Money and banking Flashcards
Monetary policy is defined as the _______________ policies that are aimed at changing the size of the money supply and interest rates to affect the national economy.
Federal Reserve
Explanation
It involves changing the money supply to assist the economy to achieve a full employment, noninflationary level of output.
Money has three functions; first it is a medium of exchange, and second it is a store of _____, and third it is a unit of account.
value
Explanation
1) As a medium of exchange money facilitates trade, especially when we compare it to the barter system.
2) As a store of value money is able to commit resources and purchases to the future. When money is held, it retains value.
3) As a unit of account it provides a standard of payments. Physical dollar bills need not exist for this to be true (e.g. checks).
There are four categories of money - M1, M2, M2+, and M3. Each category represents an increasingly less ______ form of currency.
liquid
Explanation
- M1 = Currency + demand deposits (Demand deposits pay no interest and must be paid out on demand in cash.)
- M2 = M1 + personal savings deposits + non personal notice deposits (at chartered banks)
- M2+ = M2 added to deposits held by other financial institutions (Trust companies, Credit unions etc.)
- M3 = M2+ added to non-personal term deposits and foreign currency deposits. These categories represent increasingly less liquid forms of currency. In other words, they become more and more difficult to convert to cash.
The interest rate is the amount received by a lender and paid by a borrower expressed as a percentage of the amount of the ____.
loan
Explanation
Interest is the payment made for the use of money. The interest rate on a bond varies inversely with the price of the bond.
The ________ rate is the rate the Federal Reserve charges banks to borrow funds.
discount
Explanation
A higher discount rate by the Federal Reserve results in a higher interest rate on money lent by the banks.
When a bank makes _____, it creates money.
loans
Explanation
By extending credit, the bank increases the volume of money used in the economy. The person who gets a loan has walked into the bank with nothing and comes out with X dollars and an IOU.
The ratio of a bank’s cash assets to its deposit liabilities is referred to as the ____________.
Cash Reserve
Explanation
The reserve ratio = bank’s cash / bank’s liabilities The reserve requirement is used to ensure that the commercial banks can meet their cash needs. It is an effective check on the commercial banks’ money-creating operations making sure they have enough assets to cover their liabilities.
The amount by which the bank’s actual cash reserves exceed its required cash reserves is the bank’s excess ____ reserves.
cash
Explanation
The bank’s ability to create money depends on the amount of excess cash reserves they hold.
- The bank can then only make loans up to the amount of $10,000,000.
The Money __________ indicates the multiple by which the banking system can expand the money supply for each dollar of excess reserves.
Multiplier
Explanation
No one bank can loan more than their excess reserve but the banking system as a whole can lend money (create money) by a multiple of its excess reserves. The money multiplier is calculated as 1 / required reserve ratio (reciprocal of the cash reserve ratio). Example: If the reserve requirement is 20% and the banks have excess reserves of $5 billion, then the maximum amount of additional money that can be created is $25 billion.
If the Federal Reserve lowers the reserve requirements for commercial banks, the interest rate will ________.
decrease
Explanation
By lowering the required reserve, the excess reserves will increase. This will create an increase in the money supply (more money can be loaned and created) and a decrease in interest rates.
The major task of the Federal Reserve is to manage the money _____ in accordance with the needs of the economy.
supply
Explanation
In doing so it acts as a lender of last resort for member banks, it supervises member banks, provides check-clearing activities, and controls the money supply by manipulating banks’ excess reserves.
There are several methods that the Federal Reserve (The Fed) uses for affecting interest rates and the ____________.
money supply
Explanation
The Fed will want to use these tools to achieve the desired effect on the economy. When it wants to reduce the size of national output, it will tend to raise interest rates and decrease the money supply (called tight money policy). When it wishes to expand the economy, it engages in easy money policy. The two most important of these are open market operations and the bank rate.
An ____ market operation is the purchase or sale of government securities (usually Treasury Bills) by the Federal Reserve.
open
Explanation
This is the way the Federal Reserve controls the money supply.
