Chapter 14 – Money, Banking, and Financial Institutions
14-1
Chapter 14 Money, Banking, and Financial Institutions
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.
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? LO1
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? LO1, LO2
Answer: M1 = currency (in circulation) + checkable deposits. The largest component of
Chapter 14 – Money, Banking, and Financial Institutions
14-2
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 desires.
Chapter 14 – Money, Banking, and Financial Institutions
14-3
employment and a relatively constant price level.
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? LO2
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 services as employees. And
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? LO3
Chapter 14 – Money, Banking, and Financial Institutions
14-4
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 members have long
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? LO3
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 price stability.
8. What is meant when economists say that the Federal Reserve Banks are central banks, quasi-
public banks, and bankers’ banks?
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? LO3
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
Chapter 14 – Money, Banking, and Financial Institutions
14-5
10. Identify three functions of the Federal Reserve of your choice, other than its main role of
controlling the supply of money. LO4
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.
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. LO5
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
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? LO6
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
Chapter 14 – Money, Banking, and Financial Institutions
14-6
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? LO7
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 How does a debit card differ from a credit card? How does a stored-value
card differ from both? Suppose that a person has a credit card, debit card, and stored-value card.
Create a fictional scenario in which the person uses all three cards in the same day. Explain the
person’s logic for using one card rather than one of the others for each transaction. How do
Fedwire and ACH transactions differ from credit card, debit card, and stored-value card
transactions?
Answer: Debit cards access a financial asset – a checkable deposit; credit cards incur a
liability – credit card holders take out a loan whenever they use the credit card for
Chapter 14 – Money, Banking, and Financial Institutions
14-7
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: Consider the following example. 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.
Part a:
What is M1 in Ironmania?
M1 equals Federal Reserve Notes in circulation plus checkable deposits plus Coins in
Part b:
What is M2 in Ironmania?
M2 equals M1 plus Savings deposits, including Money market deposit accounts
Chapter 14 – Money, Banking, and Financial Institutions
14-8
2. Assume that Jimmy Cash has $2000 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? LO1
Feedback: Consider the following example. Assume that Jimmy Cash has $2000 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?
The answer is zero. Jimmy withdrew $200 from his checking account, so his checkable
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? LO2
Feedback: Consider the following example. 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?
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 the dollar.
4. 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? LO5
Feedback: Consider the following example. 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?
referred to as moral hazard.
Chapter 14 – Money, Banking, and Financial Institutions
14-9
5. 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? LO5
Feedback: Consider the following example. 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. Assuming
existing ratios, by how much would the value of the financial securities decline if the
value of the underlying asset suddenly and unexpectedly fell by $5?
Since we are assuming the same ratios (or structure of the growth rates remain the same),