W H AT I S E C O N O M I C S ?

135

8

MONEY, THE
PRICE LEVEL, AND
INFLATION**

Answers to the Review Quizzes
Page 222 (page 630 in Economics)
1.

What makes something money? What functions does money perform? Why do
you think packs of chewing gum don’t serve as money?
Money is anything that is generally acceptable as a means of payment. Money has
three functions: medium of exchange (money is accepted in exchange for goods
and services), unit of account (prices are quoted in terms of money), and store of
value (money can be held and exchanged for goods and services later). Packs of
chewing gum do not function as money because they are not particularly good as
a store of value—gum deteriorates. Additionally, packs of gum are not generally
accepted in exchange for goods and services, so packs of gum are not a medium
of exchange.

2.

What are the problems that arise when a commodity is used as money?
Commodities are not used as money because of several problems. Many
commodities are bulky. And many commodities change in value over time. Using
as money a commodity that changes in value would be awkward. Prices would

change simply because the commodity’s value changed. Additionally, using a
commodity as money has a higher opportunity cost than do currency and bank
deposits because the commodity has alternative uses that must be foregone.

3.

4.

What are the main components of money in the United States today?
The main components of money in the United States today are currency and
deposits at banks and other depository institutions .
What are the official measures of money? Are all the measures really money?
The official measures of money are M1 (the sum of currency, traveler’s checks, and
checking deposits owned by individuals and businesses) and M2 (the sum of M1,
savings deposits, time deposits, and money market mutual funds and other
deposits). All of the components of M1 are truly money because all the
components serve as a means of payment. Some of the components of M2 are not
truly money because they are not a means of payment. (For instance, funds at
money market mutual funds cannot be used as a means of payment for small
purchases.) But all of these “non-money” assets are highly liquid so they are
operationally similar to money.

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136

5.

Why are checks and credit cards not money?

Checks and credit cards are not money because they are not a means of payment.
A check is an order to transfer a deposit from one person to another. The deposits
are money but the checks are not. A credit card is an ID card that lets a person
take out a loan at the instant he or she buys something. The loan still needs to be
repaid with money so the credit card is not a means of payment, that is, it is not
money.

Page 226 (page 634 in Economics)
1.

What are depository institutions?
Depository institutions are financial firms that take deposits from households and
firms. They then make loans available to other households and firms.

2.

What are the functions of depository institutions?
Depository institutions have four major economic functions: They create liquidity,
pool risk, lower the cost of borrowing, and lower the cost of monitoring borrowers.

3.

How do depository institutions balance risk and return?
Banks earn a higher return by using the funds they acquire from their deposits to
buy higher-yielding, riskier assets such as loans. But these assets are risky. If the
loans fail, then the bank might not have sufficient funds to repay their depositors.
If the bank undertakes too much risk, then its depositors might rush to withdraw
their deposits, which would cause the bank to fail. But if the bank forgoes all risky
assets its profit will be much lower. So the bank must balance its search for higher
return against the risk earning the return entails.


4.

How do depository institutions create liquidity, pool risks, and lower the cost
of borrowing?
Liquidity is the property of being easily convertible into a means of payment
without loss in value. Depository institutions create liquidity when they offer
deposits that can be withdrawn as money at short (or no) notice and then use
these deposits to make long-term loans.
Depository institutions pool risk because they use funds obtained from many
depositors to make loans to many borrowers. As a result, if a borrower defaults, no
one depositor bears the entire loss because the loss is spread over all depositors.
By spreading the risk, depository institutions are pooling risk.
Depository institutions lower the cost of borrowing because they specialize in
borrowing. For instance, a firm that wants to borrow a large sum of money need
only visit one depository institution to arrange such a loan. In the absence of
depository institutions, the firm would need to undertake many transactions with
many lenders, which would be a costly process.

5.

How have depository institutions made innovations that have influenced the
composition of money?
Checking deposits at thrift institutions such as S&L’s savings banks, and credit
unions are examples of deposits that were created by innovations in the 1980s and
1990s. These deposits have become an increasingly large percentage of M1.
Savings deposits have decreased as a percentage of M2, while time deposits and
money market mutual funds have increased, and checking deposits at commercial
banks have become a decreasing percentage of M1.


Page 230 (page 638 in Economics)
1.

136

What is the central bank of the United States and what functions does it
perform?


W H AT I S E C O N O M I C S ?

