# Macro Chapters 9a-10a

Extra Stuff . . Chapter 9a . . Chapter 10a

Answers to questions as they were in July, 2006

# Money Matters

### Exploring Money Measurement

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3. Should food stamps be counted as part of the money stock? Should thousand dollar bills? Credit limits that people have with credit cards? Explain your reasoning in each case. (Comment: Food stamps are now in the form of a debit card. When they were paper, banks could use them as equivalent to currency in meeting the reserve requirements (which we will discuss in the next chapter) even though they were not counted as part of money stock.)

This can be argued either way. Food stamps are a restricted money. They are very much like money because people spend it, but unlike standard money, they legally must be spent on a fairly limited group of items--mostly food. You cannot buy gas with it or pay the rent.

4. Money stock data does not excite people the way it once did, but you can still find it. What is U.S. money stock according to the various measures of money (M1, M2, etc.)? You should be able to find them at <http://www.federalreserve.gov/releases/H6/Current/>

By what percentage has money stock changed in the past three months? In the past year?

Internet exploration--answers will vary over time.

### Exploring the Quantity Theory

4. In a description of the economic life in a prisoner-of-war camp, R.A. Radford said that during heavy air raids in the vicinity of the camp, prisoners would smoke heavily because of nervousness. Given that cigarettes were also used as money, what effect should the heavy air raids have had on the price level in the camp? Explain, using the quantity theory of money.

5. People do not usually hold wealth in the form of milk. Why not? Does the fact that milk is a poor way to hold wealth mean that people hold none of it? Explain. How high would the rate of inflation have to be so that you would prefer to hold wealth in the form of milk rather than money? (Comment: There have been hyperinflations in which milk has been a better store of value than money. Strange things happen with hyperinflation.)

6. Below is a table showing money (M1) for 1929 to 1933. What would the simple quantity theory of money have predicted for these years given that GNP in 1929 was \$103 billion? (Hint: Compute velocity for 1929, then use it to predict GNP for the rest of the years.)

 Year Money (billions of dollars) Predicted GNP 1929 25.6 102.4 1930 25.5 102 1931 23.5 94 1932 20.6 82.4 1933 19.5 78

Velocity in 1929 was 4.02, which we will round to 4.

b) Historical GNP for 1930 to 1933 was, in billions, \$90.7, \$76.1, \$58.3, and \$55.8. What do you conclude about what happened to velocity? Is this change in velocity something that one should expect?

Velocity fell; this is not surprising because money became a much better way of holding wealth as the Depression continued. One factor was deflation. Deflation means that money is gaining value. The other was that the there was turmoil in financial markets, and in time of crisis, cash is king.

### Exploring the Aggregate Supply and Demand

7. In the middle of the 14th century, the Black Death first visited Europe, and in following decades it revisited many times. The plague destroyed about one third of the population, but of course did not destroy land, capital, housing, or money.

a) What does the quantity theory of money predict about the changes to output and price level as a result of the plague? (Hint: Use the Aggregate Supply and Demand graph.)

Money remained constant but production fell (a supply side shock in today's terminology); the result should have been a rise in prices. There were no price indices kept, but historians have found some evidence that prices did rise.

b) What does the quantity theory predict about gold flows between areas affected and areas untouched?

Gold should have flowed from the areas that had the plague to the areas that did not because prices rose in the affected areas.

c) (For those who understand the idea of a production function) Do you expect that output fell by more or less than the drop in population? Why?

By less than the drop in population; production functions have diminishing returns, so as we add more and more of any one resource, the extra production from that added resource drops.

8. "Inflation, spurred on by a booming economy, made things worse."

"Economic growth spurred on inflation, and in the mid 1980s cracks began to appear in the facade of modern industrial progress."

These two quotations are from a book about China published several years ago. They appear to imply that rapidly increasing production causes inflation. Is this cause-effect relationship predicted by the Quantity Theory of Money? Explain in a couple of neatly written sentences.

If production is rising and the stock of money is not, prices should drop. The author seems to assume that the only reason production can rise is because there is extra demand, a message of crude Keynesianism that has no support in history.

### Exploring Gold

9. Gold plays an insignificant role in the U.S. monetary system, but the United States still holds a significant amount of gold. You can find the U.S. Treasury report on gold holding at <http://www.fms.treas.gov/gold/index.html>.

a. How many ounces of gold does the United States hold?

Internet exploration--answers will vary over time.

b. At what price does the Treasury value this gold, and what is the total value at that price?
c. The price the Treasury uses to value the gold is not the same as the market price. Find the market price of gold and compute the value of the Treasury gold holdings at that price.

