Book cover for Macroeconomics

Macroeconomics

Paul Krugman, Robin Wells

ISBN #9781464110375

4th Edition

265 Questions

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Homework Questions

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Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

Chapter 14 explores how money functions in the economy, detailing its multiple roles as a medium of exchange, store of value, and unit of account. It distinguishes between types of money—including commodity and fiat—and explains the composition of monetary aggregates like M1 and M2. The chapter further delves into the mechanics of the deposit-lending process and the money multiplier effect, which together demonstrate how banks can expand the money supply. Additionally, it outlines the key tools utilized by the Federal Reserve to manage monetary policy and maintain financial stability, supported by historical examples of banking crises and regulation evolutions.

Learning Objectives

1

Describe the roles and functions of money as a medium of exchange, store of value, and unit of account.

2

Differentiate between various types of money, including commodity money and fiat currency, as well as monetary aggregates like M1 and M2.

3

Explain the process by which banks create money through the deposit-lending process and the money multiplier effect.

4

Identify and discuss the tools used by the Federal Reserve, such as open-market operations, reserve requirements, and the discount window.

Key Concepts

CONCEPT

DEFINITION

Money

Any item or verifiable record that functions as a medium of exchange, a store of value, and a unit of account.

Commodity Money

Money that has intrinsic value, typically being made of precious metals or other valuable goods.

Fiat Currency

Government-issued money that is not backed by a physical commodity but by the trust and authority of the issuing government.

Monetary Aggregates (M1 and M2)

M1 includes the most liquid forms of money (like cash and checking deposits), while M2 encompasses M1 plus less liquid forms such as savings deposits.

Deposit-Lending Process

The process through which banks accept deposits and then use a portion of these deposits to make loans, thereby creating new money.

Money Multiplier

A factor by which a change in bank reserves is magnified into a larger change in the overall money supply through repeated rounds of deposit and lending.

Open-Market Operations

The purchase and sale of government securities by the Federal Reserve to influence the level of reserves in the banking system and hence the money supply.

Reserve Requirements

Regulatory mandates that determine the minimum fraction of customer deposits that banks must hold as reserves rather than lend out.

Discount Window

A facility through which banks can borrow short-term funds directly from the Federal Reserve, typically to meet temporary liquidity shortages.

Example Problems

Example 1

For each of the following transactions, what is the initial effect (increase or decrease) on M1? On M2? a. You sell a few shares of stock and put the proceeds into your savings account. b. You sell a few shares of stock and put the proceeds into your checking account. c. You transfer money from your savings account to your checking account. d. You discover $\$ 0.25$ under the floor mat in your car and deposit it in your checking account. e. You discover $\$ 0.25$ under the floor mat in your car and deposit it in your savings account.

Example 2

There are three types of money: commodity money, commodity-backed money, and fiat money. Which type of money is used in each of the following situations? a. Bottles of rum were used to pay for goods in colonial Australia. b. Salt was used in many European countries as a medium of exchange. c. For a brief time, Germany used paper money (the "Rye Mark") that could be redeemed for a certain amount of rye, a type of grain. d. The town of Ithaca, New York, prints its own currency, the Ithaca HOURS, which can be used to purchase local goods and services.

Example 3

The following table shows the components of M1 and M2 in billions of dollars for the month of December in the years 2003 to 2013 reported by the Federal Reserve Bank of St. Louis. Complete the table by calculating M1, M2, currency in circulation as a percentage of $\mathrm{M} 1,$ and currency in circulation as a percentage of $\mathrm{M} 2$ What trends or patterns about $\mathrm{M} 1, \mathrm{M} 2,$ currency in circulation as a percentage of $\mathrm{M} 1,$ and currency in circulation as a percentage of $\mathrm{M} 2$ do you see? What might account for these trends?

Example 4

Indicate whether each of the following is part of $\mathrm{M} 1$ $\mathrm{M} 2,$ or neither: a. $\$ 95$ on your campus meal card b. $\$ 0.55$ in the change cup of your car c. $\$ 1,663$ in your savings account d. $\$ 459$ in your checking account e. 100 shares of stock worth $\$ 4,000$ f. $A \$ 1,000$ line of credit on your Sears credit card

Example 5

Tracy Williams deposits $\$ 500$ that was in her sock drawer into a checking account at the local bank. a. How does the deposit initially change the T-account of the local bank? How does it change the money supply? b. If the bank maintains a reserve ratio of $10 \%$, how will it respond to the new deposit? c. If every time the bank makes a loan, the loan results in a new checkable bank deposit in a different bank equal to the amount of the loan, by how much could the total money supply in the economy expand in response to Tracy's initial cash deposit of $\$ 500 ?$ d. If every time the bank makes a loan, the loan results in a new checkable bank deposit in a different bank equal to the amount of the loan and the bank maintains a reserve ratio of $5 \%$, by how much could the money supply expand in response to Tracy's initial cash deposit of $\$ 500 ?$
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Step-by-Step Explanations

QUESTION

How do banks create money using the deposit-lending process?

STEP-BY-STEP ANSWER:

Step 1: A customer deposits money into a bank, increasing the bank's reserves.
Step 2: The bank is required to hold a fraction of this deposit as reserves, as dictated by the reserve requirements.
Step 3: The remaining amount is lent out to borrowers, who then spend or deposit the money elsewhere.
Step 4: The new deposit created by the borrower is again subject to the reserve requirement and can be partially lent out.
Step 5: This cycle of depositing and lending continues, effectively multiplying the initial deposit into a larger overall money supply.
Final Answer: Banks create money by leveraging deposits through the deposit-lending process, where each cycle of lending and depositing results in a multiplied increase in the total money supply.

Deposit-Lending Process

QUESTION

How does the money multiplier effect amplify the initial bank deposit?

STEP-BY-STEP ANSWER:

Step 1: Identify the reserve requirement ratio (for example, 10%).
Step 2: Understand that for every dollar deposited, only a portion (e.g., 10 cents) is held in reserve, while the rest (e.g., 90 cents) is available for lending.
Step 3: Recognize that each lent amount is redeposited and again subjected to the reserve ratio, allowing further lending.
Step 4: Calculate the potential increase in the money supply using the formula: Money Multiplier = 1 / Reserve Requirement Ratio.
Step 5: For a 10% reserve requirement, the multiplier is 1 / 0.10 = 10, indicating that each dollar can potentially increase the money supply by ten dollars.
Final Answer: The money multiplier effect shows that with a deposit subjected to reserve requirements, banks can amplify the initial deposit by repeatedly lending out the excess balance, resulting in a total money supply increase that is a multiple of the original deposit.

Money Multiplier Effect

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Common Mistakes

  • Confusing commodity money with fiat currency and overlooking the inherent differences in their values and backing.
  • Failing to grasp the cumulative impact of the deposit-lending process and money multiplier, leading to an underestimation of the banks' role in money creation.
  • Overlooking the significance of Federal Reserve tools, such as reserve requirements and open-market operations, in influencing the overall economy.
  • Misinterpreting historical events like bank runs as isolated incidents rather than as catalysts for evolving monetary regulation and policy.