Chapter 14: Money, Banking, and Financial Institutions

What are the three basic functions of money? Describe how rapid
inflation can undermine money’s ability to perform each of the three
functions.
Short Answer
The basic function of money is to act as
• a medium of exchange,
• a unit of account, and
• a store of value
Money loses its value during inflation. Therefore, it is difficult to act as a
unit of account. Inflation is caused due to increased liquidity. Hence, it
fails to serve the store of value. Inflation reduces the utility and uses it
as a medium of exchange.
Which two of the following financial institutions offer checkable
deposits included within the M1 money supply: mutual fund companies;
insurance companies; commercial banks; securities firms; thrift
institutions? Which of the following items is not included in either M1 or
M2: currency held by the public; checkable deposits; money market
mutual fund balances; small-denominated (less than $100,000) time
deposits; currency held by banks; savings deposits?
Short Answer
Checkable deposits are offered by commercial banks and thrift or saving
institutions.
Currency held by the bank is not included in either M1 or M2 money
supply.
Explain and evaluate the following statements:

a. The invention of money is one of the great achievements of humanity,

for without it the enrichment that comes from broadening trade would
have been impossible.

b. Money is whatever society says it is.

c. In the United States, the debts of government and commercial banks

are used as money.

d. People often say they would like to have more money, but what they
usually mean is that they would like to have more goods and services.

e. When the price of everything goes up, it is not because everything is

worth more but because the currency is worth less.

f. Any central bank can create money; the trick is to create enough, but
not too much, of it.
Short Answer
1. This means that money has felicitated trade.
2. This implies that whatever society places values on, be it commodity or
paper, becomes money.
3. It means that government and commercial banks grant loans to the general
public, which they use as money.
4. It suggests that money is the means through which people can satisfy their
wants.
5. The price level goes up when the value of money falls.
6. This signifies that the central bank has the power to create money.
What “backs” the money supply in the United States? What determines
the value (domestic purchasing power) of money? How does the
purchasing power of money relate to the price level? In the United
States, who is responsible for maintaining money’s purchasing power?

The government backs the money supply in the United States.

The purchasing power of the money can be determined by the total amount of goods and services that
can be bought with it. When the price levels are rising, purchasing power falls and vice versa.

The monetary policy and fiscal policy are responsible for maintaining the purchasing power of money.

How is the chairperson of the Federal Reserve System selected?

Describe the relationship between the Board of Governors of the
Federal Reserve System and the 12 Federal Reserve Banks. What is the
purpose of the Federal Open Market Committee (FOMC)? What is its
makeup?
Short Answer
The president selects the chairperson of the Federal Reserve System.

The Board of Governors takes decisions and guides the 12 Federal Reserve Banks
to implement the decisions.

The purpose of the FOMC is to help the Board of Governors implement monetary
policy.

The 12 Federal Reserve Banks, along with the Board of Governors, form the FOMC.

What is TARP and how was it funded? What is meant by the term
“lender of last resort,” and how does it relate to the financial crisis of
2007–2008?
Short Answer
The TARP or trouble asset relief program is the government-funded treasury
bailout. The lender of last resort is the provider of money in case of a crisis or
emergency where no other way is available. This lender of last resort is a function
of the Federal Reserve, which it successfully performed to bring the economy out
of the financial crises of 2007-2008.

Identify three functions of the Federal Reserve, other than its main role
of controlling the supply of money.
Short Answer
The three major functions of the Federal Reserve are to

• issue Federal Reserve Notes,

• set the reserve requirements
• lend money to financial institutions and serve as the lender of last resort in
national financial emergencies.

What do economists mean when they say that the Federal Reserve
Banks are central banks, quasi-public banks, and bankers’ banks?
Short Answer
By the above statement, economists imply that the Federal Reserve
Bank serves the functions of a central bank, quasi-public bank, and
banker’ bank.
Why do economists nearly uniformly support an independent Fed rather
than one beholden directly to either the president or Congress?
Short Answer
The economist prefers an independent Fed since it keeps it free from
political pressure and therefore provides flexibility and speed in the
actions taken through monetary policy to stabilize the economy.