137

The Federal Reserve System is the central bank of the United States. The Federal
Reserve conducts the nation’s monetary policy and regulates the nation’s
depository institutions. The Fed provides banking services to commercial banks.

2.

What is the monetary base and how does it relate to the Fed’s balance sheet?
The monetary base is the sum of Federal Reserve notes, coins, and depository
institutions’ deposits at the Fed. Aside from coins, the rest of the monetary base
consists of Federal Reserve liabilities. Federal Reserve notes and depository
institutions’ deposits are liabilities of the Federal Reserve.

3.

What are the Fed’s three policy tools?
The Federal Reserve has three policy tools: required reserve ratio, last resort loans,
and open market operations.


4.

What is the Federal Open Market Committee and what are its main functions?
The Federal Open market Committee (FOMC) is the main policy-making group
within the Federal Reserve System. It decides upon the nation’s monetary policy as
conducted through open market operations. The FOMC meets approximately once
every six weeks.

137


5.

How does an open market operation change the monetary base?
The monetary base is the sum of coins, Federal Reserve notes, and depository
institution deposits at the Federal Reserve, that is, banks’ reserves. When the
Federal Reserve conducts an open market operation, it either buys securities and
pays for them with newly created reserves or it sells securities and is paid with
reserves held by banks. In both cases the monetary base changes. In the first
case, when the Fed buys securities, the monetary base increases. In the second
case, when the Fed sells securities, the monetary base decreases.

Page 232 (page 640 in Economics)
1.

How do banks create money?
Banks within the banking system create money by creating deposits, which are
part of the nation’s money. Banks create deposits by making loans because part or
all of the loans they make will be deposited in another bank. For instance, a

student given a loan may purchase books at the local bookstore. The bookstore will
then deposit the proceeds into its bank as part of the bookstore’s checking
account. Thus the loan has created new deposits at the bookstore’s bank.

2.

What limits the quantity of money that the banking system can create?
The quantity of money that the banking system can create is limited by: the
monetary base, desired reserves, and desired currency holdings.

3.

A bank manager tells you that she doesn’t create money. She just lends the
money that people deposit. Explain why she’s wrong.
Though the manager does not see the entire process, nonetheless the loans the
manager makes create more deposits and more money. Point out to the manager
that when she makes a loan, the deposits at her bank initially increase. And, when
the loan is spent, the recipient selling the goods or services that have been
purchased will deposit part or all of the proceeds in his or her bank. When the
recipient makes this deposit, the total amount of the nation’s deposits increase
and, because deposits are part of the nation’s money, the quantity of money also
increases. However, actions of other economic agents also affect the creation of
money. For example, if people decide to hold less currency and more deposits, the
immediate effect on the quantity of money is nil. But over time the quantity of
money increases because banks gain more (excess) reserves, which are then
loaned and then deposited, thereby creating additional deposits and increasing the
quantity of money.

Page 237 (page 645 in Economics)
1.


What are the main influences on the quantity of real money that people and
businesses plan to hold?
The quantity of real money demanded depends on four factors: the price level, the
nominal interest rate, real GDP, and financial innovation. An increase in the price
level increases the nominal demand for money but the quantity of real money
demanded is independent of the price level. An increase in the nominal interest
rate decreases the quantity of real money demanded, because the nominal
interest rate is the opportunity cost of holding money. An increase in real GDP
increases the demand for real money, because more real GDP implies more
transactions and an increase in the demand for money to finance the transactions.
And, financial innovations that make it less costly to get by with less money on
hand decrease the demand for money.


M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N

2.

Show the effects of a change in the nominal interest rate and a change in real
GDP using the demand for money curve.
An increase in the nominal interest rate decreases the quantity of real money
demanded. The slope of the demand for money curve shows how the quantity of
real money demanded depends on the nominal interest rate. As illustrated in
Figure 8.1, a decrease in the nominal interest rate results in a movement
downward along the demand for money curve.
A change in real GDP changes the demand for money. An increase in real GDP
increases the demand for money and shifts the demand for curve for real money
rightward from MD0 to MD1, as shown in Figure 8.2.


3.

How is money market equilibrium determined in the short run?

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CHAPTER 8

In the short run, the nominal interest rate adjusts to restore equilibrium to the
money market. When the quantity of money demanded equals the quantity
supplied, the nominal interest rate is at its equilibrium level.

4.

