5. What is the Savings-Investment Spending Identity? Savings = Investment Spending for the economy as a whole

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1 Unit 4 Test Review KEY Savings, Investment and the Financial System 1. What is a financial intermediary? Explain how each of the following fulfills that role: Financial Intermediary: Transforms funds into financial assets a. Mutual fund stock portfolio sold as shares b. Bank deposits used for investment spending loans c. Pension fund stock portfolio divided among members used for retirement d. Life insurance company payments and earnings beneficiary payments 2. What is a financial asset? Explain how each of the following fulfills that role: Financial Asset: a paper claim that entitles the buyer to future income from the seller a. Loan a lending agreement between an individual lender and an individual borrower b. Bond an IOU issued by the borrower c. Stock a share in ownership of a company d. Checkable Bank Deposit claim on a bank that obliges the bank to give the depositor their cash on demand What three main functions do they have? Reducing transaction costs, reducing financial risk, providing liquidity 3. What is liquidity? What does the term liquid asset mean? Liquidity is ability to convert an asset to cash quickly. Liquid assets are easily convertible to cash. 4. If you choose to purchase a stock, you are likely to receive a(n) (higher, lower, equivalent) return in exchange for a(n) (higher, lower, equivalent) risk. If you choose to purchase a bond, you are likely to receive a(n) (higher, lower, equivalent) return in exchange for a(n) (higher, lower, equivalent) risk. 5. What is the Savings-Investment Spending Identity? Savings = Investment Spending for the economy as a whole 6. Define the term budget balance. What is the difference between a budget surplus and a budget deficit? Budget Surplus is when tax revenue exceeds government spending (a positive budget balance number). Budget deficit is when government spending exceeds tax revenue (a negative budget balance number). Budget Balance = tax revenue government spending. 7. Define the term national savings: total amount of savings generated within the economy. National Savings = private savings + budget balance. 8. Define the term private savings: savings generated by households and firms (excludes government) Private Savings = disposable income (income after taxes) consumption. 9. Define the term capital inflow: net inflow of funds into a country. Capital Inflow = total inflow of foreign funds total outflow of domestic funds to other countries. 10. In a closed economy (S = I), suppose that GDP is $20 trillion. Consumption is $10 trillion and government spending is $5 trillion. Taxes are $1.5 trillion. What is the value of each of the following: a. Government budget balance = -$3.5 trillion = tax revenue ($1.5) government spending ($5) b. National savings = $5 trillion = private savings ($8.5) budget balance ($3.5) c. Private savings = $8.5 trillion = disposable income taxes ($20-$1.5) consumption ($10) d. Investment spending= $5 trillion (same as national savings (S=I)!) Now assume it is an open economy (S=I), where exports are $1trillion and imports are $3 trillion. How much is the net capital inflow? $2 trillion = $3 trillion (inflow of foreign funds) $1 trillion (outflow of domestic funds) Here is further explanation about why capital inflow represents imports exports:

2 So increased imports = increased borrowing = increased net capital inflow AND increased exports = decreased borrowing = decreased net capital inflow Money Measurement 11. What is included in the M1 definition of money? What is included in M2? M3? M1 = cash + demand deposits + personal checks + travelers checks M2 = M1 + savings + small time deposits + money market funds (stocks, bonds, loans, etc.) M3 = M2 + large time deposits (over $100,000 worth) 12. What is the main difference between M1 and M2? M1 is liquid and can be used as a MEDIUM OF EXCHANGE, where is M2 is considered near moneys, is not as liquid, and cannot be used for purchases of goods and services unless converted to M Indicate whether each of the following is part of M1, M2, M3, or neither: a. $95 on your campus meal card = Neither (Specified purpose/not convertible into cash) b. $0.55 in the change cup in your car = M1 c. $1,663 in your savings account = M2 d. $459 in your checking account = M1 e. $27.50 check from your friend = M1 f. $150,000 in a time deposit = M3 g. 50 shares of stock worth $2,000 = M2 h. A $1,000 line of credit on your Amazon credit card = Neither (credit card is a loan, not convertible into cash) 14. What are the three main functions/roles of money? Medium of Exchange, Store of Value, Unit of Account Indicate the correct role for each scenario: a. Using money to purchase a new MP3 player = Medium of Exchange b. Buying the latest Blue-Ray disc movie with a $20 bill = Medium of Exchange c. Keeping part of your wealth in a savings account = Store of Value d. Discovering money in your coat that you placed there last winter = Store of Value e. Putting a price on a meal = Unit of Account f. Buying a ticket to a rodeo = Medium of Exchange 15. What does the time value of money mean? In general, having a dollar today is worth than having a dollar a year from now because inflation happens over time, eroding the value of your money. 16. Explain the monetary equation of exchange (MV=PQ). Given this equation, graph the results of expansionary monetary policy. Money Supply x velocity = price level x real output (real GDP) ; Show an increase in NOMINAL GDP! a. If nominal GDP is $1,500 and the money supply is $500, what is the velocity of money? Velocity = 3 b. If the money supply is $1000 and velocity is 5, what is nominal GDP? Nominal GDP = $5, What is the federal funds rate? Rate for short term loans between banks (so they can meet reserve requirement) What determines the federal funds rate? Equilibrium interest rate (which moves with the discount rate). Who participates in the federal funds market? Banks who borrow/lend to each other at the federal funds rate. Demand for Money and the Money Market 18. What is the opportunity cost for holding money? Interest rate on small time deposits.

