Chapter 29 : The Monetary System

Section A (MCQ)

1. Money
a. is more efficient than barter.
b. makes trades easier.
c. allows greater specialization.
d. All of the above are correct.

2. Changes in the quantity of money affect

a. interest rates.
b. Prices.
c. Production.
d. All of the above are correct

3. Which of the following best illustrates the medium of exchange function of

money?
a. You keep some money hidden in your shoe.
b. You keep track of the value of your assets in terms of currency.
c. You pay for your double latte using currency.
d. None of the above is correct.

4. Liquidity refers to
a. the ease with which an asset is converted to the medium of exchange.
b. a measurement of the intrinsic value of commodity money.
c. the suitability of an asset to serve as a store of value.
d. how many time a dollar circulates in a given year.

5. Which type of currency has intrinsic value?

a. Commodity money.
b. Fiat money.
c. Both commodity money and fiat money.
d. Neither commodity money nor fiat money.

6. M1 equals currency + demand deposits +

a. nothing else.
b. other checkable deposits.
c. traveler's checks + other checkable deposits.
d. traveler's checks + other checkable deposits + savings deposits.
7. You get money for babysitting the neighbors' children. This best illustrates
which function of money?
a. medium of exchange
b. unit of account
c. store of value
d. Liquidity

8. The supply of money is determined by

a. the price level.
b. the Treasury and Congressional Budget Office.
c. the Federal Reserve System.
d. the demand for money

9. Which of the following is correct?

a. If the Fed purchases bonds in the open market, then the money supply
curve shifts right. A change in the price level does not shift the money
supply curve.
b. If the Fed sells bonds in the open market, then the money supply
curve shifts right. A change in the price level does not shift the money
supply curve.
c. If the Fed purchases bonds, then the money supply curve shifts right.
An increase in the price level shifts the money supply curve right.
d. If the Fed sells bonds, then the money supply curve shifts right. A
decrease in the price level shifts the money supply curve right.

10. Which of the following is a tool that is used by the Fed to control the
quantity of money?
a. open market operations
b. government expenditure multiplier
c. excess reserves
d. real interest rate

Section B (Short answer question)

1. Why don’t banks hold 100 percent reserves? How is the amount of reserves banks
hold related to the amount of money the banking system creates?
Answer:
2. Suppose that the T-account for First National bank is as follows:

Assets Liabilities
Cash $500,000 Deposits $500,000

(a) If the Central Bank requires banks to hold 5% of deposits as reserves, how much
in excess reserves does First National now hold?

(b) What will be the total money supply?

Answer:
Solution By Steps

Step 1: Calculate Required Reserves

The required reserves are 5% of the deposits.
0.05 * $500,000 = $25,000

Step 2: Calculate Excess Reserves

Excess reserves are the difference between actual reserves (cash) and required
reserves.
$500,000 - $25,000 = $475,000

Step 3: Calculate Total Money Supply

The total money supply includes both the deposits and the excess reserves.
$500,000 + $475,000 = $975,000

Final Answer
(a) First National Bank holds $475,000 in excess reserves.
(b) The total money supply is $975,000.

3. Suppose that the reserve requirement for checking deposits is 10 percent and that
banks do not hold any excess reserves.

(a) If the Central Bank sells $1 million of government bonds, what is the effect on
the economy’s reserves and money supply?

(b) Now suppose the Central Bank lowers the reserve requirement to 5%, but banks
choose to hold another 5% of deposits as reserves. Why might banks do so?
What is the overall change in the money multiplier and the money supply as a
result of these actions?
 Answer:
(A): With a required reserve ratio 10% and no additional reserves, the money
multiplier is 1/10% = 10. The excess reserve ratio cannot charge
The Central Bank sells $1 million of bonds, reserves will be decreased by $1 million
and the money supply will contract by 10 * $1 million = $10 million.

(B Banks might wish to hold excess reserves if they need to hold the reserves for their
day-to-day operations, such as paying other banks for customers’ transactions, making
change, cashing paychecks, and so on. If banks increase excess reserves such that
there is no overall change in the total reserve ratio, then the money multiplier does not
change and there is no effect on the money supply

Section C (Essay question)

Question 1

Assume that Miss A deposits RM50,000 with Bank Y. Assume also that required
reserves are 20 percent of checking deposits, and that banks hold no excess reserves and
households hold no currency. Explain the detailed process of money creation in the
economy and calculate the size of the money multiplier. Demonstrate your answers using
banks’ T-account.
Answer:
Initial Deposit

Miss A deposits RM50,000 into Bank Y.

