978-0077660772 Chapter 14 Solution Manual

Chapter 14 – Money, Banking, and Financial Institutions

20e McConnell Brue Flynn

DISCUSSION QUESTIONS

1. What are the three basic functions of money? Describe how rapid inflation can undermine

money’s ability to perform each of the three functions. LO1

Answer: Money is used as a medium of exchange for goods and services, as a

unit of account for expressing price, and as a store of value.

Again, drastic inflation greatly reduces money’s use as a measure of value (unit of

Finally, and most obviously, money’s usefulness as a store of value is destroyed in

a drastic inflation. The “rule of 70” is instructive here. By dividing the absolute

2. Which two of the following financial institutions offer checkable deposits included within the

M1 money supply: mutual fund companies; insurance companies; commercial banks; securities

firms; thrift institutions? Which of the following items is not included in either M1 or M2:

currency held by the public; checkable deposits; money market mutual fund balances; small-

denominated (less than $100,000) time deposits; currency held by banks; savings deposits? LO2

Answer: Commercial banks and thrift institutions offer checkable deposits.

3. What are the components of the M1 money supply? What is the largest component? Which of

the components of M1 is legal tender? Why is the face value of a coin greater than its intrinsic

value? What near-monies are included in the M2 money supply? LO2

Answer: M1 = currency (in circulation) + checkable deposits. The largest

component of M1 is currency (51 percent), and it is the only part that is legal

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4. Explain and evaluate the following statements: LO2

a. The invention of money is one of the great achievements of humankind, for without it the

enrichment that comes from broadening trade would have been impossible.

b. Money is whatever society says it is.

c. In the United States, the debts of government and commercial banks are used as money.

d. People often say they would like to have more money, but what they usually mean is that they

would like to have more goods and services.

e. When the price of everything goes up, it is not because everything is worth more but because

the currency is worth less.

f. Any central bank can create money; the trick is to create enough, but not too much, of it.

Answer: a. Without money, trade must occur through barter. Barter requires the

“double coincidence of wants,” the requirement that a seller find a buyer who not

only desires what the seller has to offer but also has to offer what the buyer

b. Money must be acceptable in exchange. That is its fundamental requirement. A

person will accept payment in whatever is called money only if that person knows

that the money can subsequently be used in exchange for something else. If the

c. All accounts (saving and checking) in the commercial banks are money owed

by these banks to their customers, who own these deposits. Since checks drawn

d. People often use the term “money” when they are referring to wealth or

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Chapter 14 – Money, Banking, and Financial Institutions

e. The statement is accurate. If the price of one thing goes up relative to another, it

f. The most important function of the Federal Reserve (or any central bank) is to

5. What “backs” the money supply in the United States? What determines the value (domestic

purchasing power) of money? How does the purchasing power of money relate to the price level?

Who in the United States is responsible for maintaining money’s purchasing power? LO3

Answer: There is no concrete backing to the money supply in the United States.

Paper money, which has no intrinsic value, has value only because people are

willing to accept it in exchange for goods and services, including their labor

6. How is the chairperson of the Federal Reserve System selected? Describe the relationship

between the Board of Governors of the Federal Reserve System and the 12 Federal Reserve

Banks. What is the purpose of the Federal Open Market Committee (FOMC)? What is its

makeup? LO4

Answer: The members of the Board of Governors of the Federal Reserve are

selected by the U.S. president and confirmed by the Senate. The seven board

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Chapter 14 – Money, Banking, and Financial Institutions

7. The following are two hypothetical ways in which the Federal Reserve Board might be

appointed. Would you favor either of these two methods over the present method? Why or why

not? LO4

a. Upon taking office, the U.S. president appoints seven people to the Federal Reserve Board,

including a chair. Each appointee must be confirmed by a majority vote of the Senate, and each

serves the same 4-year term as the president.

b. Congress selects seven members from its ranks (four from the House of Representatives and

three from the Senate) to serve at Congressional pleasure as the Board of Governors of the

Federal Reserve System.

Answer: In the opinion of most economists, the Fed should be protected from

political pressures so that it can effectively control the money supply and maintain

Option (b) would place the BOG under the control of Congress. Neither of the

8. What is meant when economists say that the Federal Reserve Banks are central banks, quasi-

public banks, and bankers’ banks? LO4

Answer: The 12 Federal Reserve Banks are “central” banks whose policies are

9. Why do economists nearly uniformly support an independent Fed rather than one beholden

directly to either the President or Congress? LO5

Answer: The objective is to protect the Fed from political pressures so that it can

effectively control the money supply and maintain price stability. Political pressures on

10. Identify three functions of the Federal Reserve of your choice, other than its main role of

controlling the supply of money. LO5

Answer: The Federal Reserve performs 7 basic functions:

1. The Fed issues Federal Reserve Notes, the paper currency used in the U.S.

monetary system.