How does a change in the quantity of money change the interest rate in the
short run?
In the short run an increase in the quantity of money lowers the interest rate and a
decrease in the quantity of money raises the interest rate. Suppose the Federal
Reserve increases the quantity of money. At the initial interest rate people hold
more money than the quantity they demand. To restore the amount of money they
hold to equality with the quantity demanded, people use the surplus in the
loanable funds market to buy bonds. The price of a bond rises which means that
the interest rate on the bond falls. When the Federal Reserve decreases the
quantity of money, the reverse occurs: At the initial interest rate people have less
money than the quantity they demand so they sell bonds in the loanable funds
market to acquire more money. Selling bonds lowers their price which raises the
interest rate.



M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N

5.

How does a change in the quantity of money change the interest rate in the
long run?
In the long run a change in the quantity of money does not change the interest
rate. For example, suppose the Federal Reserve increases the quantity of money
(the effects from a decrease in the quantity of money are the reverse of an
increase). In the short run the nominal interest rate and the real interest rate fall.
Both households and firms increase their demand for goods. The resulting
shortages force prices higher and therefore the price level rises. As the price level
rises, the quantity of real money decreases, which raises the nominal interest rate
and real interest rate. The rise in the interest rate decreases the demand for
goods. Eventually the price level rises so that the quantity of real money equals
the initial amount. At this point, the nominal interest rate and real interest rate
have risen to equal their initial values so there is no long-run effect on the interest
rate from a change in the quantity of money.

Page 239 (page 647 in Economics)
1.

What is the quantity theory of money?
The quantity theory of money is the proposition that in the long run an increase in
the quantity of money creates an equal percentage increase in the price level.

2.


How is the velocity of circulation calculated?
The velocity of circulation is the average number of times a dollar of money is
used annually to buy the goods and services that make up GDP. The velocity of
circulation equals (nominal) GDP divided by the quantity of money.

3.

What is the equation of exchange?
The equation of exchange is the formula that MV = PY, where M is the quantity of
money, V is the velocity of circulation, P is the price level, and Y is real GDP. The
equation of exchange is always true by definition because the velocity of
circulation is defined as PY/M.

4.

Does the quantity theory correctly predict the effects of money growth on
inflation?
The long-run historical and international evidence on the relationship between
money growth and the inflation rate support the quantity theory. The data suggest
a marked tendency for nations with high money growth rates to have high inflation
rates.

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Answers to the Study Plan Problems and

Applications
1.

Money in the United States today includes which of the following items?
• Cash in Citibank’s cash machines
Money includes currency outside the banks. Currency inside cash machines is not
money.

•

U.S. dollar bills in your wallet
The dollar bills inside your wallet are money.

•

Your Visa card
The Visa card is not money.

•

Your loan to pay for school fees
The loan is not money.

2.

In June 2013, currency held by individuals and businesses was $1,124 billion;
traveler’s checks were $4 billion; checkable deposits owned by individuals
and businesses were $1,042 billion; savings deposits were $6,884 billion; time
deposits were $583 billion; and money market funds and other deposits were
$647 billion. Calculate M1 and M2 in June 2011.

M1 consists of currency and traveler’s checks plus checking deposits owned by
individuals and businesses. In June, 2011 M1 equaled $1,124 billion + $4 billion +
$1,042, or $2,170 billion.
M2 consists of M1 plus time deposits, savings deposits, and money market mutual
funds and other deposits. In June, 2011 M2 equaled $2,170 + $583 billion + $6,884
billion + $647 billion, or $10,284 billion.

3.

Europe’s Banks Must Be Forced to Recapitalize
E.U. banks must hold more capital. Where private funding is not forthcoming,
recapitalization must be imposed by E.U. governments.
Source: Financial Times, November 24, 2011
What is the “capital” referred to in the news clip? How might the requirement
to hold more capital make banks safer?
The “capital” means owners’ capital; that is, funds the owners have invested in the
bank.
When loans or other assets go bad, the bank incurs a loss and the bank’s capital
decreases. If enough losses are incurred, the bank’s capital might be totally
dissipated, in which case the bank fails because the bank has no further cushion to
absorb more losses. The requirement to hold more capital makes the possibility of
failure less likely.

4.