Internet exploration--answers will vary over time.

d. Could the Treasury get the value you just computed if it sold the gold? (Hint: are the Treasury's holding big enough so that its sales would influence the market price?)

Given the large Treasury holdings, if they decided to sell more than trivial amounts, their actions would lower the price.

(Comment--there is an obvious question here, which is "Why does the Treasury hold this much gold?" I will refrain from asking it because I have no idea of what the answer is. If you have a good answer, you can send it to me.)

 Web ingrimayne.com

Extra Stuff . . Chapter 9a . . Chapter 10a

# Banks Create Money

### Exploring Money Creation

 BALANCE SHEET OF SMYTH THE GOLDSMITH Assets | Liabilities + Net Worth Pounds of Gold: 80 | Promises to Pay Gold: 80 Loans: 20 | Net Worth: 20

1a. Explain what will happen on the above balance sheet if the goldsmith makes a loan for 20 pounds to John Smyth. (Assume the borrower will take paper money. Paper money is a promise by the goldsmith to pay gold.)

 BALANCE SHEET OF SMYTH THE GOLDSMITH Assets | Liabilities + Net Worth Pounds of Gold: 80 | Promises to Pay Gold: 100 Loans: 40 | Net Worth: 20

b. What changes will take place in the above balance sheet if a merchant who borrowed 3 from Goldsmith Banker pays off his debt using paper money which the bank issued? Will the amount of money change as a result of this transaction?

 BALANCE SHEET OF SMYTH THE GOLDSMITH Assets | Liabilities + Net Worth Pounds of Gold: 80 | Promises to Pay Gold: 77 Loans: 17 | Net Worth: 20

c. Start again with the numbers in the original balance sheet above. What changes take place if the merchant pays his debt of 3 by bringing in gold? Will the amount of money change as a result of this transaction?

 BALANCE SHEET OF SMYTH THE GOLDSMITH Assets | Liabilities + Net Worth Pounds of Gold: 83 | Promises to Pay Gold: 80 Loans: 17 | Net Worth: 20

d. Start again with the original numbers. Explain what will happen in the above balance sheet if a robber steals 10 pounds of gold from the goldsmith. What if he steals 30 pounds?

 BALANCE SHEET OF SMYTH THE GOLDSMITH Assets | Liabilities + Net Worth Pounds of Gold: 70 | Promises to Pay Gold: 80 Loans: 20 | Net Worth: 10

e. Start again with the original numbers. Explain what will happen if a merchant who has borrowed 5 from the bank defaults on his loan.

 BALANCE SHEET OF SMYTH THE GOLDSMITH Assets | Liabilities + Net Worth Pounds of Gold: 80 | Promises to Pay Gold: 80 Loans: 15 | Net Worth: 15

### Exploring Check Clearing

2. Jane Doe finds that she needs more cash. She goes to her bank and withdraws \$500 from her savings account. As a result she now has \$500 more in currency and \$500 less in her savings account. Show the changes this transaction has on her bank's balance sheet:

 Jane's Bank Assets Liabilities + Net Worth Vault Cash____ Checking Accounts____ Deposits at Fed. Res____ Savings Accounts____ Loans____ Other Liabilities Securities____ Net Worth____ Other____

What happened to the legal reserves in the banking system as a result of Miss Doe's withdrawal of cash?

### Exploring Check Clearing

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4. Show what changes will happen in the balance sheets as a result of each of these transactions. In all cases you must clearly label the changes, that is, a number is not enough.

a. Sue withdraws \$100 from her checking account
 Sue . . . . . . Sue's Bank ____Assets____ _Liabilities & NW_ * ____Assets____ _Liabilities & NW_ cash +\$100 . * cash -\$100 .checking accounts -\$100 checking acoount -\$100 . * . .

b. Joe borrows \$400 from his bank. The bank gives him the loan by increasing his checking account.
 Joe . . . . . . Joe's Bank ____Assets____ _Liabilities & NW_ * ____Assets____ _Liabilities & NW_ checking acoount +\$400 laons +\$400 * laons +\$400 checking acoount +\$400 . . * . .

c. Jesse & James rob the bank, which is not insured against this event. They take \$10,000 in cash and make a clean getaway.
 Jesse & James . . . . . . Victim Bank ____Assets____ _Liabilities & NW_ * ____Assets____ _Liabilities & NW_ cash +\$10000 Net worth +\$10000 * cash -\$10000 Net worth -\$10000 *

d. The First Bank buys \$100,000 worth of t-bills from Dave, one of its depositors.
 Dave . . . . . . First Bank ____Assets____ _Liabilities & NW_ * ____Assets____ _Liabilities & NW_ checking acoount +\$100000 * T-bills +\$100000 checking acoount +\$100000 T-bills -\$100000 *

e. The Federal Reserve buys \$100,000 worth of t-bills from First Bank, which has deposits at the Fed.
 First Bank . . . . . . Federal Reserve ____Assets____ _Liabilities & NW_ * ____Assets____ _Liabilities & NW_ deposits at the Fed +\$100000 * T-bills +\$100000 deposits of First Bank +\$100000 T-bills -\$100000 *

