Questions and Answers of Economics Principles and Policy

What is compound interest? How does it relate to the formula:X dollars today 5 (1 1 i ) t X dollars in t years? What is present value? How does it relate to the formula: X y(1 1 i ) t dollars today 5
Suppose that the city of New York issues bonds to raise money to pay for a new tunnel linking New Jersey and Manhattan. An investor named Susan buys one of the bonds on the same day that the city of
The Fed can shift the entire SML upward or downward by using monetary policy to change the risk-free interest rate on short-term U.S. bonds. When the SML shifts, the average expected rate of return
The Security Market Line (SML) is a straight upsloping line showing how the average expected rates of return on assets and portfolios in the economy vary with their respective levels of
The rate of return that compensates for time preference is assumed to be equal to the rate of interest generated by short-term U.S. government bonds. These bonds are considered to be risk-free,
Average expected rates of return also must compensate for time preference and the fact that, other things equal, people prefer to consume sooner rather than later. Consequently, an asset’s average
Investors dislike risk and therefore demand compensation for being exposed to it. This compensation takes the form of higher average expected rates of return. The riskier the asset, the greater is
Beta is a statistic that measures the nondiversifiable risk of an asset or portfolio relative to the amount of nondiversifiable risk facing the market portfolio. Because the market portfolio contains
In finance, an asset is risky if its future payments are uncertain.What matters is not whether the payments are big or small, positive or negative, or good or bad—only that they are not guaranteed
Arbitrage is the process whereby investors equalize the average expected rates of return generated by identical or nearly identical assets. If two identical assets have different rates of return,
Investors evaluate the possible future returns to risky investments using average expected rates of return, which give higher weight to outcomes that are more likely to happen.Average expected rates
Stocks give shareholders the right to share in any future profits that corporations may generate. The main risk of stock investing is that future profits are unpredictable and that companies may go
All financial assets available to investors have a common characteristic: In exchange for a certain price today, they all promise to make one or more payments in the future. A risk-free
The compound interest formula states that if X dollars is invested today at interest rate i and allowed to grow for t years, it will become (1 1 i ) t X dollars in t years. The present value formula
Interpret why higher levels of nondiversifiable risk are associated with higher rates of return.
Explain portfolio diversification and why it implies that investors can focus on nondiversifiable risk when evaluating an investment opportunity.
Discuss how investment returns compensate for being patient and for bearing risk.
Identify and distinguish between the most common financial investments: stocks, bonds, and mutual funds.
Describe the idea of present value and explain why it is critical in making financial decisions.
Refer to the table for Moola at the bottom of this page to answer the following questions. What is the equilibrium interest rate in Moola? What is the level of investment at the equilibrium interest
Suppose that inflation is 2 percent, the Federal funds rate is 4 percent, and real GDP falls 2 percent below potential GDP.According to the Taylor rule, in what direction and by how much should the
Suppose that the demand for Federal funds curve is such that the quantity of funds demanded changes by $120 billion for each 1 percent change in the Federal funds interest rate. Also, assume that the
Refer to Table 33.2 and assume that the Fed’s reserve ratio is 10 percent and the economy is in a severe recession. Also suppose that the commercial banks are hoarding all excess reserves (not
In the tables that follow you will find consolidated balance sheets for the commercial banking system and the 12 Federal Reserve Banks. Use columns 1 through 3 to indicate how the balance sheets
Suppose a bond with no expiration date has a face value of$10,000 and annually pays a fixed amount of interest of$800. In the table provided to the right, calculate and enter either the interest rate
Assume that the following data characterize the hypothetical economy of Trance: money supply 5 $200 billion; quantity of money demanded for transactions 5 $150 billion;quantity of money demanded as
LAST WORD What are the three main aggregate supply factors that determine a nation’s potential (or full- employment)level of real output? What are the four main components of aggregate demand?