The FOMC sells $20 million securities to Wells Fargo. Enter the transactions
that take place to show the changes in the following balance sheets.
The first balance sheet to the right
Federal Reserve Bank of New York
shows the balance sheet of the

Assets
Liabilities
Federal Reserve Bank of New York.
(millions)
(millions)
The Fed’s assets decrease by $20
Securities
Wells Fargo reserve
million because the Fed now has $20
−$20
deposit −$20
million less securities. The Fed’s
liabilities also decrease by $20 million
because Wells Fargo pays for its purchases
Wells Fargo
using the reserves that it has on deposit at
the Fed.
Assets
Liabilities
(millions)
(millions)
The second balance sheet to the right shows
Securities
+$20
Reserve deposit
−$20


M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N


the balance sheet of Wells Fargo Bank. Wells Fargo gains assets in the form of
securities of $20 million. Simultaneously it also losses reserve deposit assets of
$20 million because it pays for the government securities using its reserve
deposits at the Fed.

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5.

CHAPTER 8

In the economy of Nocoin, bank deposits are $300 billion, bank reserves are
$15 billion of which two thirds are deposits with the central bank. Households
and firms hold $30 billion in bank notes. There are no coins. Calculate
a. The monetary base and the quantity of money.
The monetary base is $45 billion. The monetary base is the sum of the central
bank’s notes, banks’ deposits at the central bank, and coins held by households,
firms, and banks. There are $30 billion in notes held by households and firms,
banks’ deposits at the central bank are $10 billion (2/3 of $15 billion), the banks
hold other reserves of $5 billion (which are notes), and there are no coins. The
monetary base is $45 billion.
The quantity of money is $330 billion. In Nocoin, deposits are $300 billion and
currency is $30 billion, so the quantity of money is $330 billion.

b. The banks’ desired reserve ratio and the currency drain ratio (as
percentages).
The banks’ reserve ratio is 5 percent. The banks’ reserve ratio is the percent of

deposits that is held as reserves. In Nocoin, deposits are $300 billion and reserves
are $15 billion, so the reserve ratio equals ($15 billion/$300 billion) × 100, which is
5 percent.
The currency drain is 10 percent. The currency drain is the ratio of currency to
deposits. In Nocoin, currency is $30 billion and deposits are $300 billion, so the
currency drain equals ($30 billion/$300 billion)  100, which is 10 percent.

6.

China Cuts Banks’ Reserve Ratios
The People’s Bank of China announces it will cut the required reserve ratio.
Source: Financial Times, February 19, 2012
Explain how lowering the required reserve ratio will impact banks’ money
creation process.
Lowering the required reserve ratio decreases banks’ desired reserves. When
banks’ desired reserves decrease they will make more loans so the quantity of
money in China increases. (The Mathematical Note shows that an decrease in the
desired reserve ratio increases the money multiplier.)

7.

The spreadsheet provides data about the
demand for money in Minland. Columns A
and B show the demand for money schedule
when real GDP (Y0) is $10 billion and Columns
A and C show the demand for money
schedule when real GDP (Y1) is $20 billion.
The quantity of money is $3 billion. What is
the interest rate when real GDP is $10 billion?
Explain what happens in the money market in

the short run if real GDP increases to $20
billion.

1

A
r

B
Y0

C
Y1

2
3
4
5
6
7
8

7
6
5
4
3
2
1


1.0
1.5
2.0
2.5
3.0
3.5
4.0

1.5
2.0
2.5
3.0
3.5
4.0
4.5

When real GDP is $10 billion, the equilibrium nominal interest rate is 6 percent
because that is the interest rate that sets the quantity of money demanded equal
to $3 billion. If real GDP increases to $20, the quantity of money demanded
exceeds the quantity supplied, so people want to hold more money than is
available. They try to increase the amount of money held by selling bonds. The
prices of bonds fall, and the interest rate rises to its new equilibrium of 5 percent.


M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N

8.

In year 1, the economy is at full employment and real GDP is $400 million, the
GDP deflator is 200 (a price level is 2), and the velocity of circulation is 20. In

year 2, the quantity of money increases by 20 percent. If the quantity theory
of money holds, calculate the quantity of money, the GDP deflator, real GDP,
and the velocity of circulation in year 2.
The quantity of money in year 1 is $40 million. Because the equation of exchange
tells us that MV = PY, we know that M = PY/V. Then, with P = 2.0, Y = $400 million,
and V = 20, M = $40 million. Then in year 2 the quantity of money is $48 million
because money grows by 20 percent, which is $8 million. The GDP deflator is 240.
Because the quantity theory of money holds and because the factors that
influence real GDP have not changed, the GDP deflator rises by the same
percentage as the increase in the quantity of money, which is 20 percent. Real GDP
is $400 million because it remains equal to potential GDP (the quantity of GDP
produced at full employment). The velocity of circulation is 20. Because the factors
that influence velocity have not changed, velocity is unchanged.

