1.

Overview of Money and Finance

1.1. Why Study Financial Markets?

What is a stock? How do stocks affect the economy?

Answer: A stock represents a share of ownership of a corporation, or a claim on a firmʹs

earnings/assets. Stocks are part of wealth, and changes in their value affect peopleʹs
willingness to spend. Changes in stock prices affect a firmʹs ability to raise funds, and thus
their investment.

Why is it important to understand the bond market?

Answer: The bond market supports economic activity by enabling the government and
corporations to borrow to undertake their projects and it is the market where interest rates are
determined.

1.2. Why Study Financial Institutions and Banking?

What crucial role do financial intermediaries perform in an economy?

Answer: Financial intermediaries borrow funds from people who have saved and make loans
to other individuals and businesses and thus improve the efficiency of the economy.

1.3. Why Study Money and Monetary Policy?

What happens to economic growth and unemployment during a business cycle recession?
What is the relationship between the money growth rate and a business cycle recession?
Answer: During a recession, output declines and unemployment increases. Prior to every
recession in the U.S. the money growth rate has declined, however, not every decline is
followed by a recession.
1.4. Why Study International Finance?

From 1980-1985, the dollar strengthened in value against other currencies. Who was helped
and who was hurt by this strong dollar?

Answer: American consumers benefitted because imports were cheaper and consumers could
purchase more. American businesses and workers in those businesses were hurt as domestic
and foreign sales of American products fell.

1.5. Other

When interest rates decrease, how might businesses and consumers change their economic
behavior?

Answer: There will be more consumption spending on interest-sensitive items and more
investment by businesses.

2. An Overview of the Financial System

2.1. An Overview of the Financial System
Distinguish between direct finance and indirect finance. Which of these is the most
important source of funds for corporations in the United States?

Answer: With direct finance, funds flow directly from the lender/saver to the borrower. With
indirect finance, funds flow from the lender/saver to a financial intermediary who then
channels the funds to the borrower/investor. Financial intermediaries (indirect finance) are
the major source of funds for corporations in the U.S.

2.2. Structure of Financial Markets

Corporations receive funds when their stock is sold in the primary market. Why do
corporations pay attention to what is happening to their stock in the secondary market?
Answer: The existence of the secondary market makes their stock more liquid and the price
in the secondary market sets the price that the corporation would receive if they choose to sell
more stock in the primary market.

Describe the two methods of organizing a secondary market.

Answer: A secondary market can be organized as an exchange where buyers and sellers meet
in one central location to conduct trades. An example of an exchange is the New York Stock
Exchange. A secondary market can also be organized as an over-the-counter market. In this
type of market, dealers in different locations buy and sell securities to anyone who comes to
them and is willing to accept their prices. An example of an over-the-counter market is the
federal funds market.

2.3 Financial Market Instruments

2.4 Internationalization of Financial Markets

Distinguish between a foreign bond and a Eurobond.

Answer: A foreign bond is sold in a foreign country and priced in that countryʹs currency. A
Eurobond is sold in a foreign country and priced in a currency that is not that countryʹs
currency.

2.5 Function of Financial Intermediaries: Indirect Finance

Because there is an imbalance of information in a lending situation, we must deal with the
problems of adverse selection and moral hazard. Define these terms and explain how
financial intermediaries can reduce these problems.

Answer: Adverse selection is the asymmetric information problem that exists before the
transaction occurs. For lenders, it is the difficulty in judging a good credit risk from a bad
credit risk. Moral hazard is the asymmetric information problem that exists after the
transaction occurs. For lenders, it is the difficulty in making sure the borrower uses the funds
appropriately. Financial intermediaries can reduce adverse selection through intensive
screening and can reduce moral hazard by monitoring the borrower.

2.6 Types of Financial Intermediaries

2.7 Regulation of the Financial System

How do regulators help to ensure the soundness of financial intermediaries?

Answer: Regulators restrict who can set up a financial intermediary, conduct regular
examinations, restrict assets, and provide insurance to help ensure the soundness of financial
intermediaries.

2.8. Other

1. Assume that a carpenter borrowed $2,000 to be paid off in a year to finance a machine that
would make him work faster. As a result, she is able to take on more projects and collect
$400 more earnings in the first year, after paying off the principal of $2,000. However, there
is a 15% rental fee (interest) on her loan, which she also has to pay off. What is the
carpenter’s net earnings for the first year? (Round your response to the nearest dollar.)

2. Some economists suspect that one of the reasons economies in developing countries grow
so slowly is that they do not have well-developed financial markets. Does this argument
make sense?

3. Give at least three examples of a situation in which financial markets allow consumers to
better time their purchases.

4. If you suspect that a company will go bankrupt next year, which would you rather hold,
bonds issued by the company or equities issued by the company? Why?

8. The U.S. economy borrowed heavily from the British in the nineteenth century to build a
railroad system. Why did this make both countries better off?

