Principles of Macroeconomics 6th

Edition Frank Solutions Manual

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CHAPTER 9 MONEY, PRICES, AND
FINANCIAL INTERMEDIARIES
Answers to Review Questions

1. First, the financial system provides information about alternative investment

opportunities, helping to allocate saving to the most productive uses. For example,
banks specialize in evaluating the prospects of borrowers, on behalf of the depositors
whose funds are being lent. Similarly, professional stock and bond analysts
investigate the potential returns of companies seeking funding, directing resources to
the most attractive opportunities. Second, financial markets help savers share the
risks of individual investment projects, as when an individual saver is able to
diversify across a wide variety of stocks.

Learning Objective: 09-01

AACSB: Analytic
Bloom’s: Analyze

2. Money refers to any asset that can be used in making purchases (for example, cash
and checking account balances). People hold money despite its lower return precisely
because of its usefulness in transactions; a person who held no money and wanted to
make a purchase would either have to resort to time-consuming barter or else incur
the costs of selling other assets to obtain money.

Learning Objective: 09-02

AACSB: Analytic
Bloom’s: Analyze

3. If the public reduces it currency holdings in favor of bank deposits by $1 billion,

banks will have an extra billion dollars in reserves, assuming that the Fed takes no
action. Banks will then lend out these reserves, initiating a many-round process of
lending and re-deposit in the banking system. Ultimately bank deposits will grow to
an amount equaling bank reserves divided by the reserve/deposit ratio; so if the
reserve/deposit ratio is less than one, bank deposits will be larger than bank reserves.
The increase in deposits will outweigh the decline in currency held by the public,
leading to an overall increase in the national money supply.

Learning Objective: 09-01, 09-03

AACSB: Analytic
Bloom’s: Analyze

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4. The Fed’s three tools to reduce the money supply are to conduct an open-market sale
of bonds, to reduce lending to banks at the discount window, or to increase legal
reserve requirements. If the Fed sells $1 million in government bonds to the public, it
will receive $1 million in checks drawn against banks in return. By presenting these
checks to banks, the Fed can take $1 million in bank reserves out of the system,
which results in a decline in deposits by $1 million divided by the reserve/deposit
ratio and hence a decline in the money supply. Similarly, if the Fed reduces its
lending to banks at the discount window by $1 million, bank reserves again fall by $1
million, and deposits fall by $1 million divided by the reserve-deposit ratio. Raising
legal reserve requirements does not reduce bank reserves; however, it reduces the
amount of deposits that banks can hold, given the amount of reserves they have. So
again deposits and the money supply decline.

Learning Objective: 09-04

AACSB: Analytic
Bloom’s: Analyze

5. The quantity equation is M  V  P  Y . If we assume that velocity (V) and output

(Y) are constant during the period of time we are considering, then changes in the
money stock (M) are directly proportional to changes in the price level (P). For
example, a 10% increase in the money stock will lead to a 10% increase in the price
level; a 10% increase in the price level is the same as an inflation rate of 10%. Larger
percentage increases in the money stock will lead to higher inflation rates while lower
percentage increases in the money stock will lead to lower inflation rates

Learning Objective: 09-04

AACSB: Analytic
Bloom’s: Analyze

Answers to Problems
1. a. Cigarettes were used in exchange for goods and services, so they functioned as a
medium of exchange. Since in prison price quotes were made in terms of cigarettes,
they fulfilled the requirement as a unit of account. Finally, since prisoners hoarded
cigarettes for future use, they were a store of value.

b. Cigarettes are relatively durable (compared to alternatives in a POW camp such as

chocolate bars) and low enough in value to be useful in small transactions (compared
with highly valuable assets such as boots or blankets, where there is no way to
purchase a small item or "make change"). Other advantages of cigarettes include
their portability and their relative uniformity in value (for instance, a pair of boots in
good condition would be worth much more than another pair in worse condition).

c. Yes, a nonsmoking prisoner would certainly accept cigarettes as payment since he

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 could trade them for something else that he wanted. This is similar to our use of paper
money: we have no direct use for one dollar bills but we accept them because we can
trade them for things that we do want.

Learning Objective: 09-02

AACSB: Analytic
Bloom’s: Analyze

2. a. After the 5,000,000 guilders are put into circulation the consolidated balance sheet
of Gorgonzolan commercial banks looks like the following (compare to Table 20.2):

ASSETS LIABILITIES
Currency 5,000,000 Deposits 5,000,000

b. The banks want to maintain a 20 percent ratio of reserves to deposits, so they lend
out 80 percent of their cash (4,000,000 guilders). Their consolidated balance sheet
becomes (compare to Table 20.3):

ASSETS LIABILITIES
Currency 1,000,000 Deposits 5,000,000
Loans 4,000,000

c. After the loaned-out funds are redeposited in the banking system the consolidated
balance sheet looks like this (compare to Table 20.4):

ASSETS LIABILITIES
Currency 5,000,000 Deposits 9,000,000
Loans 4,000,000

d. The banks want reserves equal to 20 percent of deposits, or 1,800,000 guilders.

