Case / Fair - Chapter 25 -9-10-11-13-17

Chapter 25 -9-10-11-13-17

This is a guidance answer ... your actual answer during the exam should be longer than this answer ...

9.     M2 includes everything in M1, plus savings accounts, money market accounts, and some other categories. A shift of funds between, for example, savings accounts and checking accounts, will affect M1 but not M2, because both savings accounts and checking accounts are part of M2.

10.    (a)    Agree. The two sentences are correct. When the Fed sells bonds, the proceeds do not go back into circulation. Rather, the proceeds are withdrawn from the economy, reducing the quantity of reserves in the system and reducing the supply of money. Fed open market operations change the money supply.

        (b)    Disagree. The money multiplier is equal to 1/RR. The expenditure (fiscal) multiplier is equal to 1/MPS. The expenditure multiplier and the money multiplier are very different. The expenditure multiplier gives the change in equilibrium output (income) that would result from a sustained change in some component of aggregate expenditure.

11.    Money injected through open market operations results in a multiple expansion of the money supply only if it leads to loans, and loans can be made only if the new money ends up in banks as reserves. If the Fed buys a bond from James Q. Public, who immediately deposits the proceeds into a dollar-denominated Swiss bank account, the U.S. money supply won’t expand at all. If the money ends up in his pockets or in his mattress, the expansion of the money supply will stop right there. If he had deposited the proceeds in a U.S. bank, excess reserves would have been created, stimulating lending and further money creation.

13. People in Zimbabwe will accept U.S. dollars so long as they believe that others in the country will also accept U.S. dollars. The currency does not have to be issued by the ruling government to act as a medium of exchange in that country. Zimbabwean dollars had become virtually worthless, and U.S. dollars were a good store of value, so people had faith in the value of the U.S. dollar.

17.    The three tools the Fed can use to change the money supply are changing the required reserve ratio, changing the discount rate, and engaging in open market operations.

        If the Fed increases the required reserve ratio, banks would be legally required to hold more of all deposits as required reserves. The more banks have to legally keep as reserves, the less they have to loan to customers. As banks loan less, the money supply decreases. If the Fed lowers the required reserve ratio, banks would have more money to loan. The more banks loan, the larger the money supply grows.

        If the Fed increases the discount rate, it charges banks more to borrow from the Fed. If the discount rate increases, banks will tend to borrow less, and this leaves banks less to loan, therefore decreasing the money supply. If the Fed decreases the discount rate, banks will pay less to borrow from the Fed. This will make it more attractive for banks to borrow, and the more they borrow, the more they can loan, which will increase the money supply.

        If the Fed makes an open market purchase of government securities, it pays for the security by writing a check that, when it clears, expands the quantity of reserves in the system which increases the money supply. If the Fed makes an open market sale of government securities, it receives a check which, when cleared, reduces the quantity of reserves in the system which decreases the money supply.

Courtesy of Case/Fair/Oster, 11th edition, 2014