3 19. A. What does the Money Demand curve represent and why is it downward sloping? Represents the quantity of money held in the economy in relation to the interest rate. A higher interest rate leads to a higher opportunity cost of holding money and reduces the quantity of money demanded. B. What are the three types of Money Demand? (Act. 4-4) 1) Transactions demand to make purchases of goods and services (closely associated with my money is a medium of exchange), 2) Precautionary demand to serve as protection against an unexpected need, 3) Speculative demand to serve as a store of wealth 20. What circumstances will cause a shift in the demand for money? Changes in aggregate price level, real GDP, technology, and institutions. Which of these circumstances will cause a proportional increase in the quantity of money demanded? Price level. 21. Draw a graph depicting the money market. a. Label the point equilibrium. What does this point on the graph represent? Where supply & demand meet b. If the current interest rate was above equilibrium, what would eventually happen to interest rates? If interest rates rise above equilibrium quantity demanded for money will be less than quantity supplied (surplus); market forces will eventually bring interest rates back down to equilibrium. c. If the current interest rate was below equilibrium, what would eventually happen to interest rates? If interest rates fall below equilibrium quantity of money supplied will be less than quantity demanded (shortage); market forces will eventually bring interest rates back up to equilibrium. Banking and Money Creation 22. Why is there a money multiplier and what is its formula? Banks can create are large money supply by loaning out checkable deposits. Mm = 1/rr. Why in reality is it smaller than in theory? In reality, determining the money supply depends not only on the ratio of reserves to bank deposits but also on the fraction of the money supply that individuals choose to hold in the form of currency. That s why the money multiplier in the US is around 1.9, not What is the fractional reserve banking system? A banking system in which banks hold only a fraction of deposits as required reserves and can lend some of the money deposited by their customers to other borrowers. This allows the Money multiplier to occur. 24. Suppose the reserve requirement is 15% and you deposit a $5,000 bonus you just received in your checking account. How much of the deposit is the bank required to keep in reserves? $750 = 15% of $5,000 How much can the bank loan out? $4,250 = $5,000 - $750 What is the possible maximum expansion in the money supply? Mm = 1/.15 = 6.67 x $4,250 = $28, What will happen to the money supply under the following circumstances in a fractional reserve banking system? What is the multiplier in each scenario? (Assume the banking system does NOT hold excess reserves.) a. The required reserve is 25% and a depositor withdraws $700 from his checking account. MM=4, of $700 withdrawn, 25% was held in reserve, so, $525 loaned X 4 = -$2,100 effect on banking system (decrease) b. The required reserve is 5% and a depositor withdraws $700 from his checking account. MM=20, of $700 withdrawn,5% was held in reserve, so $665 loaned X20= -$13,300 effect on banking system (decrease) c. The required reserve ratio is 20% and a customer deposits $750 to her checking account. MM=5, Of $750 deposited, 20% is held in reserve, so $600 loaned X 5 = $3,000 d. The required reserve ratio is 10% and a customer deposits $600 to her checking account. MM=10, Of $600 deposited, 10% is held in reserve, so $540 loaned X 10 = $5, A commercial bank holds $700,000 in demand deposits and $100,000 in reserves. If the required reserve ratio is 10%, what is the maximum amount by which this bank may increase its loans? What is the maximum amount by which the banking system may increase loans as a result? With $700,000 on deposit, the bank must hold $70,000 (10%) in required reserves. Therefore, they can loan out the excess: $30,000 ($100,000 70,000). MM = 10, so the banking system may increase loans by $30,000 X 10 = $300, When the required reserve ratio is lowered, the potential for money creation (increases/decreases). When the required reserve ratio is raised, the potential for money creation (increases/decreases). 28. Where can a bank choose to store its reserves? Either 1) bank s vault as cash or 2) bank s account at the Fed