9. A significant number of European banks held large amounts of assets as mortgage-backed

securities derived from the U.S. housing market, which crashed after 2006. How does this
demonstrate both a benefit and a cost to the internationalization of financial markets?
17. Suppose a few investors are looking for an invest ment opportunity that will yield high
returns. They are willing to invest in private securities instead of government bonds.
However, their analyst found that currently most companies listed on the market and are
actively trading in securities are in trouble, which would make them risky investments. What
can you conclude from this situation? How would you advise the investors?

22. In 2008, as a financial crisis began to unfold in the United States, the FDIC raised the
limit on insured losses to bank depositors from $100,000 per account to $250,000 per
account. How would this help stabilize the financial system?

3. What is Money
3.1 Meaning of Money

3.2 Functions of Money

Explain how cigarettes could be called ʺmoneyʺ in prisoner-of-war camps of World War II.
Answer: The cigarettes performed the three functions of money. They served as the medium
of exchange because individuals did exchange items for cigarettes. They served as a unit of
account because prices were quoted in terms of the number of cigarettes required for the
exchange. They served as a store of value because an individual would be willing to save
their cigarettes even if they did not smoke because they believed that they could exchange the
cigarettes for something that they did want at some time in the future.

3.3 Evolution of the Payments System

What factors have slowed down the movement to a system where all payments are made
electronically?

Answer: The equipment necessary to set up the system is expensive, security of the
information, and privacy concerns are issues that need to be addressed before an electronic
payments system will be widely accepted.

3.4 Measuring Money

Why are most of the U.S. dollars held outside of the United States?

Answer: Concern about high inflation eroding the value of their own currency causes many
people in foreign countries to hold U.S. dollars as a hedge against inflation risk.

3.5. Others

3. Three goods are produced in an economy by three individuals:

Good

Apples

Bananas
Chocolate

Producer Orchard owner, Banana grower, Chocolatier

If the orchard owner likes only bananas, the banana grower likes only chocolate, and the
chocolatier likes only apples, will any trade between these three people take place in a barter
economy? How will introducing money into the economy benefit these three producers?

4. Suppose that the cost of a movie ticket is $12, and a latte costs $6. Why would the theater
management say the cost of admission is $12 and not two lattes? Explain why it is more
efficient to compare the value of commodities in monetary terms.

6. In Brazil, a country that underwent a rapid inflation before 1994, many transactions were
conducted in dol lars rather than in reals, the domestic currency. Why?

7. Was money a better store of value in the United States in the 1950s than in the 1970s?
Why or why not? In which period would you have been more willing to hold money?
8. Why have some economists described money during a hyperinflation as a “hot potato” that
is quickly passed from one person to another?

9. Why were people in the United States in the nineteenth century sometimes willing to be
paid by check rather than with gold, even though they knew there was a pos sibility that the
check might bounce?

13.Which of the Federal Reserve’s measures of the mon etary aggregates—M1 or M2—is
composed of the most liquid assets? Which is the larger measure? 14. It is not unusual to find
a business that displays a sign saying “no personal checks, please.” On the basis of this
observation, comment on the relative degree of liquidity of a checking account versus
currency.

16. Assume that you are interested in earning some return on the idle balances you usually
keep in your checking account and decide to buy some money market mutual funds shares by
writing a check. Comment on the effect of your action (with everything else the same) on M1
and M2.

17. In April 2009, year-over-year the growth rate of M1 fell to 6.1%, while the growth rate of
M2 rose to 10.3%. In September 2013, the growth rate of the M1 money sup ply was 6.5%,
while the growth rate of the M2 money supply was about 8.3%. How should Federal Reserve
policymakers interpret these changes in the growth rates of M1 and M2?

18. Suppose a researcher discovers that a measure of the total amount of debt in the U.S.
economy over the past 20 years was a better predictor of inflation and the business cycle than
M1 or M2. Does this discovery mean that we should define money as equal to the total
amount of debt in the economy?
 4.

4. State Budget (Public Finance textbook Chapter 1,4.)

In the simplest terms, public finance is the study of the role of the gov ernment in the
economy. This is a very broad definition. This study involves answering the four questions of
public finance: ■When should the government intervene in the economy? ■How might the
government intervene? ■What is the effect of those interventions on economic outcomes?
■Why do governments choose to intervene in the way that they do?

1. Many states have language in their constitutions that requires the state to provide for an
“adequate” level of education spending. What is the economic rationale for such a
requirement?

2. How has the composition of federal, state, and local government spending changed over
the past 40 years? What social and economic factors might have contributed to this change in
how governments spend their funds?

3. Some goods and services are provided directly by the government, while others are funded
publicly but provided privately. What is the difference between these two mechanisms of
public financing? Why do you think the same government would use one approach
sometimes and the other approach at other times?

4. Why does redistribution cause efficiency losses? Why might society choose to redistribute
resources from one group to another when doing so reduces the overall size of the economic
pie?

5. Consider the four basic questions of public finance listed in the chapter. Which of these
questions are positive—that is, questions that can be proved or disproved—and which are
normative— that is, questions of opinion? Explain your answer.

