Money Definitions and Functions

Questions and Answers

What is the difference between commodity money and fiat money?

Commodity money involves the use of an actual good in place of money (gold coin, tobacco). Fiat money has no other value than as a medium for exchange; value comes from government (paper money).

What are the three functions of money? Which function is the defining characteristic?

The three functions are Medium for exchange, Unit of account, and Store value. The defining characteristic is the Medium for exchange.

What are the components of M1 and M2? List them.

M1 includes currency and checkable deposits. M2 includes M1 plus savings deposits, money market mutual funds, and small-demonination time deposits (CDs).

Suppose you withdraw $100 from your checking account. What impact would this action have on the following? (A) The money supply (B) Your bank's required reserves (C) Your bank's excess reserves.

A: Decrease money supply by $100; B: Required reserves would decrease; C: Excess reserves would increase. Signup and view all the answers

Why is the actual money multiplier usually less than the simple money multiplier?

Because all currency is not deposited and banks hold excess reserves. Signup and view all the answers

Why can't a bank lend out all of its reserves?

Because they are legally bound to hold a fraction of their deposits on reserve (required reserves) and must accommodate withdrawals of their depositors. Signup and view all the answers

How does the Fed increase and decrease the money supply through open market operations?

By purchasing (increase money supply) or selling (decrease money supply) US Treasury securities. Signup and view all the answers

How is the discount rate different from the federal funds rate?

The discount rate is the interest rate on discount loans made by the Fed to private banks. The federal funds rate is the interest rate on loans between private banks. Signup and view all the answers

What is the current required reserve ratio? What would happen to the money supply if the Fed decreased the ratio?

10% (0.10). If the Fed decreased the ratio, it would increase the money multiplier which would increase the money supply. Signup and view all the answers

Define quantitative easing. How is it different from standard open market operations?

Quantitative easing is a form of open market operations focusing on targeted securities purchases in troubled markets and long-term Treasury securities instead of short-term. Signup and view all the answers

Study Notes

Money Definitions and Types

Commodity Money: Uses tangible goods (e.g., gold, tobacco) as currency.
Fiat Money: Has no intrinsic value; its worth is derived from governmental decree (e.g., paper money).

Functions of Money

Medium of Exchange: Facilitates trade by eliminating the need for barter.
Unit of Account: Provides a standard measure to quote prices, facilitating value comparison in transactions.
Store of Value: Allows individuals to preserve wealth over time (less effective today due to the prevalence of bank accounts).

Money Supply Measures

M1 Components: Includes currency in circulation and checkable deposits.
M2 Components: Comprises M1 plus savings deposits, money market mutual funds, and small-demonination time deposits (e.g., CDs).

Bank Reserves and Money Supply

Impact of $100 Withdrawal:
- Decreases money supply by $100.
- Reduces required reserves of the bank.
- Increases excess reserves of the bank.

Money Multiplier

Actual vs. Simple Money Multiplier:
- Actual money multiplier is usually lower due to factors like un-deposited currency and banks holding excess reserves.
- Simple money multiplier represents the theoretical maximum increase in money supply based on reserve ratios.

Bank Lending Regulations

Banks are legally required to maintain a fraction of deposits as reserves, limiting the amount of funds available for lending. This ensures liquidity for depositors.

Federal Reserve Operations

Open Market Operations:
- Increase Money Supply: Fed purchases US Treasury securities.
- Decrease Money Supply: Fed sells US Treasury securities.

Interest Rates in Banking

Discount Rate: The interest rate for loans from the Fed to private banks.
Federal Funds Rate: The interest rate for loans between private banks.

Reserve Ratio Implications

Current Required Reserve Ratio: 10% (0.10).
A decrease in the reserve ratio would enhance the money multiplier effect, thus increasing the overall money supply.

Quantitative Easing

Definition: A form of open market operation targeting specific long-term securities rather than just short-term assets.
Difference from Standard Operations: Focuses on troubled markets and long-term Treasury securities to stimulate the economy.

Description

This quiz covers the essential definitions and types of money, including commodity and fiat money. Additionally, it examines the functions of money, measures of money supply (M1, M2), and the impact of bank reserves on the money supply. Test your understanding of these fundamental concepts in economics.