ 100 million
c.
Assets Liabilities & Net Worth

Reserves $ 50 million Deposits $ 500 million

Loans $ 350 million Bank Capital $ 25 million
Bonds $ 125 million

TOTAL: 525 Million TOTAL: $ 525 Million

Answers to Self Test Questions

1. C 11. E
2. C 12. B
3. E 13. E
4. A 14. D
5. E 15. C
6. C 16. B
7. A 17. E
8. C 18. A
9. D 19. C
10. D 20. E

(note on #1: Inflation redistributes wealth from creditors to debtors)

Chapter 10 – Money, Banking, and Finance 12