6. One rationale for imposing taxes on alcohol consumption is that people who drink alcohol
impose negative spillovers on the rest of society— for example, through loud and unruly
behavior or intoxicated driving. If this rationale is correct, in the absence of governmental
taxation, will people tend to consume too much, too little, or the right amount of alcohol?

8. To make college more affordable for students from families with fewer resources, a
government has proposed allowing the student of any family with less than $50,000 in
savings to attend a public university for free. Discuss the direct and possible indirect effects
of such a policy.

9. The country of Adventureland has two citizens, Bill and Ted. Bill has a private legal
business. He earns $50 per hour. At a tax rate of 0%, Bill works 20 hours. At a 25% tax rate,
he works only 16 hours, and at a 40% tax rate, he works only 8 hours per week. Ted works in
a manufacturing job. He works 20 hours per week and earns $6 per hour, regardless of the tax
rate. The government is considering imposing an income tax of either 25% or 40% on Bill
and using the revenues to make transfer payments to Ted. The accompanying table
summarizes the three possible policies. Does either tax policy raise social welfare? Are either
of the policies obviously less than optimal? Explain your answers

12. Many states have constitutional requirements that their budgets be in balance (or in
surplus) in any given year, but this is not true for the U.S. federal government. Why might it
make sense to allow for the federal government to have deficits in some years and surpluses
in others?

Questions to keep in mind ■What has happened to the U.S. budget deficit over time? ■What
is the right way to measure the long-run budget deficit? ■What is the effect of higher budget
deficits on the economy?

8. A government is considering paving a highway with a newly developed “wear-proof”

material. Paving the highway would cost $4 billion today but would save $400 million in
maintenance costs for each of the next ten years. Use the concept of present value to
determine whether the project is worth undertaking if the government can borrow at an
interest rate of 4%. Is it worth it if the interest rate is 0%? 8%? A politician says to you, “I
don’t care what the interest rate is. The project is clearly a good investment: it more than pays
for itself in only 8 years, and all the rest is money in the bank.” What’s wrong with this
argument, and why does the interest rate matter?

9. Is it necessarily inequitable for future generations to face higher taxes as a result of

benefits that accrue to those living today? Explain

11. Consider a project that costs $126,000, provides an income of $70,000 a year for five
years, and costs $225,000 to dispose of at the very end of the fifth year. Assume that the first
payment comes at the start of the year after the project is undertaken. Should the project be
undertaken at a 0% discount rate? How about 2%? 5%? 10%?

16. Consider the same highway paving project from question 8. A second politician says to
you, “At an interest rate of 4%, the project is a bad idea. Over ten years, the project reduces
maintenance costs by a total of $4 billion. But borrowing $4 billion for ten years at a 4%
interest rate means paying $1.44 billion in interest. The total cost of the project over ten years
is therefore $5.44 billion!” What’s wrong with the second politician’s argument?

5. Credits and Interest rates

53) If the interest rate is 5%, what is the present value of a security that pays you $1, 050 next
year and $1,102.50 two years from now? If this security sold for $2200, is the yield to
maturity greater or less than 5%? Why?

Answer: PV = $1,050/(1. +.05) + $1,102.50/(1 + 0.5)2 PV = $2,000 If this security sold for
$2200, the yield to maturity is less than 5%. The lower the interest rate the higher the present
value.

Your favorite uncle advises you to purchase long-term bonds because their interest rate is
10%. Should you follow his advice?

Answer: It depends on where you think interest rates are headed in the future. If you think
interest rates will be going up, you should not follow your uncleʹs advice because you would
then have to discount your bond if you needed to sell it before the maturity date. Long-term
bonds have a greater interest-rate risk.

Would it make sense to buy a house when mortgage rates are 14% and expected inflation is
15%? Explain your answer. Answer: Even though the nominal rate for the mortgage appears
high, the real cost of borrowing the funds is -1%. Yes, under this circumstance it would be
reasonable to make this purchase.

24) Everything else held constant, would an increase in volatility of stock prices have any
impact on the demand for rare coins? Why or why not?

Answer: Yes, it would cause the demand for rare coins to increase. The increased volatility of
stock prices means that there is relatively more risk in owning stock than there was
previously and so the demand for an alternative asset, rare coins, would increase.

49) What is the impact on interest rates when the Federal Reserve decreases the money
supply by selling bonds to the public?

Answer: Bond supply increases and the bond supply curve shifts to the right. The new
equilibrium bond price is lower and thus interest rates will increase.

50) Use demand and supply analysis to explain why an expectation of Fed rate hikes would
cause Treasury prices to fall.

Answer: The expected return on bonds would decrease relative to other assets resulting in a
decrease in the demand for bonds. The leftward shift of the bond demand curve results in a
new lower equilibrium price for bonds.

36) Using the liquidity preference framework, what will happen to interest rates if the Fed
increases the money supply?
Answer: The Fedʹs actions shift the money supply curve to the right. The new equilibrium
interest rate will be lower than it was previously. Ques Status: Previous Edition

37) Using the liquidity preference framework, show what happens to interest rates during a
business cycle recession.