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11. How do each of the following relate to the financial crisis of 2007-2008: declines in real

estate values, subprime mortgage loans, mortgage backed securities, AIG. LO6

Answer: Prior to the 2007-2008 financial crisis the banking institutions issued a large

number of loans to borrowers that were relatively more ‘risky’ in the sense that these

borrowers were more likely to default on their loans. This was referred to as the sub-

When housing prices started to decline and individuals started to default on their

mortgages (initially sub-prime borrowers) this reduced or completely eliminated the

12. What is TARP and how was it funded? What is meant by the term “lender of last resort” and

how does it relate to the financial crisis of 2007-2008? How do government and Federal Reserve

emergency loans relate to the concept of moral hazard? LO7

Answer: In late 2008 Congress passed the Troubled Asset Relief Program (TARP),

which allocated $700 billion—yes, billion—to the U.S. Treasury to make emergency

One of the roles of the Federal Reserve is to serve as the lender of last resort to financial

institutions in times of financial emergencies. That is, the Federal Reserve stands ready to

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Chapter 14 – Money, Banking, and Financial Institutions

TARP indeed saved several financial institutions whose bankruptcy would have caused a

13. What are the major categories of firms that make up the U.S. financial services industry? Are

there more or fewer banks today than before the start of the financial crisis of 2007-2008? Why

are the lines between the categories of financial firms even more blurred than they were before

the crisis? How did the Wall Street Reform and Consumer Protection Act of 2010 try to address

some of the problems that helped cause the crisis? LO8

Answer: The major categories of firms that make up the U.S. financial services industry

include: commercial banks, thrifts, insurance companies, mutual fund companies,

pension funds, and securities related firms. Commercial banks and thrifts have declined

14. LAST WORD Why are federal prosecutors reluctant to bring major charges against large

financial firms? What was the main regulatory action of the Glass-Steagall law? Why might

having many smaller financial firms be more stable than having fewer larger firms? What

argument can be made for the possibility that larger financial firms might be more stable than

smaller financial firms?

Answer: Federal prosecutors are reluctant to bring major charges against large financial

The Glass-Steagall Act required Wall Street to segregate high-risk and low-risk financial

activities across different firms. In particular, Glass-Steagall required commercial banks

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One also might argue that larger financial firms could be more stable than smaller

REVIEW QUESTIONS

1. The three functions of money are: LO1

a. Liquidity, store of value, and gifting.

b. Medium of exchange, unit of account, and liquidity.

c. Liquidity, unit of account, and gifting.

d. Medium of exchange, unit of account, and store of value.

Feedback: Liquidity is not a good answer because liquidity is not a function of money

but is rather the ease with which any other asset besides money can be quickly converted

2. Suppose that a small country currently has $4 million of currency in circulation, $6 million of

checkable deposits, $200 million of savings deposits, $40 million of small denominated time

deposits, and $30 million of money market mutual fund deposits. From these numbers we see that

this small country’s M1 money supply is ____________, while ____________ its M2 money

supply is. LO2

a. $10 million; $280 million.

b. $10 million; $270 million.

c. $210 million; $280 million.

d. $250 million; $270 million.

Feedback: From these numbers, we see that M1 is $10 million while M2 is $280

million. M1 is defined as currency in circulation plus checkable deposits. For this small

3. Recall the formula that states that $V = 1/P, where V is the value of the dollar and P is the price

level. If the price level falls from 1 to 0.75, what will happen to the value of the dollar? LO3

a. It will rise by a third (33.3 percent).

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b. It will rise by a quarter (25 percent).

c. It will fall by a quarter (-25 percent).

d. It will fall by a third (-33.3 percent).

Feedback: The easiest way to see this is to note that the original value of money when

the price level is 1 will be 1/1 = 1, while the value of money after the price level falls to

4. Which group votes on the open-market operations that are used to control the U.S. money

supply and interest rates? LO4

a. The Federal Reserve System.

b. The 12 Federal Reserve Banks.

c. The Board of Governors of the Federal Reserve System.

d. The Federal Open Market Committee (FOMC).

Feedback: The FOMC is made up of 12 individuals: the seven members of the Board of

5. An important reason why members of the Federal Reserve’s Board of Governors are each

given extremely long, 14-year terms is to: LO4

a. Insulate members from political pressures that could result in inflation.

b. Help older members avoid job searches before retiring.

c. Attract younger people with lots of time left in their careers.

d. Avoid the trouble of constantly having to deal with new members.