Mathematical Note
9.

In Problem 5, the banks have no excess reserves. Suppose that the central
bank of Nocoin increases bank reserves by $0.5 billion.
a. Explain what happens to the quantity of money and why the change in the
quantity of money is not equal to the change in the monetary base.
The quantity of money increases by $3.67 billion. The quantity of money increases
by the change in the monetary base multiplied by the money multiplier. The
money multiplier is 7.33 (see part b), so when the monetary base increases by
$0.5 billion, the quantity of money increases by $3.67 billion.
The change in the quantity of money is not equal to the change in the monetary
base because of the multiplier effect. The open market operation increases bank
reserves and creates excess reserves, which banks use to make new loans. New
loans are used to make payments and some of these loans are placed on deposit
in banks. The increase in bank deposits increases banks’ reserves and increases

desired reserves. But the banks now have excess reserves which they loan out and
the process repeats until excess reserves have been eliminated.

b. Calculate the money multiplier.
The money multiplier is 7.33. The money multiplier is equal to (1 + C/D)/(R/D +
C/D), where C/D is the currency drain ratio and R/D is the banks’ reserve ratio.
From the problem, C/D = 0.1 and R/D = 0.05, so the money multiplier equals (1 +
0.1)/(0.1 + 0.05), which equals 7.33.

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Answers to Additional Problems and Applications
10.

Kristin deposits $5,000 cash into her savings account at the First National
Bank. What is the immediate change in M1 and M2?
The deposit of $5,000 in the savings account will decrease M1. However, M2 will
not change.

11.

Rapid inflation in Brazil in the early 1990s caused the cruzeiro to lose its
ability to function as money. Which of the following commodities would most
likely have taken the place of the cruzeiro in the Brazilian economy? Explain
why.

a. Tractor parts
It is unlikely that tractor parts would be used as money because tractor parts are
heavy and unwieldy to carry around for use as a medium of exchange.

b. Packs of cigarettes
Packs of cigarettes would likely be used as a substitute for money because they
are light to carry around, are durable, and can be easily divided into fractions of
packs for making change.

c. Loaves of bread
Loaves of bread would be unlikely to be used as a substitute for money because
they would spoil too rapidly.

d. Impressionist paintings
Impressionist paintings would be unlikely to be used as a substitute for money
because they would be unwieldy to carry around and because their quality and
value differs dramatically from one artist to another.

e. Baseball trading cards
Baseball cards would be unlikely to be used as a substitute for money because
most Brazilians are unfamiliar with baseball (and unlikely to value the cards per
se) and because the cards are not very durable.

12.

Are You Ready to Pay by smartphone?
Starbucks customers can now pay for their coffee using their smartphone.
Does this mean the move to electronic payments is finally coming?
Source: The Wall Street Journal, January 20, 2011
If people can use their smartphone to make payments, will currency

disappear? How will the components of M1 change?
People will probably carry less currency because their cell phone will substitute for
currency, but currency won’t disappear because currency is used in the
underground economy. As a component of M1, currency and traveler’s checks will
be smaller and most of M1 will be checkable deposits.


M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N

Use the following news clip to work Problems 13 and 14.
The World’s 29 Too Big to Fail Banks, JP Morgan at the Top
The Financial Stability Board has released the latest list of the world’s too-big-tofail banks. Each year, the board examines banks to decide which ones pose a
threat to the global economy if they were to fail. Those on the list of too-big-to-fail
must hold more capital to absorb potential losses, and therefore protect taxpayers
from bailouts. In 2013, JPM and HSBC top the list. This means they must each hold
an extra 2.5% of capital on top of the additional 7% that will be required down the
road.
Source: www.forbes.com, November 11, 2013
13.

Explain how the failure of big banks would be disastrous for the economy?
A commercial bank lends its excess reserves which are the actual reserves minus
required (safe) reserves. Hence, to maximize its profit, the bank minimizes these
reserves to the maximum or lends all its excess reserves. If there is a run on the
bank from depositors and a large number of depositors request the return of their
funds, the bank might fail if it does not have adequate reserves in hand to meet
these withdrawals. In this case, depositors will lose their savings and if the bank is
too big and holds an important share of the total banking system assets this will
affect the savings of a country. A fall in the savings may lead to a recession.


