Fiscal policy refers to the use of government expenditure, tax, and borrowing activities to achieve economic goals. Monetary policy refers to central bank activities to control the supply of money. Their goals are maximum employment, stable prices, and moderate long-term interest rates.

The Functions of Money

Money performs three basic functions.

• It serves as a medium of exchange to buy and sell goods and services. Money simplifies and reduces the costs of transactions.
  In the absence of money, a barter economy would exist. Acquiring a belt, for example, would entail finding a belt maker who happened to want what you had to offer in exchange, making transactions tedious, enormously costly, and inefficient.
  Money permits us to realize the enormous gains from the specialization, division of labor, and mass-production processes that underlie our modern standard living.

• It is used as an accounting unit to compare the value and cost of things. As a unit of measurement, like a centimeter, money is used by people to post prices and keep track of revenues and costs.

• It provides a way of storing value to allow the movement of purchasing power from one period to another. Although it is not the only way of storing value, it is the most liquid of all assets, due to its function as the medium of exchange. However, many methods of holding money do not yield an interest return and the purchase power of money will decline during a time of inflation.

The Money Creation Process

Reserves are the cash in a bank's vault and deposits at Federal Reserve Banks. Under the fractional reserve banking system, a bank is obligated to hold a minimum amount of reserves to back up its deposits. Reserves held for that purpose, which are expressed as a percentage of a bank's demand deposits, are called required reserves. Therefore, the required reserve ratio is the percentage of a bank's deposits that are required to be held as reserves.

Banks create deposits when they make loans; the new deposits created are new money.

Example

Suppose the required reserve ratio in the U.S. is 20%, and then suppose that you deposit $1,000 cash with Citibank. Citibank keeps $200 of the $1,000 in reserves. The remaining $800 of excess reserves can be loaned out to, say, John. After the loan is made, the money supply increases by $800 (your $1,000 + John's $800). After getting the loan, John deposits the $800 with Bank of America (BOA). BOA keeps $160 of the $800 in reserves and can now loan out $640 to another person. Thus, BOA creates $640 of money supply. The process goes on and on. With each deposit and loan, more money is created. However, the money creation process does not create an infinite amount of money.

The money multiplier is the amount by which a change in the monetary base is multiplied to calculate the final change in the money supply. Money Multiplier = 1/b, where b is the required reserve ratio. In our example, b is 0.2, so money multiplier = 1/0.2 = 5.

Definitions of Money

There are different definitions of money. The two most widely used measures of money in the U.S. are:

• The M1 Money Supply: cash, checking accounts and traveler's checks. This is the narrowest definition of the money supply. This definition focuses on money's function as a medium of exchange.
• The M2 Money Supply: M1 + savings + small time deposits + retail money funds. This definition focuses on money's function as a medium of exchange and store of value.

Credit cards are not purchasing power, but instead are a convenient means of arranging a loan. Credit is a liability acquired when one borrows funds, while money is a financial asset that provides the holder with future purchasing power. However, the widespread use of credit cards will tend to reduce the average quantity of money people hold.

Deposits are money, but checks are not - a check is an instruction to a bank to transfer money.

The Quantity Theory of Money

Money Supply (M) x Velocity of Money (V) = Price (P) x Real Output (Y)

• The velocity of money is the average number of times a dollar is used to purchase final goods and services during a year. It is computed as V = GDP/Money Supply = PY/M. In essence, it is the turnover rate of money. For example, if the nominal GDP is $200 billion and the money supply is $40 billion: V = 200/40 = 5.
• The equation of exchange reflects two ways of viewing GDP: the left side reflects the monetary flow of expenditures on final products and the right side reflects the sum of the price (P) times the output (Y) of each final product purchased during the period.

If both Y and V are constant, then the equation indicates that an increase in money supply will lead to a proportional increase in price level.

This equation of exchange leads to the quantity theory of money, which hypothesizes that a change in the money supply will cause a proportional change in the price level because velocity and real output are unaffected by the quantity of money.

Practice Question 1

According to the quantity theory of money, if the GDP is $6 trillion and the M1 money supply is $800 billion, the velocity of the M1 money supply is ______.