Answer: During a business cycle recession, income will fall. This causes the money demand
curve to shift to the left. The resulting equilibrium will be at a lower interest rate.

47) The spread between the interest rates on Baa corporate bonds and U.S. government bonds
is very large during the Great Depression years 1930-1933. Explain this difference using the
bond supply and demand analysis. Answer: During the Great Depression many businesses
failed. The default risk for the corporate bond increased compared to the default-free
Treasury bond. The demand for corporate bonds decreased while the demand for Treasury
bonds increased resulting in a larger risk premium.

48) If the federal government where to raise the income tax rates, would this have any impact
on a stateʹs cost of borrowing funds? Explain.

Answer: Yes, if the federal government raises income tax rates, demand for municipal bonds
which are federal income tax exempt would increase. This would lower the interest rate on
the municipal bonds thus lowering the cost to the state of borrowing funds.

If a higher inflation is expected, what would you expect to happen to the shape of the yield
curve? Why?

Answer: The yield curve should have a steep upward slope. Nominal interest rates will
increase if the inflation rate increases, therefore, bond purchasers will require a higher term
premium to hold the riskier long-term bond.

1. Would $200, which is to be received in exactly one year, be worth more to you today when
the interest rate is 12% or when it is 17%?

2. What is the formula used to calculate the yield to maturity on a 20-year coupon bond with
a current yield of 12% and $1,000 face value that sells for $2,500.

3. To help pay for college, you have just taken out a $1,000 government loan that makes you
pay $126 per year for 25 years. However, you don’t have to start making these payments until
you graduate from college two years from now. Why is the yield to maturity necessarily less
than 12%? (This is the yield to maturity on a normal $1,000 fixed-payment loan on which
you pay $126 per year for 25 years.)

4. Do bondholders fare better when the yield to maturity increases or when it decreases?
Why?

5. Suppose today you buy a coupon bond that you plan to sell one year later. Which part of
the rate of return for mula incorporates future changes into the bond’s price? Note: Check
Equations 7 and 8 in this chapter.
6. If mortgage rates rise from 5% to 10% but the expected rate of increase in housing prices
rises from 2% to 9%, are people more or less likely to buy houses?

7. When is the current yield a good approximation of the yield to maturity?

9. Under what conditions will a discount bond have a negative nominal interest rate? Is it
possible for a cou pon bond or a perpetuity to have a negative nominal interest rate?

10. True or False: With a discount bond, the return on the bond is equal to the rate of capital
gain. 11. If interest rates decline, which would you rather be holding, long-term bonds or
short-term bonds? Why? Which type of bond has the greater interest-rate risk?

12. Interest rates were lower in the mid-1980s than in the late 1970s, yet many economists
have commented that real interest rates were actually much higher in the mid 1980s than in
the late 1970s. Does this make sense? Do you think that these economists are right?

13. Retired persons often have much of their wealth placed in savings accounts and other
interest-bearing investments and complain whenever interest rates are low. Do they have a
valid complaint?

14. If the interest rate is 15%, what is the present value of a security that pays you $1,100
next year, $1,250 the year after, and $1,347 the year after that?

15. Calculate the present value of a $1,300 discount bond with seven years to maturity if the
yield to maturity is 8%.

16. A lottery claims its grand prize is $15 million, payable over five years at $3,000,000 per
year. If the first payment is made immediately, what is this grand prize really worth? Use an
interest rate of 7%.

21. Consider a coupon bond that has a $900 par value and a coupon rate of 6%. The bond is
currently selling for $860.15 and has two years to maturity. What is the bond’s yield to
maturity?

22.What is the price of a perpetuity that has a coupon of $70 per year and a yield to maturity
of 1.5%? If the yield to maturity doubles, what will happen to the per petuity’s price?

23. Property taxes in a particular district are 2% of the purchase price of a home every year. If
you just purchased a $150,000 home, what is the present value of all the future property tax
payments? Assume that the house remains worth $150,000 forever, property tax rates never
change, and a 4% interest rate is used for discounting.

24. A $1,100-face-value bond has a 5% coupon rate, its current price is $1,040, and it is
expected to increase to $1070 next year. Calculate the current yield, the expected rate of
capital gains, and the expected rate of return.

25. Assume you just deposited $1,250 into a bank account. The current real interest rate is
1%, and the expected rate of inflation over the next year is 5%. What nominal interest rate
should the bank charge you over the next year? How much money will you have at the end of
one year? If you are saving to buy a motorbike that currently sells for $1,300, will you have
enough money to buy it?

1. Explain why you would be more or less willing to buy a share of Microsoft stock in the
following situations: a. Your wealth falls. b. You expect the stock to appreciate in value. c.
The bond market becomes more liquid. d. You expect gold to appreciate in value. e. Prices in
the bond market become more volatile.