What do economists mean when they say that monetary policy can exhibit cyclical asymmetry? How does the idea of a liquidity trap relate to cyclical asymmetry? Why is this possibility of a liquidity
Explain the links between changes in the nation’s money supply, the interest rate, investment spending, aggregate demand, real GDP, and the price level. LO4
Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp rise in the inflation rate. What change in the Federal funds rate would you
Why is a decrease in the supply of Federal funds shown as an upshift of the supply curve in Figure 33.3 , whereas an increase in Federal funds is shown as a downshift of the supply curve? LO3
Distinguish between the Federal funds rate and the prime interest rate. Why is one higher than the other? Why do changes in the two rates closely track one another? LO3
Use commercial bank and Federal Reserve Bank balance sheets to demonstrate the effect of each of the following transactions on commercial bank reserves: LO2a. Federal Reserve Banks purchase
What is the basic objective of monetary policy? What are the major strengths of monetary policy? Why is monetary policy easier to conduct than fiscal policy? LO2
What is the basic determinant of ( a ) the transactions demand and ( b ) the asset demand for money? Explain how these two demands can be combined graphically to determine total money demand. How is
If the spending-income multiplier is 4 in the economy depicted, an increase in the money supply from $125 billion to $150 billion will:a. shift the aggregate demand curve rightward by $20 billion.b.
The Federal Reserve could increase the money supply from Sm1 to Sm2 by:a. increasing the discount rate.b. reducing taxes.c. buying government securities in the open market.d. increasing the reserve
A successful restrictive monetary policy is evidenced by a shift in the money supply curve from:a. Sm3 to a point half way between Sm2 and Sm3, a decrease in investment from $25 billion to $22.5
The ultimate objective of an expansionary monetary policy is depicted by:a. a decrease in the money supply from Sm3 to Sm2.b. a reduction of the interest rate from 8 to 6 percent.c. an increase in
Suppose the supply of money declines to $100 billion. The equilibrium interest rate would:a. fall, the amount of money demanded for transactions would rise, and the amount of money demanded as an
Curve D a slopes downward because:a. lower interest rates increase the opportunity cost of holding money.b. lower interest rates reduce the opportunity cost of holding money.c. the asset demand for
In this graph, at an interest rate of 10 percent:a. no money will be demanded as an asset.b. total money demanded will be $200 billion.c. the Federal Reserve will supply $100 billion of money.d.
In this graph, at the interest rate i e (5 percent):a. the amount of money demanded as an asset is $50 billion.b. the amount of money demanded for transactions is $200 billion.c. bond prices will
Explain the effectiveness of monetary policy and its shortcomings
Identify the mechanisms by which monetary policy affects GDP and the price level.
Describe the Federal funds rate and how the Fed directly influences it.
List and explain the goals and tools of monetary policy.
Discuss how the equilibrium interest rate is determined in the market for money.
If the required reserve ratio is 10 percent, what is the monetary multiplier? If the monetary multiplier is 4, what is the required reserve ratio? LO5 Assets Liabilities and net worth (1) (1')
Suppose the simplified consolidated balance sheet shown in the right column is for the entire commercial banking system and that all figures are in billions of dollars. The reserve ratio is 25
The balance sheet at the top of the next page is for Big Bucks Bank. The reserve ratio is 20 percent. LO3a. What is the maximum amount of new loans that Big Bucks Bank can make? Show in columns 1 and
Suppose again that Third National Bank has reserves of$20,000 and checkable deposits of $100,000. The reserve ratio is 20 percent. The bank now sells $5000 in securities to the Federal Reserve Bank
Third National Bank has reserves of $20,000 and checkable deposits of $100,000. The reserve ratio is 20 percent.Households deposit $5000 in currency into the bank and that currency is added to
Suppose that Serendipity Bank has excess reserves of$8000 and checkable deposits of $150,000. If the reserve ratio is 20 percent, what is the size of the bank’s actual reserves? LO2
Suppose the assets of the Silver Lode Bank are $100,000 higher than on the previous day and its net worth is up$20,000. By how much and in what direction must its liabilities have changed from the
LAST WORD Explain how the bank panics of 1930–1933 produced a decline in the nation’s money supply. Why are such panics highly unlikely today?