14.

Should such banks receive financial support from their governments to avoid
failure?
The world’s largest financial institutions, at least most of them, are connected.
These connections would pose a systemic risk in the sense that the failure of one
large bank could bring down others and threaten the stability of the financial
system. In order to prevent such a default, the government may use public funds
to ensure payment of a large bank’s debt. This would increase the stability of the
banking system. However, the financial support by the government will encourage
the bank to take more risks and might lead to a greater chance of failure than it
would without the government’s financial support. Moreover, these funds could be
alternatively allocated by the government to other sectors that are productive.

15.

Explain the distinction between a central bank and a commercial bank.
A central bank is basically a “bank for banks.” It will conduct business with
commercial banks, such as making loans to them and holding their reserves. A
central bank does not accept deposits from private citizens. A central bank also
regulates the nation’s depository institutions and conducts the nation’s monetary
policy.
A commercial bank conducts business with firms and households. It accepts
deposits from individuals and then makes loans to other people or firms.
Commercial banks are privately owned and have as their objective the
maximization of their profit.

16.

If the Fed makes an open market sale of $1 million of securities to a bank,

what initial changes occur in the economy?
If the Fed sells $1 million of securities to a bank, both the Fed’s balance sheet and
the bank’s balance sheet change. The Fed’s holding of securities falls by $1 million
and the bank’s holding of securities rises by $1 million. The bank pays for the
purchase with its reserves, so the reserves held by the Fed fall by $1 million and
the bank’s reserves fall by $1 million. The amount of the bank’s assets does not
change, though the composition changes (more securities, fewer reserves). The
Fed’s assets and liabilities both fall by an equal amount ($1 million in this case).

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110

17.

CHAPTER 8

Set out the transactions that the Fed undertakes to increase the quantity of
money.
The Fed has three procedures by which it can increase the quantity of money:
• The Fed could use an open market purchase of securities from banks. When
the Fed buys securities, it pays for the purchase by increasing banks’ reserves.
The increase in banks’ reserves increases the monetary base and allows
banks to make more loans, which then increase the quantity of money.
• The Fed could make a last resort loan to a bank. When the Fed makes a loan to
a bank, the bank’s reserves increase. The increase in reserves increases the
monetary base and allows the bank to make more loans, which then increase
the quantity of money.
• The Fed could lower the required reserve ratio. By lowering the required

reserve ratio, the Fed lowers the reserves banks must hold and thereby lowers
their desired reserve ratio. Banks respond by increasing their loans, which
then increase the quantity of money.

18.

Describe the Fed’s assets and liabilities. What is the monetary base and does
it relate to the Fed’s balance sheet?
The Fed has two main assets: U.S. government securities and loans to depository
institutions. The Fed also has two main liabilities, Federal Reserve notes and
depository institution deposits (the reserves that depository institutions hold at the
Fed). The monetary base is the sum of coins, Federal Reserve notes, and
depository institution deposits at the Fed. Coins are only a small part of the
monetary base. The two largest components of the monetary base, Federal
Reserve notes and depository institutions deposits at the Fed, are the Fed’s two
liabilities.

19.

Fed Minutes Show Active Discussion of QE3
The FOMC discussed “a new large-scale asset purchase program” commonly
called “QE3.” Some FOMC members said such a program could help the
economy by lowering long-term interest rates and making financial conditions
more broadly easier. They discussed whether a new program should snap up
more Treasury bonds or buying mortgage-backed securities issued by the
likes of Fannie Mae and Freddie Mac.
Source: The Wall Street Journal, August 22, 2012
What would the Fed do to implement QE3, how would the monetary base
change, and how would bank reserves change?
To implement QE3 the Fed would undertake massive (“quantitative”) purchases of

assets. These assets likely would be long-term securities and could include
Treasury bonds and/or mortgage backed securities, such as those issued by Fannie
Mae or Freddie Mac. These purchases would increase both the monetary base and
banks’ reserves.

20.

Banks in New Transylvania have a desired reserve ratio of 10 percent of
deposits and no excess reserves. The currency drain ratio is 50 percent of
deposits. Now suppose that the central bank increases the monetary base by
$1,200 billion.
a. How much do the banks lend in the first round of the money creation
process?
Banks loan $1,200 billion because the entire increase in reserves is excess
reserves.