7. Suppose Maria prefers to buy a bond with a 7% expected return and 2% standard deviation
of its expected return, while Jennifer prefers to buy a bond with a 4% expected return and 1%
standard deviation of its expected return. Can you tell if Maria is more or less risk-averse
than Jennifer?

8. What will happen in the bond market if the government imposes a limit on the amount of
daily transactions? Which characteristic of an asset would be affected?

14. Suppose that people in France decide to permanently increase their savings rate. Predict
what will happen to the French bond market in the future. Can France expect higher or lower
domestic interest rates?

15. Suppose you are in charge of the financial department of your company and you have to
decide whether to borrow short or long term. Checking the news, you realize that the
government is about to engage in a major infrastructure plan in the near future. Predict what
will happen to interest rates. Will you advise bor rowing short or long term?

19.M1 money growth in the U.S. was about 15% in 2011 and 2012, and 10% in 2013. Over
the same time period, the yield on 3-month Treasury bills was close to 0%. Given these high
rates of money growth, why did interest rates stay so low, rather than increase? What does
this say about the income, price-level, and expected-inflation effects

1. If junk bonds are “junk,” then why do investors buy them?

3. Do you think that a U.S. Treasury bill will have a risk premium that is higher than, lower
than, or the same as that of a similar security (in terms of maturity and liquidity) issued by the
government of Colombia?

4. In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk
of defaulting due to the severity of the global financial crisis. As a result, the U.S.
government stepped in to support AIG with large capital injections and an ownership stake.
How would this affect, if at all, the yield and risk premium on AIG corporate debt?

5. Risk premiums on corporate bonds are usually anticycli cal; that is, they decrease during
business cycle expan sions and increase during recessions. Why is this so?

7. What is a key function of credit-rating agencies? Do credit-rating agencies always provide

reliable informa tion? What was the role of credit-rating agencies in the sub-prime crisis of
2008?
12. Prior to 2008, mortgage lenders required a house inspection to assess a home’s value and
often used the same one or two inspection companies in the same geo graphical market.
Following the collapse of the housing market in 2008, mortgage lenders required a house
inspection, but this inspection was arranged through a third party. How does the pre-2008
scenario illustrate a conflict of interest similar to the role that credit-rating agencies played in
the global financial crisis?

13. “According to the expectations theory of the term structure, it is better to invest in one-
year bonds, reinvested over two years, than to invest in a two-year bond if interest rates on
one-year bonds are expected to be the same in both years.” Is this statement true, false, or
uncertain?

14. If bond investors decide that 30-year bonds are no lon ger as desirable an investment as
they were previously, predict what will happen to the yield curve, assuming (a) the
expectations theory of the term structure holds; and (b) the segmented markets theory of the
term struc ture holds.

6. Commercial banks
Using T-accounts show what happens to reserves at Security National
Bank if one individual deposits $1000 in cash into her checking account
and another individual withdraws $750 in cash from her checking account.
Answer: Security National Bank Assets Liabilities Reserves +$250
Checkable deposits +$250

18) How can specializing in lending help to reduce the adverse selection
problem in lending?

Answer: Reducing the adverse selection problem requires the banks to

acquire information to screen bad credit risks from good credit risks. It is
easier for banks to obtain information about local businesses. Also if the
bank lends to firms in a few specific industries they will become more
knowledgeable about those industries and a better judge of
creditworthiness in those industries.
1. Why might a bank be willing to borrow funds from other banks at a
higher rate than the rate at which it can borrow from the Fed?

6. If the bank you own has no excess reserves and a sound customer
comes in asking for a loan, should you auto matically turn the customer
down, explaining that you don’t have any excess reserves to lend out?
Why or why not? What options are available that will enable you to
provide the funds your customer needs?

15. “Because diversification is a desirable strategy for avoid ing risk, it

never makes sense for a bank to specialize in making specific types of
loans.” Is this statement true, false, or uncertain? Explain your answer.

16. If you are a banker and expect interest rates to rise in the future,
would you prefer to make short-term loans or long-term loans?

17. “Bank managers should always seek the highest return possible on
their assets.” Is this statement true, false, or uncertain? Explain your
answer.

18. After July 2010, bank customers using a debit card had to specifically
opt-in to the bank’s overdraft protection plan. Explain the effect of this
regulation on a bank’s noninterest income

20.What happens to reserves at the First National Bank if one person

withdraws $1,100 of cash and another per son deposits $200 of cash? Use
T-accounts to explain your answer.

5. What are the costs and benefits of a too-big-to-fail policy?

7. CENTRAL BANK AND MONETARY POLICY

15) Explain the time-inconsistency problem. What is the likely outcome of discretionary
policy? What are the solutions to the time-inconsistency problem?

Answer: With policy discretion, policymakers have an incentive to attempt to increase output
by pursuing expansionary policies once expectations are set. The problem is that this policy
results not in higher output, but in higher actual and expected inflation. The solution is to
adopt a rule to constrain discretion. Nominal anchors can provide the necessary constraint on
discretionary behavior.

35) Why does the Federal Reserve Bank of New York play a special role within the Federal
Reserve System?