A. 0.133
B. 7.500
C. 6.500

Correct Answer: B

Practice Question 2

If people transfer money from their checking accounts to their savings accounts, ______

A. M1 falls and M2 rises.
B. M1 falls and M2 remains constant.
C. M1 rises and M2 falls.

Correct Answer: B

M2 contains the components of M1 plus savings accounts and money market funds. Thus, if you transfer money out of M1 to M2, M2 does not change because it already accounted for the money.

Practice Question 3

Assuming velocity is relatively constant and real income is relatively stable, an increase of 40 percent in the money supply will bring about an approximate change of ______ in the price level.

A. 4%
B. 40%
C. 0%

Correct Answer: B

Using the equation of exchange, MV = PQ, given these assumptions, there is a close relationship between changes in M and changes in P.

Practice Question 4

An assumption of the quantity theory of money is that ______

A. the velocity of circulation is not influenced by potential GDP.
B. potential GDP is influenced by the quantity of money.
C. the velocity of circulation is not influenced by the quantity of money.
D. the quantity of money is not influenced by potential GDP.

Correct Answer: C

Practice Question 5

Suppose the banking system has $100,000 in outstanding deposits and actual reserves of $35,000. If the required reserve ratio is 25% and individuals hold no cash, the maximum amount the banking system can now add to the money supply is ______.

A. $10,000
B. $25,000
C. $40,000

Correct Answer: C

Excess reserves are $10,000 and the simple money multiplier is 4, so (10,000 x 4) = $40,000 can be added.

Practice Question 6

The reserve requirement is 10%. You take $5,000 cash and deposit it in your checking account. What is the change in the money supply from this deposit?

Correct Answer: An increase of $45,000

The money supply is currency plus deposits. Deposits have increased by $50,000, but currency has been reduced by $5,000 (since it is no longer in the hands of the public). Thus the change in the money supply is an increase of $45,000.

Practice Question 7

If the desired reserve is 10%, and the Fed buys $10,000 worth of bonds from the public sector, what is the change in the money supply, provided that people don't keep any cash?

A. $90,000; increase
B. $100,000; increase
C. $90,000; decrease

Correct Answer: B

The multiplier is 10, so the monetary expansion is $100,000. Note that we do not have to subtract the original $10,000 because this is new money created by the Fed.

Practice Question 8

The M1 money supply measure does not include ______.

I. demand deposits
II. interest-earnings checkable deposits
III. checkable deposits
IV. traveler's checks

A. II only
B. I and III
C. None of them

Correct Answer: C

Checkable deposits (III) include both demand deposits (I) and interest-earning checkable deposits (II)! M1 includes circulating currencies, checkable deposits, and traveler's checks. All of the choices belong to M1.

Practice Question 9

Brian takes out $200 from an ATM against his checking account at his bank. He then gives the money to Rick, who deposits the whole $200 in his checking account at his bank (a different one from Brian's). In theory, after the process finishes, the bank reserves will ______ and the M1 money supply will ______.

A. remain the same; remain the same
B. remain the same; decrease
C. decrease; remain the same

Correct Answer: A

There should be no change in either bank reserves or M1. The process is just a transfer of money from one bank to another, and these two banks have the same reserve requirement and should maintain identical reserves. M1 remains the same because the total amount of deposits in the economy is the same; the money supply is affected only by injections of money by the Fed.

Practice Question 10

James Morrison is a profit-seeking banker. His bank has $25 million in excess reserves. Mr. Morrison ______

A. can probably increase his profits by increasing his excess reserves.
B. cannot change excess reserves held by his bank because this level is set and strictly enforced by the Fed.
C. can probably increase his profits by reducing his excess reserves.

Correct Answer: C

A bank holding excess reserves can increase its profits by extending more loans and holding fewer excess reserves. This is because the excess reserves held by the bank do not earn any interest. However, excess reserves extended as loans earn a positive interest rate and therefore will allow the bank to make a positive profit. Excess reserves represent the portion of reserves held by the bank in excess of the required reserve ratio set by the Fed.