M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N

b. How much of the initial amount lent flows back to the banking system as
new deposits?
$800 billion flows back to the banks as new deposits. The currency drain, which is
the percentage ratio of currency to deposits, is 50 percent. Of the $1,200 billion
that has been loaned, $800 billion is deposited back in banks and 50 percent of
the deposits, $400 billion, is kept as currency.

c. How much of the initial amount lent does not return to the banks but is held
as currency?
Currency increases by $400 billion. The currency drain, which is the percentage of
currency to deposits, is 50 percent. Of the $1,200 billion that has been loaned,

$800 billion is deposited and 50 percent of the deposits, $400 billion, is kept as
currency.

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d. Why does a second round of lending occur?
A second round of lending takes place because the $800 billion flowing back to the
banks as new deposits means that banks have excess reserves. Of the $800 billion
flowing back to the banks, 10 percent, or $80 billion, is kept as reserves leaving
$720 billion that will be loaned in a second round of lending.

21.

Explain the change in the nominal interest rate in the short run if
a. Real GDP increases.
The nominal interest rate rises. When real GDP increases, the demand for money
increases. At the initial interest rate people are holding less money than the
quantity they demand. People sell bonds to increase the money they hold. The
price of a bond falls and the nominal interest rate rises.

b. The money supply increases.
The nominal interest rate falls. When the supply of money increases, the quantity
of real money increases. At the initial interest rate people are holding more money
than the quantity they demand. People buy bonds to decrease the money they
hold. The price of a bond rises and the nominal interest rate falls.


c. The price level rises.
The nominal interest rate rises. When the price level rises, the quantity of real
money decreases. The supply of money decreases. The demand for money does
not change. At the initial interest rate people are holding less money than the
quantity they demand. People sell bonds to increase the money they hold. The
price of a bond falls and the nominal interest rate rises.

22.

Figure 8.3 shows the demand for
money curve. If the Fed decreases the
quantity of real money supplied from
$4 trillion to $3.9 trillion, explain how
the price of a bond will change.
If the Fed decreases the quantity of
money to $3.9 trillion, the price of a
bond falls. The decrease in the quantity
of money means that at the initial
interest rate, 4 percent, people are
holding less money than the quantity
they demand. In response people sell
bonds to try to increase the quantity of
money they hold. As people sell bonds,
the price of a bond falls and the interest
rate rises, in the figure from 4 percent
to 6 percent.

23.


Use the data in Problem 7 to work this problem. The interest rate is 4 percent
a year. Suppose that real GDP decreases from $20 billion to $10 billion and
the quantity of money remains unchanged. Do people buy bonds or sell
bonds? Explain how the interest rate changes.
When real GDP decreases, the demand for money decreases. At the initial interest
rate of 4 percent, the quantity of money people are holding exceeds the quantity of


M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N

money they want to hold. People buy bonds to decrease the quantity of money
they are holding. When people demand bonds, the price of a bond rises, and the
interest rate falls. When the interest rate equals 3 percent a year, people are
holding exactly the quantity of money that they want to hold so 3 percent is the
new equilibrium interest rate.

24.

The table provides some data for
the United States in the first
decade following the Civil War.
Source of data: Milton
Friedman and Anna J.
Schwartz, A Monetary History
of the United States 1867–
1960
a. Calculate the value of X in
1869.

Quantity of

money
Real GDP (1929
dollars)
Price level (1929 =
100 )
Velocity of
circulation

1869
$1.3
billion
$7.4
billion
X

1879
$1.7
billion
Z

4.50

4.61

54

Using the formula MV = PY gives ($1.3 billion × 4.5) = (P × $7.4 billion) so that P
equals 0.79, or, transformed to an index number, P = 79.

b. Calculate the value of Z in 1879.

Using the formula MV = PY gives ($1.7 billion × 4.61) = (0.54 × Y) so that Y equals
$14.5 billion.

c. Are the data consistent with the quantity theory of money? Explain your
answer.
The quantity theory holds. The quantity theory predicts that the inflation rate
equals the growth rate of the quantity of money plus the growth rate of velocity
minus the growth rate of real GDP. The growth rate of velocity is approximately
zero, so the inflation rate equals the growth rate of the quantity of money minus
the growth rate of real GDP. The quantity of money grew by approximately 27
percent, real GDP grew by approximately 65 percent and the price level fell by
approximately 38 percent. (These percentages are calculated using the average of
the quantity of money, the price level, and real GDP as the base for the
percentage.) The inflation rate, −38 percent (deflation) equals the growth rate of
the quantity of money, 27 percent, minus the growth rate of real GDP, 65 percent.