Answer: The New York district contains the largest banks in the country. The New York Fed
supervises and examines these banks to insure their soundness and the safety of the nationʹs
financial system. The New York Fed conducts open market operations and foreign exchange
transactions for the Fed and Treasury. The New York Fed belongs to the Bank for
International Settlements, so its president and the chairman of the Board of Governors
represent the U.S. at the monthly meetings of the worldʹs central banks. The New York Fed
president is the only president of a regional Fed who is a permanent voting member of the
FOMC.

36) Who are the voting members of the Federal Open Market Committee and why is this
committee important? Where does the power lie within this committee?

Answer: The FOMC determines the monetary policy of the United States through its
decisions about open market operations. It also effectively determines the discount rate and
reserve requirements. The seven members of the Board of Governors, the president of the
New York Fed, and four of the other eleven regional bank presidents are voting members on
a rotating basis. Within the FOMC, the chairman of the Board of Governors wields the
power.

6) Explain two concepts of central bank independence. Is the Fed politically independent?
Why do economists think central bank independence is important? Answer: Instrument
independence is the ability of the central bank to set its instruments, and goal independence is
the ability of a central bank to set its goals. The Fed enjoys both types of independence. The
Fed is largely independent of political pressure due to its earnings and the conditions of
appointment of the Board of Governors and its chairman. However, some political pressure
can be applied through the threat or enactment of legislation affecting the Fed. Independence
is important because there is some evidence that independent central banks pursue lower rates
of inflation without harming overall economic performance.

10) Explain the similarities and differences between the European System of Central Banks
and the Federal Reserve System.

Answer: The similarities between the two are in their structure. The National Central Banks
of the member countries of the Eurosystem have the same role as the Federal Reserve Banks
in the Federal Reserve system. The Executive Board and the Governing Council of the
Eurosystem resemble the Board of Governors and the Federal Open Market Committee of the
Federal Reserve System, respectively. There are three major differences between the two.
The first difference is concerning the control of the budgets. In the Fed, the Board of
Governors controls the budgets of the Reserve Banks while in the Eurosystem, the National
Banks control the budget of the European Central Bank. The second difference is the
monetary operations of the Eurosystem are conducted by the National Banks, so they are not
as centralized as the monetary operations in the Federal Reserve System. Finally, the
European Central Bank is not involved in the supervision and regulation of the financial
institutions in the euro zone while the Federal Reserve is involved with the regulation and
supervision of the financial institutions in the United States.

4) What is the theory of bureaucratic behavior and how can it be used to explain the behavior
of the Federal Reserve?

Answer: The theory of bureaucratic behavior concludes that the main objective of any
bureaucracy is to maximize its own welfare, which is related to power and prestige. This can
explain why the Federal Reserve has defended its autonomy, avoids conflict with Congress
and the president, and its push to gain more control over banks.

6) Make the case for and against an independent Federal Reserve.

Answer: Case for: 1. An independent Federal Reserve can shield the economy from the
political business cycle, and it will be less likely to have an inflationary bias to monetary
policy. 2. Control of the money supply is too important to leave to inexperienced politicians.
Case against: 1. It is undemocratic to have monetary policy be controlled by a small number
of individuals that are not accountable. 2. In the past, an independent Fed has not used its
freedom wisely. 3. Its independence may encourage it to pursue its own self-interest rather
than the publicʹs interest.

37) Explain two ways by which the Federal Reserve System can increase the monetary base.
Why is the effect of Federal Reserve actions on bank reserves less exact than the effect on the
monetary base?

Answer: The Fed can increase the monetary base by purchasing government bonds and by
extending discount loans. If the person selling the security chooses to keep the proceeds in
currency, bank reserves do not increase. Because the Fed cannot control the distribution of
the monetary base between reserves and currency, it has less control over reserves than the
base.

51) Assume that no banks hold excess reserves, and the public holds no currency. If a bank
sells a $100 security to the Fed, explain what happens to this bank and two additional steps in
the deposit expansion process, assuming a 10% reserve requirement. How much do deposits
and loans increase for the banking system when the process is completed?

Answer: Bank A first changes a security for reserves, and then lends the reserves, creating
loans. It receives $100 in reserves from the sale of securities. Since all of these reserve will
be excess reserves (there was no change in checkable deposits), the bank will loan out all
$100. The $100 will then be deposited into Bank B. This bank now has a change in reserves
of $100, of which $90 is excess reserves. Bank B will loan out this $90, which will be
deposited into Bank C. Bank C now has an increase in reserves of $90, $81 of which is
excess reserves. Bank C will loan out this $81 dollars and the process will continue until
there are no more excess reserves in the banking system. For the banking system, both loans
and deposits increase by $1000. Ques Status: Previous Edition

52) Explain two reasons why the Fed does not have complete control over the level of bank
deposits and loans. Explain how a change in either factor affects the deposit expansion
process.

Answer: The Fed does not completely control the level of bank deposits and loans because
banks can hold excess reserves and the public can change its currency holdings. A change in
either factor changes the deposit expansion process. An increase in either excess reserves or
currency reduces the amount by which deposits and loans are increased.