Required Reserves

Bank Y must hold 20% of the deposit as required reserves. Calculate: 20% of

RM50,000 = RM10,000.

Excess Reserves

The remaining RM40,000 (RM50,000 - RM10,000) becomes excess reserves that

Bank Y can lend out.

 Loan Creation

Bank Y lends out the excess reserves of RM40,000 to a borrower.

New Deposit

The borrower receives RM40,000, which they deposit into another bank, say Bank Z.

Required Reserves for Bank Z

Bank Z must hold 20% of the new deposit as required reserves. Calculate: 20% of

RM40,000 = RM8,000.

Excess Reserves for Bank Z

The remaining RM32,000 (RM40,000 - RM8,000) becomes excess reserves for Bank

Z.

Repeat Process

This process continues as the newly created deposits are lent out and redeposited,

creating more deposits and expanding the money supply.

Money Multiplier Calculation

Money Multiplier = 1 / Required Reserve Ratio = 1 / 0.20 = 5.

Question 2

a) What are the tools of monetary control used by central banks and explain how central
banks use them to control money supply?
Answer:
 1: Open Market Operations
 Central banks buy or sell government securities to adjust the money supply. Buying
securities injects money into the economy, increasing the money supply, while
selling securities withdraws money, decreasing the money supply.
 2: Reserve Requirements
Central banks set the minimum amount of reserves banks must hold. Increasing
reserve requirements reduces the amount banks can lend, decreasing the money
supply. Lowering reserve requirements has the opposite effect.
 3: Discount Rate
The discount rate is the interest rate at which banks can borrow from the central
bank. Raising the discount rate discourages borrowing, reducing the money supply.
Lowering the rate encourages borrowing, increasing the money supply.
 4: Interest on Reserves
Paying interest on reserves held at the central bank incentivizes banks to hold more
reserves, reducing the amount available for lending and thus decreasing the money
supply.
b) Why is the central banks unable to fully control the money supply?
Chapter 30 : Money Growth and Inflation

Section A (MCQ)

1. What will happen to the price of bonds when the interest rate falls?
a. Bond prices will remain the same.
b. Bond prices will rise.
c. Bond prices will fall.
d. Ambiguous.

2. What will happen to the interest rate if the quantity of money demanded is
less than the quantity of money supplied?
a. Either increase or decrease, depending on the amount of excess
demand.
b. Increase.
c. Decrease.
d. Unaffected.

3. What causes an increase in the equilibrium interest rate?

a. A decrease in the level of output (real GDP).
b. The purchase of government securities by the Fed.
c. An increase in the level of output (real GDP) and an increase in the
money supply.
d. The sale of government securities by the Fed.

4. Which of the following is NOT a monetary policy tool of the Federal

Reserve?
a. Changes in required reserves.
b. Last resort loans.
c. Deposit insurance.
d. Open market operations.

5. The minimum percentage of deposits that a depository institution must hold

and cannot use for lending is known as the
a. Minimum rate.
b. required reserve ratio.
c. money multiplier.
d. discount rate.

6. The required reserve ratio

a. is the amount of money that banks require borrowers to reserve in their
accounts.
 b. is the fraction of a bank's total deposits that is required to be held in
reserves.
c. increases when withdrawals from a bank are made.
d. is higher for banks that make riskier loans.

7. If the desired reserve ratio is 3 percent and deposits totaled $575 billion, banks
would hold
a. $534.75 in reserves.
b. $17.25 billion in excess reserves.
c. $1,725 billion in currency.
d. $17.25 billion in reserves.

8. An increase in the price level makes the value of money

a. increase, so people want to hold more of it.
b. increase, so people want to hold less of it.
c. decrease, so people want to hold more of it.
d. decrease, so people want to hold less of it.

