ECO 301 FINAL EXAM QUESTIONS WITH VERIFIED
ANSWERS
Fractional Reserve Baking - Answers - Financial innovation where banker can keep a
fraction of deposits in the vault and then lend out the remaining fraction and earn
interest on it
Why is fractional reserve banking feasible? - Answers - Deposits and withdrawals are
approximately equal leaving a relatively stable balance
Multiple Deposit Creation - Answers - Multiple deposits made with same original deposit
so the bank realized they can loan out that money and effectively allow multiple people
to use it and redeposit it. Similar to the credit system of loans
Deposit Multiplier - Answers - (1/rr) where rr is (reserves/deposits)
Banks as the intermediaries between households and businesses: - Answers - - make
profit from the difference in rates less the costs of being an intermediary
- when this is equal to zero there is an increase in welfare due to the long run average
cost being lowered due to a smaller spread
Bank Panic - Answers - Sudden demand for withdrawals, typically associated with poor
economic conditions and recessions. Bank panics end when banks suspend payments
Bank Panic of 1907 - Answers - Because of it, Congress formed National Monetary
Commission to study the cause of panics and figure out a solution. They concluded that
the supply of money was inelastic and as a result formed the Federal Reserve System
Federal Reserve System - Answers - Create elastic currency through it's 3 powers:
a) issue currency
b) make loans to banks (Banker's Bank)
c) buy, sell & hold govt securities
Goal of Federal Reserve System - Answers - - stop bank panics
- improve welfare
2 Reasons Banks Fail - Answers - 1. Liquidity Failure - banks cannot give depositors
their cash back on demand
2. Insolvency Failure - the value of a bank's assets is less than the value of a bank's
liabilities
Monetary Policy Tools - Answers - 1. The Discount Rate
2. Reserve Requirements
,3. Open Market Operations
The Discount Rate - Answers - The interest rate the Fed charges on loans made by
banks. If the money supply increases, the discount rate decreases
what is the degree of control the Fed has over the discount rate and the federal funds
rate? - Answers - -Fed can set the discount rate
-Fed can change the money supply, discount rate, and reserve interest rate to influence
the FF rate, but cannot set it directly
FF rate is determined in a private market using supply & demand
Reserve Requirements - Answers - If reserve requirements increase, bank profits
decrease because the assets must be held instead of loans out so it won't earn interest.
If reserve requirements decrease, the amount of lending banks can do increases
Open Market Operations - Answers - The most important policy tool. 3 key factors, its
divisible, its anonymous, its reversible.
When the Fed buys govt securities, money supply increases because more money is
going into circulation.
Monetary Base - Answers - all currency + bank deposits at the Fed
M1 - Answers - [(1+k)/(rr*k)]*Base
M2 - Answers - M1 + Savings Deposits + Small Time Deposits + Money Market
Deposits Accounts + Retail Money Market Funds
M1 Money Multiplier - Answers - [(1+k)/(rr*k)]
M1 explained - Answers - rr is chosen by the banks, k is chosen by the non-bank public.
If K increases, money multiplier decreases IF rr <1.
If rr increases, money multiplier decreases.
M1 & M2 Properties - Answers - -M2 is always larger than M1
-M1 includes readily spendable funds
-M2 includes assets that households and businesses keep for short term savings
"Lags" impact on monetary policy - Answers - Recognition Lag: realizing there is
actually a recession
Implementation Lag: It takes time to write strategies to correct the recession
Reactionary Lag: time it takes to react to situation
, 1982 Recession: "Volcker Recession" - Answers - - originally proposed by Paul Volcker
- prevents banks from making certain types of investments that could cause a financial
crisis
- lets recessions go unchecked in order to drive down prices
Costs of Financial Intermediation - Answers - Financial intermediaries match buyers to
sellers which can be costly. They derive their revenue from the Bid-Ask spread
"Corridor" - Answers - Interest rates on reserves can create a floor since the Fed is able
to control the BaseD/P by changing interest rate paid on reserves. Discount rate can
create a ceiling at the BaseS/P.