53) Explain why the simple deposit multiplier overstates the true deposit multiplier.
Answer: The simple model ignores the role banks and their customers play in the creation
process. The bankʹs customers can decide to hold currency and the bank can decide to hold
excess reserves. Both of these will restrict the banking systemʹs ability to create deposits.
Thus, the true multiplier is less than the prediction of the simple deposit multiplier.

59) Explain the complete formula for the M1 money supply, and explain how changes in
required reserves, excess reserves, the currency ratio, the nonborrowed base, and borrowed
reserves affect the money supply.

Answer: The formula is M = 1 + c r + c + e × (MBn + BR). The formula indicates that the
money supply is the product of the multiplier times the base. Increases in any of the
multiplier components, required reserves, r; excess reserves, e; or the currency ratio, c;
reduce the multiplier and the money supply. Increases in the nonborrowed base and borrowed
reserves both increase the base and the money supply.

60) The monetary base increased by 20% during the contraction of 1929-1933, but the
money supply fell by 25%. Explain why this occurred. How can the money supply fall when
the base increases?

Answer: The banking crisis caused the public to fear for the safety of their deposits,
increasing both the currency ratio and bank holdings of excess reserves in anticipation of
deposit outflows. Both of these changes reduce the money multiplier and the money supply.
In this case, the fall in the multiplier due to increases of currency and excess reserves more
than offset the increase in the base, causing the money supply to fall.

53) Explain the Fedʹs three tools of monetary policy and how each is used to change the
money supply. Does each tool affect the monetary base or the money multiplier?

Answer: The three tools are open market operations, the purchase and sale of government
securities; discount policy, controlling the price and quantity of discount loans to banks; and
reserve requirements, setting the percentage of deposits that banks must hold in reserve. Open
market operations and the discount rate affect the monetary base, and reserve requirements
affect the money multiplier.

54) State whether the following statement is true or false AND explain why: ʺA decrease in
the discount rate will always cause a decrease in the federal reserve funds rate.ʺ

Answer: False. Since the discount rate is set above the federal funds rate, a decrease in the
discount rate will only cause a decrease in the federal funds rate if the discount rate is
decreased below the original federal funds rate level. If the decrease in the discount rate is
such that the new rate is still above the federal funds rate, then the federal funds rate does not
change, everything else held constant.

55) State whether the following statement is true or false AND explain why: ʺAn increase in
the interest rate paid on excess reserves will always cause an increase in the federal reserve
funds rate.ʺ
Answer: False. If the interest rate paid on excess reserves is set below the federal funds rate,
an increase in the interest rate paid on excess reserves will only cause an increase in the
federal funds rate if the interest rate paid on excess reserves is increased above the original
federal funds rate level. If the increase in the interest rate paid on excess reserves is such that
the new rate is still below the federal funds rate, then the federal funds rate does not change,
everything else held constant.

30) Explain dynamic and defensive open market operations. What is the purpose of each
type? Describe two situations when defensive open market operations are used. How are
defensive open market operations typically conducted?

Answer: Dynamic OMOs are used to permanently change the monetary base and money
supply. Defensive operations are used to offset temporary changes in the monetary base
and/or money supply. Defensive operations are used to offset float, shifts in Treasury
balances into or out of the Fed, and temporary changes in currency. Defensive purchases are
typically conducted by using repurchase agreements, while reverse repos or matched sale-
purchase transactions are used to conduct defensive open market sales

9) Explain what inflation targeting is. What are the advantages and disadvantages of this type
of monetary policy strategy?

Answer: There are five main elements to inflation targeting: 1. a public announcement of a
medium-term target for the inflation rate; 2. a commitment to price stability as the primary
long-term goal of policy; 3. many variables are used in making decisions about policy moves;
4. increased transparency about policy strategy with the public; 5. the central bank has
increased accountability for attaining policy goals. The advantages of inflation targeting
include: 1. the simplicity and clarity of a numerical target for the inflation rate; 2. does not
rely on a stable money-inflation relationship; 3. there is increased accountability of the
central bank; 4. reduces the effects of inflationary shocks. The disadvantages of inflation
targeting include: 1. there is a delayed signal about the achievement of the target; 2. it could
lead to a rigid rule where the only focus is the inflation rate (has not happened in practice); 3.
if sole focus is the inflation rate, larger output fluctuations can occur (has not happened in
practice).

8) Explain the Federal Reserveʹs ʺjust do itʺ approach to monetary policy. What are the
advantages and disadvantages to this type of strategy?

Answer: The Federal Reserve doesnʹt use an explicit nominal anchor such as a monetary
aggregate or the inflation rate. Its strategy revolves around using an implicit nominal anchor
in the form of an overriding concern to control inflation in the long run. This involves
forward-looking behavior and ʺpre-emptive strikesʺ by policy actions to prevent inflation.
This forward-looking behavior is necessary because of the long time lags between monetary
policy action and its impact on inflation. The advantages of this policy strategy include: 1. it
doesnʹt rely on a stable money-inflation relationship; 2. the demonstrated success it has had in
the United States. The disadvantages of this policy strategy include: 1. there is a lack of
transparency; 2. its success depends on the individuals in charge of policy; 3. there is low
accountability of the central bank.

