The Functions of Money, T-Accounts, and Monetary Policy

Question 1: (The functions of money)

Question 1: (The functions of money) You visit a tropical island that has only four goods in its economy – oranges, pineapples, coconuts, and bananas. There is no money in this economy.

1. An islander suggests designating oranges as the means of payment and unit of account for the economy. How many prices would there be if her suggestion was followed?

2. Would you recommend the issue of a paper currency by the government of the island? What advantages might this strategy have over the use of oranges as money? (Discuss according to the features of money.)

Question 2: (T-accounts)

1. If the central bank lends five banks a total of $100 million, what happens to reserves and the monetary base? Use T-accounts to explain your answer.

2. Suppose that depositors withdraw $50 million in deposits to hold as currency. Use T-accounts to explain what happens to the balance sheets of the banking system and the depositors.

Question 3: (Monetary base, money multiplier and money supply)

Suppose that currency in circulation is $600 billion, the amount of checkable deposits is $900 billion, the required reserve ratio is 10% and excess reserves are $15 billion.

1. Calculate the money supply, the currency deposit ratio, the excess reserve ratio, and the money multiplier.

2. Suppose the central bank conducts a monetary policy that increases bank reserves by $1400 billion due to a sharp contraction in the economy. Assuming the money multiplier remains the same as in Part 1, predict the effect on the money supply.

3. Suppose the central bank conducts the policy as in Part 2, except that banks choose to hold all of these proceeds as excess reserves rather than loan them out, due to fear of a financial crisis. Assuming that currency and deposits remain the same, what happens to the amount of excess reserves, the excess reserve ratio, the money supply, and the money multiplier?

4. During the financial crisis in 2008, the Federal Reserve began injecting the banking system with massive amounts of liquidity, and at the same time, very little lending occurred. As a result, the M1 money multiplier was below 1 for most of the time from October 2008 through 2011. How does this scenario relate to your answer to Part 3?