Accounting Profit - Answers - Revenue - Explicit Costs
Economic Profit - Answers - Accounting Profit - Implicit Costs
Quantity Theory of Money - Answers - M * V = P * Y
Quantity Theory of Money Explained - Answers - - M = Quantity of Money
- V = Velocity of Circulation (The number of times the typical dollar changes hands in
the purchase of a final good/service)
- P = Price Level
- Y = Real Output
- P *Y = Nominal GDP / Output
When new reserves that are available to the banking system increase, then - Answers -
credit increases by a multiple of the increase in reserves as deposits are loaned out,
those loans are spent, and the expenditure is redeposited into the system
Which of the following was not provided for in the Federal Reserve Act - Answers - the
Fed has the power to set reserve requirements for member banks. Was not a power
when originally created, but became a power in the 30s and then redefined in the 80s
M2 differs from M1 in that - Answers - M2 is never smaller than M1
If the interest rate on reserves is 2%, the discount rate is 5%, and the fed funds rate is
in equilibrium at 4%, then if the Fed wants to lower the funds rate, it will - Answers -
Purchase government securities
If the Fed purchases a government security, then - Answers - Multiple deposit creation
will occur unless banks sharply increase their excess reserves. Releasing money into
the monetary supply by purchasing securities would cause the monetary supply to
increase and multiple deposit and credit creation to happen, unless the bank keeps all
of that new money in their excess reserves. Then it is never lent out and no new
deposits or credits occur
ANSWERS
Fractional Reserve Baking - Answers - Financial innovation where banker can keep a
fraction of deposits in the vault and then lend out the remaining fraction and earn
interest on it
Why is fractional reserve banking feasible? - Answers - Deposits and withdrawals are
approximately equal leaving a relatively stable balance
Multiple Deposit Creation - Answers - Multiple deposits made with same original deposit
so the bank realized they can loan out that money and effectively allow multiple people
to use it and redeposit it. Similar to the credit system of loans
Deposit Multiplier - Answers - (1/rr) where rr is (reserves/deposits)
Banks as the intermediaries between households and businesses: - Answers - - make
profit from the difference in rates less the costs of being an intermediary
- when this is equal to zero there is an increase in welfare due to the long run average
cost being lowered due to a smaller spread
Bank Panic - Answers - Sudden demand for withdrawals, typically associated with poor
economic conditions and recessions. Bank panics end when banks suspend payments
Bank Panic of 1907 - Answers - Because of it, Congress formed National Monetary
Commission to study the cause of panics and figure out a solution. They concluded that
the supply of money was inelastic and as a result formed the Federal Reserve System
Federal Reserve System - Answers - Create elastic currency through it's 3 powers:
a) issue currency
b) make loans to banks (Banker's Bank)
c) buy, sell & hold govt securities
Goal of Federal Reserve System - Answers - - stop bank panics
- improve welfare
2 Reasons Banks Fail - Answers - 1. Liquidity Failure - banks cannot give depositors
their cash back on demand
2. Insolvency Failure - the value of a bank's assets is less than the value of a bank's
liabilities
Monetary Policy Tools - Answers - 1. The Discount Rate
2. Reserve Requirements
,3. Open Market Operations
The Discount Rate - Answers - The interest rate the Fed charges on loans made by
banks. If the money supply increases, the discount rate decreases
what is the degree of control the Fed has over the discount rate and the federal funds
rate? - Answers - -Fed can set the discount rate
-Fed can change the money supply, discount rate, and reserve interest rate to influence
the FF rate, but cannot set it directly
FF rate is determined in a private market using supply & demand
Reserve Requirements - Answers - If reserve requirements increase, bank profits
decrease because the assets must be held instead of loans out so it won't earn interest.
If reserve requirements decrease, the amount of lending banks can do increases
Open Market Operations - Answers - The most important policy tool. 3 key factors, its
divisible, its anonymous, its reversible.
When the Fed buys govt securities, money supply increases because more money is
going into circulation.
Monetary Base - Answers - all currency + bank deposits at the Fed
M1 - Answers - [(1+k)/(rr*k)]*Base
M2 - Answers - M1 + Savings Deposits + Small Time Deposits + Money Market
Deposits Accounts + Retail Money Market Funds
M1 Money Multiplier - Answers - [(1+k)/(rr*k)]
M1 explained - Answers - rr is chosen by the banks, k is chosen by the non-bank public.
If K increases, money multiplier decreases IF rr <1.
If rr increases, money multiplier decreases.
M1 & M2 Properties - Answers - -M2 is always larger than M1
-M1 includes readily spendable funds
-M2 includes assets that households and businesses keep for short term savings
"Lags" impact on monetary policy - Answers - Recognition Lag: realizing there is
actually a recession
Implementation Lag: It takes time to write strategies to correct the recession
Reactionary Lag: time it takes to react to situation
, 1982 Recession: "Volcker Recession" - Answers - - originally proposed by Paul Volcker
- prevents banks from making certain types of investments that could cause a financial
crisis
- lets recessions go unchecked in order to drive down prices
Costs of Financial Intermediation - Answers - Financial intermediaries match buyers to
sellers which can be costly. They derive their revenue from the Bid-Ask spread
"Corridor" - Answers - Interest rates on reserves can create a floor since the Fed is able
to control the BaseD/P by changing interest rate paid on reserves. Discount rate can
create a ceiling at the BaseS/P.
Accounting Profit - Answers - Revenue - Explicit Costs
Economic Profit - Answers - Accounting Profit - Implicit Costs
Quantity Theory of Money - Answers - M * V = P * Y
Quantity Theory of Money Explained - Answers - - M = Quantity of Money
- V = Velocity of Circulation (The number of times the typical dollar changes hands in
the purchase of a final good/service)
- P = Price Level
- Y = Real Output
- P *Y = Nominal GDP / Output
When new reserves that are available to the banking system increase, then - Answers -
credit increases by a multiple of the increase in reserves as deposits are loaned out,
those loans are spent, and the expenditure is redeposited into the system
Which of the following was not provided for in the Federal Reserve Act - Answers - the
Fed has the power to set reserve requirements for member banks. Was not a power
when originally created, but became a power in the 30s and then redefined in the 80s
M2 differs from M1 in that - Answers - M2 is never smaller than M1
If the interest rate on reserves is 2%, the discount rate is 5%, and the fed funds rate is
in equilibrium at 4%, then if the Fed wants to lower the funds rate, it will - Answers -
Purchase government securities
If the Fed purchases a government security, then - Answers - Multiple deposit creation
will occur unless banks sharply increase their excess reserves. Releasing money into
the monetary supply by purchasing securities would cause the monetary supply to
increase and multiple deposit and credit creation to happen, unless the bank keeps all
of that new money in their excess reserves. Then it is never lent out and no new
deposits or credits occur