1. Should central banks be privately or publicly owned? Explain.

4. In what ways can the national central banks influence the conduct of monetary policy?

11. A central bank decides by how much an interest rate should be changed in order to restore
equilibrium. What are the tools it uses to take such decisions?

1. Classify each of these transactions as an asset, a liability, or neither for each of the
“players” in the money supply process—the Federal Reserve, banks, and depositors. a. You
get a $10,000 loan from the bank to buy an automobile.

b. You deposit $400 into your checking account at the local bank. c. The Fed provides an
emergency loan to a bank for $1,000,000. d. A bank borrows $500,000 in overnight loans
from another bank. e. You use your debit card to purchase a meal at a res taurant for $100.

2. The First National Bank receives an extra $100 of reserves but decides not to lend out any
of these reserves. How much deposit creation takes place for the entire banking system?

3. Suppose the Fed buys $1 million of bonds from the First National Bank. If the First
National Bank and all other banks use the resulting increase in reserves to purchase securities
only and not to make loans, what will happen to checkable deposits?

7. “The Fed can perfectly control the amount of reserves in the system.” Is this statement
true, false, or uncer tain? Explain.

8. “The Fed can perfectly control the amount of the mon etary base, but has less control over
the composition of the monetary base.” Is this statement true, false, or uncertain? Explain. 9.
The Fed buys $100 million of bonds from the public and also lowers the required reserve
ratio. What will happen to the money supply?
15. The money multiplier declined significantly during the period 1930–1933 and also during
the recent finan cial crisis of 2008–2010. Yet the M1 money supply decreased by 25% in the
Depression period but increased by more than 20% during the recent financial crisis. What
explains the difference in outcomes?

16. If the Fed sells $2 million of bonds to the First National Bank, what happens to reserves
and the monetary base? Use T-accounts to explain your answer.

17. For the following operations, what happens to the central bank’s and commercial bank’s
reserves and the monetary base? Use T-account to show changes in balances. Assume that the
amount is $10 million. a. The central bank provides loan to commercial bank. b. The central
bank sells securities to the commercial bank. c. The commercial bank repays the loan to the
central bank.

18. If the Fed lends five banks a total of $100 million but depositors withdraw $50 million
and hold it as cur rency, what happens to reserves and the monetary base? Use T-accounts to
explain your answer.
1. If the manager of the open market desk hears that a snowstorm is about to strike New York
City, making it difficult to present checks for payment there and so raising the float, what
defensive open market operations will the manager undertake?

2. During the holiday season, when the public’s holdings of currency increase, what
defensive open market operations typically occur? Why?

3. If the Treasury pays a large bill to defense contrac tors and as a result its deposits with the
Fed fall, what defensive open market operations will the manager of the open market desk
undertake?

4. If float decreases to below its normal level, why might the manager of domestic operations
consider it more desirable to use repurchase agreements to affect the monetary base, rather
than an outright purchase of bonds?

5. “The only way that the Fed can affect the level of borrowed reserves is by adjusting the
discount rate.” Is this statement true, false, or uncertain? Explain your answer.

6. “The federal funds rate can never be above the discount rate.” Is this statement true, false,
or uncertain? Explain your answer.

7. “The federal funds rate can never be below the interest rate paid on reserves.” Is this
statement true, false, or uncertain? Explain your answer.

8. Why is paying interest on reserves an important tool for the Federal Reserve in managing
crises?

12. “Discount loans are no longer needed because the pres ence of the FDIC eliminates the
possibility of bank pan ics.” Is this statement true, false, or uncertain?

13.What are the disadvantages of using loans to financial institutions to prevent bank panics?
15. Compare the methods of controlling the money supply—open market operations, loans to
financial institutions, and changes in reserve requirements—on the basis of the following
criteria: flexibility, reversibil ity, effectiveness, and speed of implementation.
 8. Inflation

10. Suppose that the economy is at the natural rate of output. Explain
how a positive supply shock, followed by a more restrictive monetary
policy, allows policymakers a painless way to reduce inflation.

Answer: The positive supply shock increases aggregate supply, exerting

downward pressure on prices. Policymakers can now reduce demand to
further reduce inflationary pressure without reducing output below the
natural rate.

11. Suppose the economy is at the natural rate of output. Explain how a
tax increase reduces demand and increases unemployment. Why is the
speed of the adjustment of wages and/or the role of expectations
important in this situation?

Answer: The tax increase decreases aggregate demand. Output falls

below the natural rate, increasing unemployment. If wages are slow to
adjust, the economy remains below the natural rate for a long time, but
adjustment back to the natural rate is rapid if wages adjust quickly or if
expectations lead to rapid adjustment of wages