SOLUTIONS MANUAL
CHAP: 1
Introduction to Money and Banking
OBJS
Goals of Chap: 1
A. Provide an introduction to the| textbook.
B. Discuss two main themes in the| book
C. Describe the| value of money and banking for everyday life.
D. Discuss why government policy is so crucial for money and banking.
E. Examine ten surprising facts about money and banking that will be discussed in greater detail in
the| book.
TEACHING NOTES
A. Introduction
1. Money flows around the| world and is affected by government policy
2. People encounter money and the| financial system frequently
3. If economic policy is poor, the| economy does not work well
4. The| Federal Reserve is a key policy institution; its decisions have worldwide implications
B. What Is in This Text?
1. The| Value of Money and Banking for Everyday Life
a) The| amount you must repay on a student loan is affected by decisions of the| Federal
Reserve
b) The| interest rate on mortgage loans depends on many factors, including the| Federal
Reserve’s decision
c) The| returns from investing in the| stock market depend on the| profits of corporations,
which in turn depend on economic growth
d) Understanding interest rates and returns to the| stock market will help you make better
decisions
2. Why Is Government Policy So Crucial for Money and Banking?
a) Why do we care about economic policy?
(1) Economic policy affects everyone in her or his everyday life
(2) Policy matters more for the| financial system than for other industries because of
externalities
b) Who are the| policymakers and why are they so important?
(1) Policymakers are a diverse group, including the| Securities and Exchange Commission,
accounting rule-makers, and the| FDIC
(2) They are important because their decisions affect the| nation in many ways
c) What is the| Federal Reserve?
(1) The| Federal Reserve determines the| money supply, sets rules for check clearing,
distributes currency, supervises and regulates banks
(2) A major decision by the| Fed is to change the| target for the| federal funds rate
1
,SOLUTIONS MANUAL
C. Ten (Surprising) Facts Concerning Money and Banking
1. Most financial formulas—no matter how complicated they look—are based on the|
compounding of interest
a) Complicated formulas related to financial transactions are based on the| simple idea of
compounding
b) Borrowing requires repayment plus interest
c) Interest compounds over time; interest today is earned on interest earned previously
d) Compounding makes a large difference over long periods
e) Compounding is the| major principle in finance
2. More U.S. currency is held in foreign countries than in the| United States
a) More U.S. dollars circulate outside our borders than within
b) Foreigners use U.S. dollars to avoid problems caused by inflation in their own countries
c) U.S. taxes are lower because foreigners use our currency, as the| U.S. government profits
from the| sale of currency to foreigners
3. Interest rates on long-term loans are generally higher than interest rates on short-term loans
a) There are many different interest rates
b) The| longer the| time before a loan is repaid, the| higher the| interest rate usually is
c) The| higher interest rate on long-term loans arises from lender’s preferences and the|
increased riskiness of long-term loans
4. To understand how interest rates affect economic decisions, you must account for expected
inflation
a) People do not care about how many dollars they earn from lending; they care about what
they can buy
b) How much a lender can buy in the| future depends on the| expected inflation rate
c) People form expectations of inflation in different ways, depending on circumstances
d) The| real interest rate is of concern to investors; policymakers can change the| nominal
interest rate, but changes in the| real interest rate depend on changes in people’s inflation
expectations
5. Buying stocks is the| best way to increase your wealth—and the| worst
a) Deciding how to invest your savings depends on your willingness to take risk
b) Investing in the| stock market may yield high returns but it is very risky
c) Stock investors should understand both how the| stock market works within the| financial
system and what a particular investment will yield
6. Banks and other financial institutions made major errors that led to the| financial crisis of 2008
a) Banks were relatively healthy in the| 1990s and the| early 2000s
b) Rapid growth in housing prices led banks and mortgage brokers to make loans to people
who did not have sufficient income to pay back the| loans
c) When housing prices dropped, banks lost money on subprime loans and mortgage-backed
securities
d) The| global financial system froze up and a deep recession followed