Economics in the News
25.

After you have studied Reading Economics in the News on pp. 240–241 (648–
649 in Economics,) answer the following questions.
a. What changes in the interest rate and the quantity of M2 occurred between
2007 and 2014?
The interest rate plummeted from almost 5 percent per year to near 0 percent per
year. Meanwhile the quantity of M2 soared from about $7 trillion to $10 trillion.

b. Why is the outcome feared by bankers optimistic?
Bankers are concerned that the quantity of money demanded will decrease by $1
trillion if the Fed raises the interest rate to 1 percent. Because most of the decrease
will be a decrease in deposits, bankers expect a $1 trillion decrease in deposits.

But the demand curve for M2 shows that if the interest rate rises to 1 percent, the
quantity of money demanded will decrease by $1.8 trillion. Bankers expect a
decrease of only $1 trillion, so the predicted decrease is much larger than the
outcome they expect.

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c. By how much would the quantity of M2 demand decrease if the interest rate
rose to 2 percent, 3 percent, and 4 percent? (Express your answer as a
percentage of GDP.)
If the interest rate rises to 2 percent, the quantity of money demanded is
approximately 50 percent of GDP; if the interest rate rises to 3 percent, the
quantity of money demanded is approximately 48 percent of GDP; and, if the
interest rate rises to 4 percent, the quantity of money demanded is approximately
47 percent of GDP.

d. What could the banks do to prevent deposits from decreasing by as much as
predicted by the demand for M2 curve in Fig. 3 on p. 241 (page 649 in
Economics)?
Banks can raise the interest rate they pay on deposits in order to prevent the
deposits from decreasing as much as the demand for M2 curve shows.

e. What would you expect to happen to the monetary base if interest rates
rise? Why?
The monetary base will decrease. If interest rates rise, banks will have a greater

incentive to loan the funds they are keeping as reserves at the Fed. Decreasing the
quantity of reserves decreases the monetary base.


M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N

26.

The Truth is Out: Money is Just an IOU, and the Banks Are Rolling In It
The central bank can print as much money as it wants to, but it doesn’t as it
was created to regulate money supply. If governments could print money, and
not independent central banks, they would surely put out too much of it, and
the resulting inflation would throw the economy into chaos.
Source: The Guardian, March 18, 2014
a. Explain how the money market will be affected if too much money is printed
by the central bank.
Printing money will increase money supply. The excess money supply will lower the
interest rate. A change in the interest rate will bring a movement along the
demand for money curve.

b. Explain using the quantity theory of money how printing money increases
inflation in the long run
Printing money by the central bank increases money supply (M). In the long run,
with the economy at full employment, real GDP equals potential GDP, so the real
GDP growth rate equals the potential GDP growth rate. If we assume a constant
velocity in the long run, the inflation rate will be the money growth rate minus the
real GDP growth rate. The increase in M will increase the price level proportionally
if the growth rate of real GDP is assumed to be zero in the long run.

Mathematical Note

27.

In the United Kingdom, the currency drain ratio is 38 percent of deposits and
the reserve ratio is 2 percent of deposits. In Australia, the quantity of money
is $150 billion, the currency drain ratio is 33 percent of deposits, and the
reserve ratio is 8 percent of deposits.
a. Calculate the U.K. money multiplier.
The money multiplier equals 3.45. The money multiplier is equal to (1 + C/D)/(R/D
+ C/D), where C/D is the currency drain ratio and R/D is the banks’ reserve ratio.
From the problem, C/D = 38 percent and R/D = 2 percent, so the money multiplier
equals (1 + 0.38)/(0.38 + 0.02), which equals 3.45.

b. Calculate the monetary base in Australia.
The monetary base equals $46.2 billion. The monetary base equals the sum of
currency and depository institution deposits at the central bank. The currency
drain is 33 percent, so with the quantity of money equal to $150 billion, currency is
$37.2 billion and deposits are $112.8 billion. The banks’ reserve ratio is 8 percent,
so reserves are ($112.8 × 0.08), which is $9 billion. The monetary base equals
$37.2 billion + $9.0 billion, or $46.2 billion.

115