4 The Federal Reserve and Monetary Policy 29. Why do monetarist argue monetary policy is more effective than fiscal policy? Because it puts economics, not politicians, in charge of the economy and it does not suffer from the long time lags of fiscal policy. 30. What are the functions of the Fed? 1) provide financial services, 2) supervise and regulate the banks, 3) maintain financial stability, 4) conduct monetary policy In what ways is it the banker s bank? Holds reserves, clears checks, provides cash and transfers funds for banks What is the Fed s target for unemployment rates? Inflation rates? Unemployment rate target = 4-6%, inflation rate target = 2-3% 31. What are the tools of the Federal Reserve? 1) reserve requirements, 2) discount rate, 3) open-market operations Which tool does the Fed utilize most often? Open-market operations! 32. Explain how the Federal Reserve uses open market operations to increase/decrease the monetary base. Buy Treasury Bills increases monetary base by liquefying assets and increasing bank s excess reserves, which can then be lent (and multiplied) Sell Treasury Bills decrease monetary base by illiquefying assets and decreasing bank s excess reserves, reducing lending capability 33. Why is the discount rate higher than the set by the Fed purposely higher than the federal funds rate? The discount rate is slightly higher than the federal funds rate (usually 1% higher) to discourage banks from directly borrowing from the Fed. 34. Complete this chart depicting the impact of Fed open market operations: Operation Bank (Excess) Reserves Money Supply Interest Rates Bond Prices Buying Bonds Selling Bonds 35. Complete this chart depicting Federal Reserve monetary policy options: Response to Type of Monetary Policy Reserve Requirements Discount Rate Open Market Operations Impact on Aggregate Supply & Demand High Inflation Contractionary Sell Bonds Aggregate Demand Recession Expansionary Buy Bonds Aggregate Demand 36. Complete this chart depicting economic impacts of monetary policy: Type of Monetary Policy Interest Rates Private (Business) Real GDP Unemployment Investment Contractionary Expansionary 37. Assume that the reserve requirement for demand deposits is 10 percent, that banks hold no excess reserves and that the public holds no currency. a. If the central bank buys $10,000 worth of government securities to commercial banks, the total money supply will b. If the central bank sells $10,000 worth of government securities to commercial banks, the total money supply will c. If the central bank buys $10,000 worth of government securities to the public, the total money supply will d. If the central bank sells $10,000 worth of government securities to the public, the total money supply will Because the public must first deposit the $10,000 and the bank must hold 10% in reserves, you can only time the multiplier by the excess reserves ($9,000) and then add the original $10,000 of new money created or taken away from the buying or selling of bonds. The Market for Loanable Funds 38. What is the real interest rate? How is it related to the nominal interest rate? Real interest rate = nominal interest rate expected inflation rate. 39. What is the rate of return? How is it utilized in project evaluation? Return must outpace interest rate Rate of return = revenue cost of project x 100 Cost of project

5 40. What circumstances will cause a shift in the demand for loanable funds? 1) perceived business opportunities, 2) government borrowing 41. What circumstances will cause a shift in the supply of loanable funds? 1) saving behavior, 2) capital inflows, 3) monetary policy (increasing/decreasing money supply will increase or decrease the supply of loanable funds) 42. Illustrate and explain: a. The Fisher effect: the expected real interest rate is unaffected by the change in expected future inflation b. Crowding Out: occurs when a government deficit drives up the interest rate and leads to reduce investment spending 43. Complete this chart depicting the Loanable Funds Market: LF Market response to Shift in supply or demand or in supply or demand Interest rates Total amount borrowed (Quantity of LF) Government budget deficit Demand Government budget surplus Demand Increase in private savings Supply Decrease in private savings supply