7. Recessions are difficult to predict
a) A recession occurs when overall business activity declines
b) Recessions are difficult to predict; indicators that seem to predict recessions at one time
lose their predictive ability at other times
c) But analysis can reveal the| economy’s susceptibility to a shock that may lead to a
recession
2
,SOLUTIONS MANUAL
8. The| Fed creates money by changing a number in its computer system
a) Money is created when the| Federal Reserve buys government securities, which it does by
writing down a larger number in its computer system
b) Dollar bills come into being when the| Federal Reserve gives them to banks in exchange
for reducing the| number in the| computer system representing banks’ deposits
c) If the| Federal Reserve creates too much money, the| inflation rate rises, so the| Federal
Reserve limits money creation
9. In the| long run, the| only economic variable the| Federal Reserve can affect is the| rate of
inflation—the| Fed has no effect on economic activity
a) The| Fed can change economic activity in the| short run by changing the| money supply
and interest rates
b) In the| long run, the| Fed’s policy does not affect economic activity, but only determines
the| inflation rate
10. You can predict how the| Federal Reserve will change interest rates using a simple equation
a) We can use our knowledge about the| Fed’s actions in the| short run and long run to
predict its behavior
b) The| Fed’s decisions largely depend on the| level of output relative to potential and the|
inflation rate relative to its desired level
c) The| Taylor rule is an equation that describes the| Fed’s behavior reasonably well
ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION
1. Ask your students which of the| ten facts they found most surprising. For those of us who teach
money and banking or macroeconomics, none of the| facts are surprising at all. But students with
little backgrounds in economics are often quite surprised by many of the| ten facts. In giving
speeches as a Federal Reserve economist, I found that fact number 9, that the| Fed can only
affect inflation in the| long run, comes as a surprise to almost everyone.
2. It may be interesting to talk about fact number 5, “buying stocks is the| best way to increase your
wealth—and the| worst” now, then come back to it when you get to Chap: 7. It seems that almost
everyone who has not looked at the| data on stock returns thinks that if only they had some
wealth, they could make a fortune in the| stock market. Giving them a healthy dose of reality is a
goal of the| book and should be clear in Chap: 7.
3. The| idea that recessions are difficult to predict, which is idea number 7, is one that many people
struggle with. A useful class discussion can arise from the| question: How can the| government
use policy to prevent recessions if they are not predictable in the| first place? That is a tough one
to answer!
ADDITIONAL TEACHING NOTES
Policy Issue: How Much Should Policymakers Do?
A key question that every policymaker faces is: how much should I do? That decision influences
everyone, because how policymakers answer that question determines whom citizens vote for and
how they perceive government.
3
, SOLUTIONS MANUAL
In this textbook, we will look at both sides of the| coin, divided between activist policy, in which the|
government does a lot, and passive policy, in which the| government does little. In some cases, it will
be clear that activist government policy is wrong. But in others (such as setting up accounting rules),
it is equally clear that government policy actions are valuable.
In 2000, for example, the| Securities and Exchange Commission (SEC) passed a new rule about “fair
disclosure.” It stopped the| practice that many companies had engaged in of telling some people
(usually investment analysts from Wall Street) useful information about the| company and its future
prospects. Why did the| SEC adopt this rule? Because it gave the| Wall Street guys a big advantage
over the| average investor, who did not have access to the| same information. Prior to the| rule, it
would be common for an analyst from a large Wall Street firm to call the| president of a company with
questions, the| president would disclose valuable information, and the| analyst would then often
write a favorable report on the| company. The| average investor might eventually learn the| same
information, but in the| meantime the| Wall Street firm and its clients would have already benefited
by purchasing the| company’s stock. This gave an unfair advantage to Wall Street firms and their
clients. The| new rule levels the| playing field for all investors.