When the Federal Reserve purchases securities it _________ the banks’ reserves.
increases
Explanation
When the Fed purchases a bond / security it then gives the individual or institution that sold the bond some money in return for the bond. This money is then immediately deposited into the banking system. This then gives more reserves for the bank to make more loans and to therefore expand the total amount of deposits held by the bank system, in the same manner as any new deposit in the bank. The purchase of a bond by the Fed will have an expansionary effect on the money supply.
When the Federal Reserve sells securities it _________ the banks’ reserves.
decreases
Explanation
When the Fed sells a bond / security, the individual or institution that buys the bond gives the Fed some money in return for the bond. This money is then immediately withdrawn from the banking system. This results in fewer reserves available for the bank to make loans and therefore decreases the total amount of deposits held by the bank system, in the same manner as any withdrawal in the bank. The sale of a bond by the Fed will have a contractionary effect on the money supply.
The transactions demand for money is independent of the ________ rate.
interest
Explanation
It is shown as a vertical line on a graph plotting interest rates and money demanded.
The Asset Demand for money stems from the fact that _____ is a store of value and people hold their financial assets in many forms.
money
Explanation
It is important to remember that the opportunity cost of holding money is that the holder (saver) will not earn interest on that money, so interest rates are the ‘price’ of money. When interest rates rise, it is assumed that people will try to hold less cash. Therefore, the amount of cash held will be inversely related to the rate of interest in the economy. This provides us with a downward sloping money demand curve.
A change in the interest rate brings a movement along the money ______ curve.
demand
Explanation
At higher rates, less money is demanded than at lower rates.
A change in ______ brings a shift of the money demand curve.
real GDP
Explanation
For example, when national income rises, more cash is needed to finance the transactions that occur in the economy (transactions demand increases). As well, when nominal GDP rises, we will also need more money to use in day-to-day transactions. This is shown as a shift of the money demand curve.
The _______ rate is determined such that the quantity of money demanded equals the quantity supplied.
interest
Explanation
1) Here, the equilibrium interest rate is 5%. At interest rates above 5%, the quantity of money demanded is less than the quantity supplied. People try to get rid of money by buying bonds (saving). This causes Bond prices to rise (more demand for them) and the interest rate falls.
2) At interest rates below 5%, the quantity of money demanded exceeds the quantity supplied. People try to get more money by selling bonds. Bond prices fall and the interest rate rises. Only when the interest rate is 5% are people not trying to change their holding of money, so the interest rate is constant.
The Federal Reserve’s open market operations that change the money supply also influence _______ rates.
interest
Explanation
A decrease in the money supply raises interest rates and an increase in the money supply lowers interest rates.
1) Initially, the money supply curve is MS0 and the interest rate is 5 percent.
2) Suppose the Fed increases the money supply to MS1, the interest rate falls to 3 percent (increased money supply leads to a decreased money demand and lower equilibrium interest rate)
3) Suppose the Fed decreases the money supply to MS2, the interest rate rises to seven percent (decreased money supply leads to a increased money demand and higher equilibrium interest rate).
Monetary policy changes that cause interest rates to drop are used in a _________.
recession
Explanation
Follow this example closely: If real GDP is $550 billion and potential GDP is $600 billion there is a recessionary gap (demand for products is low, high unemployment). An open market purchase will increase the amount of reserves the commercial banks have to lend.
1) This will increase the money supply and will cause interest rates to drop. As interest rates drop, aggregate demand will increase (money costs less to borrow) and the AD curve will shift right to AD1, and Real GDP will increase (more investment, more employment) back up to its potential of $600 billion and the price level rises to equilibrium 130. In this way monetary policy can have an effect on the employment level.
Monetary policy changes that cause interest rates to rise are used during _________.
inflation
Explanation
Real GDP is $650 billion and there is an inflationary gap. With no further action by the Bank, the price level will rise to 145. An open market sale will decrease the amount of reserves the commercial banks have to lend. This will decrease the money supply and will cause interest rates to rise. The rising interest rates will cause Aggregate demand to decrease and real GDP decreases to potential GDP. The price level falls back to 130.