9. Which of the following is correct?

a. If the Fed purchases bonds in the open market, then the money supply
curve shifts right. A change in the price level does not shift the money
supply curve.
b. If the Fed sells bonds in the open market, then the money supply
curve shifts right. A change in the price level does not shift the money
supply curve.
c. If the Fed purchases bonds, then the money supply curve shifts right.
An increase in the price level shifts the money supply curve right.
d. If the Fed sells bonds, then the money supply curve shifts right. A
decrease in the price level shifts the money supply curve right.
 10.

Refer to the above figure. If the money supply is MS2 and the value of
money is 2,
a. the value of money is less than its equilibrium level.
b. the price level is higher than its equilibrium level.
c. the quantity of money demanded is greater than the quantity of money
supplied.
d. the quantity of money supplied is greater than the quantity of money
demanded.

Section B (Short answer question)

1. Explain the difference between nominal and real variables, and give two examples of
each. According to the principle of monetary neutrality, which variables are affected
by changes in the quantity of money?
Answer:
Nominal variables are those measured in monetary units, while real variables are
those measured in physical units. Examples of nominal variables include the prices of
goods, wages, and nominal GDP.
Examples of real variables include relative prices (the price of one good in terms of
another), real wages, and real GDP.
According to the principle of monetary neutrality, only nominal variables are affected
by changes in the quantity of money.

2. In what sense is inflation like a tax? How does thinking about inflation as a tax help
explain hyperinflation?
Answer:
Inflation is like a tax because everyone who holds money loses purchasing power.
 In a hyperinflation, the government increases the money supply rapidly, which leads
to a high rate of inflation.
Thus the government uses the inflation tax, instead of taxes, to finance its spending.

3. According to Fisher effect, how does an increase in the inflation rate affect the real
interest rate and the nominal interest rate?
Answer:
According to the Fisher effect, an increase in the inflation rate raises the nominal
interest rate by the same amount that the inflation rate increases, with no effect on the
real interest rate.

4. Suppose that this year’s money supply is $500 billion, nominal GDP is $10 trillion,
and real GDP is $5 trillion.
I) What is the price level? What is the velocity of money?
II) Suppose that velocity is constant and the economy’s output of goods and
services rises by 5% each year.
a. What will happen to nominal GDP and the price level next year if
the Reserve Bank keeps the money supply constant?
b. What money supply should the Reserve Bank set next year if it
wants to keep the price level stable?
c. What money supply should the Reserve Bank set next year if it
wants inflation of 10%?
Answer:
I. To find the price level, we use the equation Money Supply x Velocity =
Nominal GDP = Price Level x Real GDP. Therefore, Price Level = Nominal
GDP / Real GDP = $10 trillion / $5 trillion = 2. The velocity of money can be
found by rearranging the equation as Velocity = Nominal GDP / (Money Supply x
Real GDP) = $10 trillion / ($500 billion x $5 trillion) = 4.
II.
a. If the Fed keeps the money supply constant, but the economy's output increases
by 5%, then next year's nominal GDP will also increase by 5% because Nominal
GDP = Price Level x Real GDP. The price level will remain unchanged.

b. If the Fed wants to keep the price level stable, it should set the money supply
next year to be the same as this year, which is $500 billion.

c. If the Fed wants inflation of 10%, it should set the money supply next year to be
$550 billion. This can be found using the equation Price Level = Nominal GDP /
Real GDP = ($550 billion x $5 trillion) / $5 trillion = 11.

Section C (Essay Question)

Question 1
 Explain the six costs of inflation.
Answer:
 1: Definition of Inflation
Inflation refers to the general increase in prices of goods and services in an economy over
a period of time.
 2: Shoe-Leather Costs
People hold less money during inflation, leading to increased trips to the bank (shoe-
leather costs) to avoid the loss of purchasing power.
 3: Menu Costs
Businesses incur costs to update prices frequently due to inflation, such as reprinting
menus or changing price tags.
 4: Unit of Account Costs
Inflation distorts the comparison of prices over time, making it harder to use money as a
reliable unit of account for comparing values.
 5: Wealth Redistribution Costs
Inflation can redistribute wealth arbitrarily, benefiting debtors (who repay loans with less
valuable money) and harming creditors.
 6: Uncertainty Costs
Inflation introduces uncertainty about future price levels, making it harder for businesses
and individuals to plan effectively.