We will spend a lot of time in this textbook discussing monetary policy, and address the| tremendous
debate over how activist policy should be. Keynesian theory in the| 1970s suggested that monetary
policy could offset many disturbances in the| economy. But the| Great Inflation of the| 1970s caused
economists to rethink the| ability of policymakers to fine-tune the| economy. On the| other hand, the|
deep recession of 2008-2009 led to resurgence of Keynesian policies. If policymakers are to be less
activist, how much should they do? Should they act based on their discretion, keeping in mind the|
failures of the| past? Chairman Bernanke testified that the| Fed should do its best with the| models it
has to help the| economy. But some economists think the| Fed should instead eliminate its discretion
and follow a simple rule, such as, “make the| money supply grow 5 percent each year.”
Others—such as Mickey Levy, Chief Economist of Bank of America—argue that, “The| Fed must
avoid being sidetracked from its long-run objectives; in the| past, attempts to over-manage the|
economy by smoothing short-run fluctuations, calming financial market turmoil, stabilizing currency
fluctuations, or responding to fiscal policy have been destabilizing.” Levy thinks that most of the|
Fed’s actions are counterproductive, doing more harm than good. He would rather see the| Fed
focus on its long-run goals and stop engaging in policy to affect the| economy in the| short run. Levy
did admit, however, that after the| financial shock of the| fall of 2008, “financial markets have
stabilized and the| economy has adjusted, benefiting primarily from the| Federal Reserve’s
extraordinary liquidity provisions.”
In research studies on monetary policy, economists have found some support for that argument. In
comparing the| performance of different rules for monetary policy, a number of studies have shown
that when the| Fed tries to respond to short-run fluctuations in economic growth, it tends to have
worse overall performance than if it focuses solely on inflation.
In the| past, macroeconomic theory has suggested that policymakers can do exactly what Levy
cautions against. As a discipline, macroeconomics was really begun by John Maynard Keynes, who
was responding to depressed economic conditions worldwide. Keynesian theory, as it was
subsequently developed, showed that there was a large range of government policies that could be
useful in getting an economy out of recession or depression. Indeed, graduate schools in economics
today teach students how government policy works to manipulate the| economy in the| short run.
4
CHAP: 1
Introduction to Money and Banking
OBJS
Goals of Chap: 1
A. Provide an introduction to the| textbook.
B. Discuss two main themes in the| book
C. Describe the| value of money and banking for everyday life.
D. Discuss why government policy is so crucial for money and banking.
E. Examine ten surprising facts about money and banking that will be discussed in greater detail in
the| book.
TEACHING NOTES
A. Introduction
1. Money flows around the| world and is affected by government policy
2. People encounter money and the| financial system frequently
3. If economic policy is poor, the| economy does not work well
4. The| Federal Reserve is a key policy institution; its decisions have worldwide implications
B. What Is in This Text?
1. The| Value of Money and Banking for Everyday Life
a) The| amount you must repay on a student loan is affected by decisions of the| Federal
Reserve
b) The| interest rate on mortgage loans depends on many factors, including the| Federal
Reserve’s decision
c) The| returns from investing in the| stock market depend on the| profits of corporations,
which in turn depend on economic growth
d) Understanding interest rates and returns to the| stock market will help you make better
decisions
2. Why Is Government Policy So Crucial for Money and Banking?
a) Why do we care about economic policy?
(1) Economic policy affects everyone in her or his everyday life
(2) Policy matters more for the| financial system than for other industries because of
externalities
b) Who are the| policymakers and why are they so important?
(1) Policymakers are a diverse group, including the| Securities and Exchange Commission,
accounting rule-makers, and the| FDIC
(2) They are important because their decisions affect the| nation in many ways
c) What is the| Federal Reserve?