Feedback: If incumbent politicians were in control of the Federal Reserve, they would be

tempted to increase the money supply and lower interest rates in order to stimulate the

6. Which of the following is not a function of the Fed? LO5

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a. Setting reserve requirements for banks.

b. Advising Congress on fiscal policy.

c. Regulating the supply of money.

d. Serving as a lender of last resort.

Feedback: That’s because the Fed’s area of control and supervision is monetary policy

and the soundness of the banking system. Thus, the Fed’s main functions include issuing

7. James borrows $300,000 for a home from Bank A. Bank A resells the right to collect on that

loan to Bank B. Bank B securitizes that loan with hundreds of others and sells the resulting

security to a state pension plan, which at the same time purchases an insurance policy from AIG

that will pay off if James and the other people whose mortgages are in the security can’t pay off

their mortgage loans. Suppose that James and all the other people can’t pay off their mortgages.

Which financial entity is legally obligated to suffer the loss? LO6

a. Bank A.

b. Bank B.

c. The state pension plan.

d. AIG.

Feedback: Because it sold loan-default insurance to the pension plan, AIG will have to

suffer the loss when James and the other mortgage borrowers can’t pay off their

mortgages. During the financial crisis, the insurance company AIG was overwhelmed

with claims on the many “collateralized default swaps” that it had sold as insurance on

8. City Bank is considering making a $50 million loan to a company named SheetOil that wants

to commercialize a process for turning used blankets, pillowcases, and sheets into oil. This

company’s chances for success are dubious, but City Bank makes the loan anyway because it

believes that the government will bail it out if SheetOil goes bankrupt and cannot repay the loan.

City Bank’s decision to make the loan has been affected by: LO7

a. Liquidity.

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b. Moral hazard.

c. Token money.

d. Securitization.

Feedback: As it relates to financial investment, moral hazard is the tendency for financial

investors to take on greater risks because they are at least partially insured against losses.

In this case, City Bank is only willing to invest because it believes that it will be bailed

9. True or False: The financial crisis hastened the ongoing process in which the financial services

industry was transforming from having a few large firms to many small firms. LO8

PROBLEMS

1. Assume that the following asset values (in millions of dollars) exist in Ironmania: Federal

Reserve Notes in circulation = $700; Money market mutual funds (MMMFs) held by individuals

= $400; Corporate bonds = $300; Iron ore deposits = $50; Currency in commercial banks = $100;

Savings deposits, including money market deposit accounts (MMDAs) = $140; Checkable

deposits = $1500 ; Small-denominated (less than $100,000) time deposits = $100; Coins in

circulation = $40. LO1

a. What is M1 in Ironmania?

b. What is M2 in Ironmania?

Feedback: Part a:

M1 equals Federal Reserve Notes in circulation plus checkable deposits plus Coins in

circulation.

Part b:

M2 equals M1 plus Savings deposits, including Money market deposit accounts

(MMDAs) plus Small-denominated (less than $100,000) time deposits plus Money

Market Mutual Funds (MMMFs) held by individuals.

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2. Assume that Jimmy Cash has $2,000 in his checking account at Folsom Bank and uses his

checking account card to withdraw $200 of cash from the bank’s ATM machine. By what dollar

amount did the M1 money supply change as a result of this single, isolated transaction? LO2

Feedback: The answer is zero. Jimmy withdrew $200 from his checking account, so his

3. Suppose the price level and value of the U.S. dollar in year 1 are 1 and $1, respectively. If the

price level rises to 1.25 in year 2, what is the new value of the dollar? If, instead, the price level

falls to .50, what is the value of the dollar? LO3

Feedback: The amount a dollar will buy varies inversely with the price level; that is, a

reciprocal relationship exists between the general price level and the purchasing power of

4. Assume that securitization combined with borrowing and irrational exuberance in Hyperville

have driven up the value of existing financial securities at a geometric rate, specifically from $2

to $4 to $8 to $16 to $32 to $64 over a 6-year time period. Over the same period, the value of the

assets underlying the securities rose at an arithmetic rate from $2 to $3 to $4 to $5 to $6 to $7. If

these patterns hold for decreases as well as for increases, by how much would the value of the

financial securities decline if the value of the underlying asset suddenly and unexpectedly fell by

$5? LO6

Feedback: Since we are assuming the same ratios (or the structure of the growth rates

remains the same), a decline in the underlying asset value by $5 results in a new asset

5. Suppose that Lady Gaga goes to Las Vegas to play poker and at the last minute her record

company says it will reimburse her for 50 percent of any gambling losses that she incurs. Will

Lady Gaga wager more or less as a result of the reimbursement offer? What economic concept

does your answer illustrate? LO7

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Feedback: Since Lady Gaga will get reimbursed for part of her losses she will gamble

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