5. For an economist interested in monetary theory, paypal.com is one of the more interesting sites on the web. It allows individuals to pay others over the internet using a credit card. Here was their pitch:

"PayPal.com is a completely free service that lets users Pay Money to anyone with an email address. Use PayPal.com to settle restaurant tabs with colleagues, pay friends for movie tickets, or buy a baseball card at an online auction - all with the click of a mouse! PayPal charges the money to an existing credit card or bank account. It's faster, safer and easier than mailing a personal check.

"Signing up is quick, easy and you can download the money to your bank account at any time. No strings attached."

Visit paypal.com at http://www.paypal.com/ to see what they are doing. Then answer the questions below.

a. Suppose I have paypal charge my credit card \$500 which I then have them send to you. You let the funds sit in your paypal account and I pay my credit card bill. What has happened to your balance sheet, my balance sheet, and paypal's balance sheet? Does this transaction change the amount of bank deposits? Does it change bank reserves? Does it change the amount of money in the economy?

The questions does not say what the \$500 was for. Suppose it is a gift.

Mine: I lose both checking account deposits and net worth of \$500.

You: You gain net worth and a balance at Paypal worth \$500.

Psypsl: Owes you \$500 in your account and has an account at a bank for \$500.

b. Paypal accounts are new, and they are not counted as part of the money stock. Should they be counted as money? Why or why not?

c. When paypal started, they gave anyone who signed up \$10.00 in their new account. Where did that \$10.00 come from? Can you show on balance sheets what happened?

They created it. Debt is easy to create. The reason they created these funds was that there are network economies in this market, and the firm that got biggest first was likely to be the firm that dominated.

d. How can paypal make a profit?

In the same way as a bank--it can invest the funds on the asset side of its balance sheet, and does not have to pay interest on much of its liabilities.

### Exploring the Fed

6. What did the Fed do at its last FOMC meeting? Why did it take the actions it did? (You can find the answer at <http://www.federalreserve.gov/FOMC/>.)

Internet exploration--answers will vary over time.

### Exploring Monetary Policy

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8. We have seen how changes in the Fed's balance sheet can affect the amount of reserves in the banking system. The Fed publishes the essentials of its balance sheet in tables showing sources and uses of reserve funs. You can find them on the web at <http://www.federalreserve.gov/releases/H41/Current/>.

a. What is the dominant asset the Fed has on its balance sheet?

Federal Reserve notes--paper money

b. Which items on its balance sheet earn interest for the Fed? On which does it have to pay interest? What do you conclude about the profitability of the Fed?

It earns interest on its huge holdings of U.S. government securities. It pays no significant interest on its liabilities. Hence, it is enormously profitable. Its profits are returned to the U.S. Treasury.

c. Look at the size of bank deposits with the Federal Reserve. Do you think banks are complaining a lot about how much money they are losing because of reserve requirements?

Bank deposits are fairly low. Many banks completely meet their reserve requirements with vault cash because they have a lot of cash in ATMs. The Fed has special arrangements with them concerning deposits at the Fed--but that takes beyond where we need to go in this course.

d. What is the dollar amount of Federal Reserve notes that the Fed has issued? The population of the United States is less than 300 million. Using 300 million as the population of the US, what is your share of that currency? Do you have your share?

Amounts will vary depending on when you look. There is huge amount of currency outstanding for every person in the U.S. and it is very unlikely you have your share. It is widely held outside the U.S.

e. If you answered d correctly, it should not surprise you that at least half of the paper money that the Federal Reserve has issued is held outside of the U.S. Is the fact that people in other nations want to hold U.S. dollars good or bad for the citizens of the United States? (Hint: We trade paper that has no value except as money for real goods and services.)

It is good for the U.S. We got goods and services from them and they got paper. When the time comes that the paper is redeemed, we will have to give them goods and services and get our paper back. Until then, we are getting an interest free loan. One reason Europe went to the Euro was to try to capture some of the advantages of having an international currency that the dollar has given the U.S.

Some on the far left accuse the U.S. of exploiting the poor. Usually the reasons they have for that are nonsense. In the case of the holdings of the U.S. dollars abroad, the U.S. does gain an advantage. I have never seen the radical left comment on this, probably because they do not understand enough economics to understand what is happening here.

Extra Stuff . . Chapter 9a . . Chapter 10a