They, therefore, lend out the “extra” 3,200,000 guilders of currency in their vaults.
After the proceeds of these loans are redeposited in the banking system the balance
sheet is (compare Table 20.5):

ASSETS LIABILITIES
Currency 5,000,000 Deposits 12,200,000
Loans 7,200,000

e. The process will not end until reserves equal 20 percent of deposits. Since reserves
at the end of each round equal 5,000,000, at the end of the process deposits must be
25,000,000 (5,000,000/.2). To make assets equal liabilities, loans must be 20,000,000.

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 The final balance sheet of the commercial banks looks like this (compare to Table
20.6):

ASSETS LIABILITIES
Currency 5,000,000 Deposits 25,000,000
Loans 20,000,000

Learning Objective: 09-03

AACSB: Analytic
Bloom’s: Apply

3. Using the following equation:

Money supply = Currency held by the public + Bank reserves/Desired reserve-

deposit ratio

a. Deposits equal bank reserves/(desired reserve-deposit ratio) = $100/0.25 = $400.

The money supply equals currency held by the public + deposits = $200 + $400 =
$600.

b. Let X = currency held by the public = bank reserves. Then the money supply
equals X + X/(reserve-deposit ratio); substituting what we know from the problem:

$500 = X + X/0.25

$500 = 5X

X = $100

Thus, currency and bank reserves both equal $100.

c. Since the money supply equals $1,250 and the public holds $250 in currency, bank
deposits must equal $1,000. If bank reserves are $100, the desired reserve-deposit
ratio equals $100/$1,000 = 0.10.

Learning Objective: 09-03

AACSB: Analytic
Bloom’s: Apply

4. a. In a fractional-reserve banking system (where the reserve-deposit ratio is less than

one), banks loan out part of their deposits. The process of banks making loans and the
public redepositing their funds in banks increases deposits and the money supply,
until the point that the banking system has reached its desired ratio of reserves to
deposits. Because each dollar of reserves ultimately supports several dollars of

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 deposits, one extra dollar of bank reserves results in an increase in the money supply
of several dollars (the money multiplier is greater than one). The money multiplier
equals one only in the case of 100 percent reserve banking. In that case, reserves are
equal to deposits, so that an extra dollar of bank reserves increases deposits and the
money supply by only one dollar.

b. Initially the money supply is $1,000 and currency held by the public is $500,
hence deposits are $500. Since the desired ratio of reserves to deposits is 0.2, initial
bank reserves are equal to the reserve ratio x deposits, or 0.2 x 500 = $100.

An increase of $1 in bank reserves expands deposits from $500 to $101/0.2 = $505,

increasing deposits and the money supply by $5. Similarly, an increase of $5 in
reserves increases deposits and the money supply by $5/0.2 = $25, and an increase of
$10 raises deposits and the money supply by $10/0.2 = $50. As the money supply
rises by 5 times the increase in bank reserves, the money multiplier in this economy is
5 (1/.02).

c. As the example in part b illustrates, in general, the increase in deposits and the
money supply equals the change in bank reserves times 1/(desired reserve-deposit
ratio). Hence the money multiplier equals 1/(desired reserve-deposit ratio).

Money Multiplier = Increase in money supply/ Increase in reserves

In this problem, the money multiplier therefore equals 1/0.2 = 5 as we see in part b
above.

d. The Fed could reduce the money multiplier by increasing reserve requirements. If
this action forced banks to raise their ratio of reserves to deposits, the result would be
a smaller money multiplier (since the money multiplier is the inverse of the reserve-
deposit ratio).

Learning Objective: 09-03

AACSB: Analytic
Bloom’s: Apply

5. With nominal GDP = P x Y, velocity (V) is equal to (P × Y)/M

For M1, V = $10 trillion/$2 trillion = 5.

For M2, V = $10 trillion/$5 trillion = 2.

Learning Objective: 09-04

AACSB: Analytic
Bloom’s: Apply

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6. a. The price levels for 2015 and 2016 and the inflation rate between the two years are
given below:
2015 2016
M $1,000 $1,050
V 8 8
Y $12,000 $12,000

P = (MxV)/Y 0.67 0.70

Inflation rate = 5%

b. As the table below illustrates, when the money supply increases the inflation rate
also rises, holding output at its previous level.

2015 2016
M $1,000 $1,100
V 8 8
Y $12,000 $12,000

P = (MxV)/Y 0.67 0.73

Inflation rate = 10%

c. As the following table illustrates, if the money supply rises at the same rate that
real output rises, the inflation rate remains the same.

2015 2016
M $1,000 $1,100
V 8 8
Y $ 12,000 $ 12,600

P = (MxV)/Y 0.67 0.70

Inflation rate = 5%

Learning Objective: 09-04

AACSB: Analytic
Bloom’s: Apply

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© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.