How would a decrease in the reserve requirement affect the(a) size of the money multiplier, (b) amount of excess reserves in the banking system, and (c) extent to which the system could expand the
Explain why a single commercial bank can safely lend only an amount equal to its excess reserves but the commercial banking system as a whole can lend by a multiple of its excess reserves. What is
Suppose that Mountain Star Bank discovers that its reserves will temporarily fall slightly below those legally required.How might it temporarily remedy this situation through the Federal funds
“When a commercial bank makes loans, it creates money;when loans are repaid, money is destroyed.” Explain. LO3
“Whenever currency is deposited in a commercial bank, cash goes out of circulation and, as a result, the supply of money is reduced.” Do you agree? Explain why or why not. LO2
Why does the Federal Reserve require commercial banks to have reserves? Explain why reserves are an asset to commercial banks but a liability to the Federal Reserve Banks. What are excess reserves?
Why is the banking system in the United States referred to as a fractional reserve bank system? What is the role of deposit insurance in a fractional reserve system? LO1
Explain why merchants accepted gold receipts as a means of payment even though the receipts were issued by goldsmiths, not the government. What risk did goldsmiths introduce into the payments system
What is the difference between an asset and a liability on a bank’s balance sheet? How does net worth relate to each?Why must a balance sheet always balance? What are the major assets and claims on
The multiple by which the banking system can lend on the basis of each dollar of excess reserves is the reciprocal of the reserve ratio. This multiple credit expansion process is reversible.
The commercial banking system as a whole can lend by a multiple of its excess reserves because the system as a whole cannot lose reserves. Individual banks, however, can lose reserves to other banks
Banks earn interest by making loans and by purchasing bonds; they maintain liquidity by holding cash and excess reserves. The Fed pays interest on excess reserves. Nevertheless, banks often can
Rather than making loans, banks may decide to use excess reserves to buy bonds from the public. In doing so, banks merely credit the checkable-deposit accounts of the bond sellers, thus creating
The ability of a single commercial bank to create money by lending depends on the size of its excess reserves. Generally speaking, a commercial bank can lend only an amount equal to its excess
Commercial banks create money—checkable deposits, or checkable-deposit money—when they make loans. They convert IOUs, which are not money, into checkable-deposits, which are money. Money is
Banks lose both reserves and checkable deposits when checks are drawn against them.
Commercial banks keep required reserves on deposit in a Federal Reserve Bank or as vault cash. These required reserves are equal to a specified percentage of the commercial bank’s checkable-deposit
The operation of a commercial bank can be understood through its balance sheet, where assets equal liabilities plus net worth.
Modern banking systems are fractional reserve systems:Only a fraction of checkable deposits is backed by currency.
Define the money multiplier, explain how to calculate it, and demonstrate its relevance.
Describe the multiple expansion of loans and money by the entire banking system.
Describe how a bank can create money.
Explain the distinction between a bank’s actual reserves and its required reserves.
Explain the basics of a bank’s balance sheet and discuss why the U.S. banking system is called a“fractional reserve” system.
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
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
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
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 M 1
Assume that the following asset values (in millions of dollars)exist in Ironmania: Federal Reserve Notes in circulation 5 $700; Money market mutual funds (MMMFs) held by individuals 5 $400; Corporate
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
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
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
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
Identify three functions of the Federal Reserve of your choice, other than its main role of controlling the supply of money. LO4
Why do economists nearly uniformly support an independent Fed rather than one beholden directly to either the president or Congress? LO3
What is meant when economists say that the Federal Reserve Banks are central banks, quasi-public banks, and bankers’ banks? LO3
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? LO3a. Upon taking
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
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
Explain and evaluate the following statements: LO2a. The invention of money is one of the great achievements of humankind, for without it the enrichment that comes from broadening trade would have
What are the components of the M 1 money supply? What is the largest component? Which of the components of M 1 is legal tender? Why is the face value of a coin greater than its intrinsic value? What
Which two of the following financial institutions offer checkable deposits included within the M 1 money supply:mutual fund companies; insurance companies; commercial banks; securities firms; thrift
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
In response to the financial crisis, Congress passed the Wall Street Reform and Consumer Financial Protection Act of 2010.

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