(1) The| Federal Reserve determines the| money supply, sets rules for check clearing,
distributes currency, supervises and regulates banks
(2) A major decision by the| Fed is to change the| target for the| federal funds rate
1
,SOLUTIONS MANUAL
C. Ten (Surprising) Facts Concerning Money and Banking
1. Most financial formulas—no matter how complicated they look—are based on the|
compounding of interest
a) Complicated formulas related to financial transactions are based on the| simple idea of
compounding
b) Borrowing requires repayment plus interest
c) Interest compounds over time; interest today is earned on interest earned previously
d) Compounding makes a large difference over long periods
e) Compounding is the| major principle in finance
2. More U.S. currency is held in foreign countries than in the| United States
a) More U.S. dollars circulate outside our borders than within
b) Foreigners use U.S. dollars to avoid problems caused by inflation in their own countries
c) U.S. taxes are lower because foreigners use our currency, as the| U.S. government profits
from the| sale of currency to foreigners
3. Interest rates on long-term loans are generally higher than interest rates on short-term loans
a) There are many different interest rates
b) The| longer the| time before a loan is repaid, the| higher the| interest rate usually is
c) The| higher interest rate on long-term loans arises from lender’s preferences and the|
increased riskiness of long-term loans
4. To understand how interest rates affect economic decisions, you must account for expected
inflation
a) People do not care about how many dollars they earn from lending; they care about what
they can buy
b) How much a lender can buy in the| future depends on the| expected inflation rate
c) People form expectations of inflation in different ways, depending on circumstances
d) The| real interest rate is of concern to investors; policymakers can change the| nominal
interest rate, but changes in the| real interest rate depend on changes in people’s inflation
expectations
5. Buying stocks is the| best way to increase your wealth—and the| worst
a) Deciding how to invest your savings depends on your willingness to take risk
b) Investing in the| stock market may yield high returns but it is very risky
c) Stock investors should understand both how the| stock market works within the| financial
system and what a particular investment will yield
6. Banks and other financial institutions made major errors that led to the| financial crisis of 2008
a) Banks were relatively healthy in the| 1990s and the| early 2000s
b) Rapid growth in housing prices led banks and mortgage brokers to make loans to people
who did not have sufficient income to pay back the| loans
c) When housing prices dropped, banks lost money on subprime loans and mortgage-backed
securities
d) The| global financial system froze up and a deep recession followed
7. Recessions are difficult to predict
a) A recession occurs when overall business activity declines
b) Recessions are difficult to predict; indicators that seem to predict recessions at one time
lose their predictive ability at other times
c) But analysis can reveal the| economy’s susceptibility to a shock that may lead to a
recession
2
,SOLUTIONS MANUAL
8. The| Fed creates money by changing a number in its computer system
a) Money is created when the| Federal Reserve buys government securities, which it does by
writing down a larger number in its computer system
b) Dollar bills come into being when the| Federal Reserve gives them to banks in exchange
for reducing the| number in the| computer system representing banks’ deposits
c) If the| Federal Reserve creates too much money, the| inflation rate rises, so the| Federal
Reserve limits money creation
9. In the| long run, the| only economic variable the| Federal Reserve can affect is the| rate of
inflation—the| Fed has no effect on economic activity
a) The| Fed can change economic activity in the| short run by changing the| money supply
and interest rates
b) In the| long run, the| Fed’s policy does not affect economic activity, but only determines
the| inflation rate
10. You can predict how the| Federal Reserve will change interest rates using a simple equation
a) We can use our knowledge about the| Fed’s actions in the| short run and long run to
predict its behavior
b) The| Fed’s decisions largely depend on the| level of output relative to potential and the|
inflation rate relative to its desired level
c) The| Taylor rule is an equation that describes the| Fed’s behavior reasonably well
ADDITIONAL ISSUES FOR CLASSROOM DISCUSSION
1. Ask your students which of the| ten facts they found most surprising. For those of us who teach
money and banking or macroeconomics, none of the| facts are surprising at all. But students with
little backgrounds in economics are often quite surprised by many of the| ten facts. In giving
speeches as a Federal Reserve economist, I found that fact number 9, that the| Fed can only
affect inflation in the| long run, comes as a surprise to almost everyone.
2. It may be interesting to talk about fact number 5, “buying stocks is the| best way to increase your
wealth—and the| worst” now, then come back to it when you get to Chap: 7. It seems that almost
everyone who has not looked at the| data on stock returns thinks that if only they had some
wealth, they could make a fortune in the| stock market. Giving them a healthy dose of reality is a
goal of the| book and should be clear in Chap: 7.