Practice Question 11

Assuming there are no leakages out of the banking system, a money multiplier equal to 10 means that ______

A. an additional $10 of reserves creates one dollar of deposits.
B. each additional dollar of deposits creates $10 of reserves.
C. each additional dollar of reserves creates $10 of additional deposits.

Correct Answer: C

Additional reserves create additional deposits, not the other way around.

Practice Question 12

If BJSH Bank is required to maintain a 20 percent reserve by its central bank, and currently it has excess reserves of $500,000, what is the maximum amount of a loan this bank can extend?

A. $400,000
B. $500,000
C. $2,500,000

Correct Answer: C

The BJSH Bank can lend out all its excess reserves of $500,000 initially. If borrowers deposit the money BJSH Bank lends out with BJSH again, BJSH can continue to keep the 20% as required reserve and lend out the rest. This process could potential "create" a total of $2,500,000 in money supply.

Practice Question 13

The change in the quantity of money that results from a given change in the monetary base is determined by the ______.

A. currency drain
B. reserve ratio
C. money multiplier

Correct Answer: C

Practice Question 14

The equation of exchange hypothesized by the quantity theory of money indicates that ______

I. MY = PV
II. velocity is equal to money supply divided by nominal GDP.
III. rate of inflation + growth rate of money supply = growth rate of real output + growth rate of velocity.

A. I only
B. II and III
C. None of these statements is correct.

Correct Answer: C

The equation of exchange is MV = PY, or: rate of inflation + growth rate of real output = growth rate of money supply + growth rate of velocity.

Practice Question 15

If the existing money stock is $100 billion, the nominal GDP is $400 billion, and the average price level is $20, then according to the quantity theory of money, the velocity of money is ______.

A. 4
B. 5
C. 80

Correct Answer: A

Since PY = GDP = MV, V = GDP/M:
Velocity = 400 / 100 = 4.
The price level is not needed here.

Practice Question 16

The equation of exchange states that ______

A. money supply multiplied by nominal GDP equals velocity.
B. velocity multiplied by money supply equals nominal GDP.
C. money supply divided by velocity equals real GDP.

Correct Answer: B

The equation of exchange implies that when the existing money stock (M) is multiplied by the number of times (V) that money is used to buy final products, this yields the economy's nominal GDP (or output times the price level).

Practice Question 17

The nation of Economica has increased their M1 money supply by 10% over the last year by printing currency. This policy causes no price inflation. Which of the following could explain this phenomenon?

I. The nation of Islandia begins using the Economican currency as a reserve.
II. Aggregate output increases in Economica.
III. The Central Bank begins a government debt buy-back program.

A. I, II, III
B. I, II
C. I only

Correct Answer: B

Under the basic price level equation P = M / Y (Price Level = Money Supply / Output, ignoring the velocity of money for the moment), a 10% increase in the money supply would result in an increase in the price level. One obvious thing that could prevent price inflation would be a corresponding increase in output. Another possibility would be some reduction in the money available for the purchase of goods, such as a foreign nation holding domestic currency as a reserve.

When Central Banks buy government debt, they usually do so with newly printed cash, and even if not, a debt buy-back would serve to decrease interest rates, which would result in an expansion of the money supply.

Practice Question 18

According to the quantity theory of money, which one of the following economic variables would change in response to an increase in the money supply?

A. Prices
B. Velocity
C. Employment

Correct Answer: A

The quantity theory of money implies that the existing money stock (M) multiplied by velocity (V) equals the nominal GDP (output times the price level). In order to maintain the equality, if M increases, the price level (P) must also increase.

Practice Question 19

If the real growth rate of the economy is 3% and the money supply is increasing at 4%, given that the velocity of money is constant, ______

A. the rate of inflation will equal 1%.
B. prices will decline at the rate of 1%.
C. nominal interest rates will decline by 1%.

Correct Answer: A

According to the quantity theory of money, if the velocity of money does not change, rate of inflation = rate of money supply growth - real growth rate of economy = 4% - 3% = 1%.

Practice Question 20

The quantity theory of money is best described as the proposition that, in the long run, an increase in the quantity of money brings a percentage increase in the price level that is ______.

A. higher
B. lower
C. equal

Correct Answer: C

The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.