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Money and Monetary Policy in Creation of Money

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Week 3: Discussion Questions

1 What are the uses of money and how do banks create money?
2. Is monetary policy conducted independently in the US and is the intended effect always achieved? Why or why not?
3. What is the difference between contractionary and expansionary monetary policy? What are the pros and cons of using expansionary and contractionary monetary policy tools under the following scenarios; depression, recession, and robust economic growth? Which do you think is more appropriate today?
4. What happens to the money supply, interest rates, and the economy in general if the Federal Reserve is a net seller of government bonds? Then describe what happens to the money supply, interest rates, and the economy in general if the Federal Reserve is a net buyer of government bonds. How do these policies impact the firm or industry you work in?
5. What are the advantages and disadvantages of adjustable-rate versus fixed-rate mortgages? Identify the conditions that should exist that make adjustable and fixed-rate mortgages favorable to lenders and borrowers. Which would you suggest for a homebuyer at this time? Explain.
6. In the early 1990s, Argentina stopped increasing the money supply and fixed the exchange rate of the Argentine austral at 10,000 to the dollar. It then renamed the Argentine currency the "peso" and cut off four zeros so that one peso equaled one dollar. Inflation slowed substantially. After this was done, the following observations were made. Explain why these observations did not surprise economists.
1. The golf courses were far less crowded.
2. The price of goods in dollar-equivalent pesos in Buenos Aires, the capital of the country, was significantly above that in New York City.
3. Consumer prices-primarily services-rose relative to other goods.
4. Luxury auto dealers were shutting down.

7. Explain how Franklin D. Roosevelt's statement "We have nothing to fear but fear itself" pertains to macroeconomic policy.
8. How do automatic stabilizers work? How can they slow an economic recovery?

9. The Fed wants to increase the money supply (which is currently 4,000) by 200. The money multiplier is 3 and people hold no cash. For each 1 percentage point the discount rate falls, banks borrow an additional 20. Explain how the Fed can achieve its goals using the following tools:
a. Change the reserve requirement.
2. Change the discount rate.
3. Use open market operations.

10. Suppose the price of a one-year 10 percent coupon bond with a $100 face value is $98.
1. Are market interest rates likely to be above or below 10 percent? Explain.
2. What is the bond's yield or return?
3. If market interest rates fell, what would happen to the price of the bond?

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Solution Summary

How the manipulation of the money supply is used to control the economy

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1. What are the uses of money and how do banks create money?

Money serves three purposes: as a medium of exchange, as a store of value, and as a means of comparing the value of different commodities. Banks create money by using the fractional reserve system. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As this fractional-reserve banking process continues, banks can expand the initial deposit of $100 into a maximum of $1,000 ($100+$90+81+$72.90+...=$1,000). The larger the reserve ratio, the less banks can loan and the less revenue they can produce.

2. Is monetary policy conducted independently in the US and is the intended effect always achieved? Why or why not?

In theory, monetary policy is independent of the rest of the government. By not allowing policymakers to control the money supply, the nation avoids the temptation of paying off deficits by printing money which can result in severe hyperinflation. was set up to act independently of the government. This mans that a particular political party should not be able to manipulate the economy to its advantage. However there is some argument about how independent the Fed truly is. The President appoints the seven members of Board of Governors and the Chairman, and the Senate confirms them, so political pressure or informal pressure could be put upon the Reserve.

3. What is the difference between contractionary and expansionary monetary policy? What are the pros and cons of using expansionary and contractionary monetary policy tools under the following scenarios; depression, recession, and robust economic growth? Which do you think is more appropriate today?

Monetary policies change the level of the money supply in a country. Expansionary monetary policy expands (increases) the supply of money, whereas contractionary monetary policy contracts (decreases) the supply of a country's currency. Monetary policy can be used to control inflation or improve the economy. Contractionary monetary policy has the effect of reducing inflation by reducing upward pressure on price levels. Expansionary monetary policy spurs economic growth lowering the interest rates, which lowers the cost of financing capital projects. So expansionary policy will also help households who are in debt, by lowering the interest rate they pay. It also encourages them to buy because often purchases are made on credit. Business benefits from the increased capital investment as well. GDP increases as demand increases. Unemployment drops. The federal budget will often show a surplus as the tax base increases.

As you might guess contractionary monetary policy is the opposite of an expansionary monetary policy. By selling bonds, raising the discount rate, or increasing reserve requirements, the Fed causes interest rates to rise, either directly or through the increase in the supply of bonds on the open market through sales by the Fed or by banks. The demand for domestic currency rises and the demand for foreign currency falls, causing an increase in the exchange rate. A higher exchange rate causes exports to decrease, imports to increase and the trade deficit to increase. As well, higher interest rates cause the cost of financing capital projects to be higher, so capital investment will be reduced. Consumers will cut back on their spending and unemployment will rise. This is one of the main of using monetary policy during recessions and depressions: an increase in demand for US goods overseas ...

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