3. The| idea that recessions are difficult to predict, which is idea number 7, is one that many people
struggle with. A useful class discussion can arise from the| question: How can the| government
use policy to prevent recessions if they are not predictable in the| first place? That is a tough one
to answer!
ADDITIONAL TEACHING NOTES
Policy Issue: How Much Should Policymakers Do?
A key question that every policymaker faces is: how much should I do? That decision influences
everyone, because how policymakers answer that question determines whom citizens vote for and
how they perceive government.
3
, SOLUTIONS MANUAL
In this textbook, we will look at both sides of the| coin, divided between activist policy, in which the|
government does a lot, and passive policy, in which the| government does little. In some cases, it will
be clear that activist government policy is wrong. But in others (such as setting up accounting rules),
it is equally clear that government policy actions are valuable.
In 2000, for example, the| Securities and Exchange Commission (SEC) passed a new rule about “fair
disclosure.” It stopped the| practice that many companies had engaged in of telling some people
(usually investment analysts from Wall Street) useful information about the| company and its future
prospects. Why did the| SEC adopt this rule? Because it gave the| Wall Street guys a big advantage
over the| average investor, who did not have access to the| same information. Prior to the| rule, it
would be common for an analyst from a large Wall Street firm to call the| president of a company with
questions, the| president would disclose valuable information, and the| analyst would then often
write a favorable report on the| company. The| average investor might eventually learn the| same
information, but in the| meantime the| Wall Street firm and its clients would have already benefited
by purchasing the| company’s stock. This gave an unfair advantage to Wall Street firms and their
clients. The| new rule levels the| playing field for all investors.
We will spend a lot of time in this textbook discussing monetary policy, and address the| tremendous
debate over how activist policy should be. Keynesian theory in the| 1970s suggested that monetary
policy could offset many disturbances in the| economy. But the| Great Inflation of the| 1970s caused
economists to rethink the| ability of policymakers to fine-tune the| economy. On the| other hand, the|
deep recession of 2008-2009 led to resurgence of Keynesian policies. If policymakers are to be less
activist, how much should they do? Should they act based on their discretion, keeping in mind the|
failures of the| past? Chairman Bernanke testified that the| Fed should do its best with the| models it
has to help the| economy. But some economists think the| Fed should instead eliminate its discretion
and follow a simple rule, such as, “make the| money supply grow 5 percent each year.”
Others—such as Mickey Levy, Chief Economist of Bank of America—argue that, “The| Fed must
avoid being sidetracked from its long-run objectives; in the| past, attempts to over-manage the|
economy by smoothing short-run fluctuations, calming financial market turmoil, stabilizing currency
fluctuations, or responding to fiscal policy have been destabilizing.” Levy thinks that most of the|
Fed’s actions are counterproductive, doing more harm than good. He would rather see the| Fed
focus on its long-run goals and stop engaging in policy to affect the| economy in the| short run. Levy
did admit, however, that after the| financial shock of the| fall of 2008, “financial markets have
stabilized and the| economy has adjusted, benefiting primarily from the| Federal Reserve’s
extraordinary liquidity provisions.”
In research studies on monetary policy, economists have found some support for that argument. In
comparing the| performance of different rules for monetary policy, a number of studies have shown
that when the| Fed tries to respond to short-run fluctuations in economic growth, it tends to have
worse overall performance than if it focuses solely on inflation.
In the| past, macroeconomic theory has suggested that policymakers can do exactly what Levy
cautions against. As a discipline, macroeconomics was really begun by John Maynard Keynes, who
was responding to depressed economic conditions worldwide. Keynesian theory, as it was
subsequently developed, showed that there was a large range of government policies that could be
useful in getting an economy out of recession or depression. Indeed, graduate schools in economics
today teach students how government policy works to manipulate the| economy in the| short run.
4
