What three main functions do they have? Reducing transaction costs, reducing financial risk, providing liquidity

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1 Unit 4 Test Review KEY Savings, Investment and the Financial System 1. What is a financial intermediary? Explain how each of the following fulfills that role: Financial Intermediary: Transforms funds into financial assets a. Mutual fund stock portfolio sold as shares b. Bank deposits used for investment spending loans c. Pension fund stock portfolio divided among members used for retirement d. Life insurance company payments and earnings beneficiary payments 2. What is a financial asset? Explain how each of the following fulfills that role: Financial Asset: a paper claim that entitles the buyer to future income from the seller a. Loan a lending agreement between an individual lender and an individual borrower b. Bond an IOU issued by the borrower c. Stock a share in ownership of a company d. Checkable Bank Deposit claim on a bank that obliges the bank to give the depositor their cash on demand What three main functions do they have? Reducing transaction costs, reducing financial risk, providing liquidity 3. What is liquidity? What does the term liquid asset mean? Liquidity is ability to convert an asset to cash quickly. Liquid assets are easily convertible to cash. 4. If you choose to purchase a stock, you are likely to receive a(n) (higher, lower, equivalent) return in exchange for a(n) (higher, lower, equivalent) risk. If you choose to purchase a bond, you are likely to receive a(n) (higher, lower, equivalent) return in exchange for a(n) (higher, lower, equivalent) risk. 5. What is the Savings-Investment Spending Identity? Savings = Investment Spending for the economy as a whole 6. Define the term budget balance. What is the difference between a budget surplus and a budget deficit? Budget Surplus is when tax revenue exceeds government spending (a positive budget balance number). Budget deficit is when government spending exceeds tax revenue (a negative budget balance number). Budget Balance = tax revenue government spending. 7. Define the term national savings: total amount of savings generated within the economy. National Savings = private savings + budget balance. 8. Define the term private savings: savings generated by households and firms (excludes government) Private Savings = disposable income (income after taxes) consumption. 9. Define the term capital inflow: net inflow of funds into a country. Capital Inflow = total inflow of foreign funds total outflow of domestic funds to other countries. 10. In a closed economy (S = I), suppose that GDP is $20 trillion. Consumption is $10 trillion and government spending is $5 trillion. Taxes are $1.5 trillion. What is the value of each of the following: a. Government budget balance = -$3.5 trillion = tax revenue ($1.5) government spending ($5) b. National savings = $5 trillion = private savings ($8.5) budget balance ($3.5) c. Private savings = $8.5 trillion = disposable income taxes ($20-$1.5) consumption ($10) d. Investment spending= $5 trillion (same as national savings (S=I)!) Now assume it is an open economy (S=I), where exports are $1trillion and imports are $3 trillion. How much is the net capital inflow? $2 trillion = $3 trillion (inflow of foreign funds) $1 trillion (outflow of domestic funds) Here is further explanation about why capital inflow represents imports exports:

2 So increased imports = increased borrowing = increased net capital inflow AND increased exports = decreased borrowing = decreased net capital inflow Money Measurement 11. What is included in the M1 definition of money? What is included in M2? M3? M1 = cash + demand deposits + personal checks + travelers checks M2 = M1 + savings + small time deposits + money market funds (stocks, bonds, loans, etc.) M3 = M2 + large time deposits (over $100,000 worth) 12. Indicate whether each of the following is part of M1, M2, M3, or neither: a. $95 on your campus meal card = Neither (Specified purpose/not convertible into cash) b. $0.55 in the change cup in your car = M1 c. $1,663 in your savings account = M2 d. $459 in your checking account = M1 e. $27.50 check from your friend = M1 f. $150,000 in a time deposit = M3 g. 50 shares of stock worth $2,000 = M2 h. A $1,000 line of credit on your Amazon credit card = Neither (credit card is a loan, not convertible into cash) 13. What are the three main functions/roles of money? Medium of Exchange, Store of Value, Unit of Account Indicate the correct role for each scenario: a. Using money to purchase a new MP3 player = Medium of Exchange b. Buying the latest Blue-Ray disc movie with a $20 bill = Medium of Exchange c. Keeping part of your wealth in a savings account = Store of Value d. Discovering money in your coat that you placed there last winter = Store of Value e. Putting a price on a meal = Unit of Account f. Buying a ticket to a rodeo = Medium of Exchange 14. Explain the monetary equation of exchange (MV=PQ). Given this equation, graph the results of expansionary monetary policy. Money Supply x velocity = price level x real output (GDP) Show an increase in NOMINAL GDP! 15. What is the federal funds rate? Rate for short term loans between banks (so they can meet reserve requirement) What determines the federal funds rate? Equilibrium interest rate (which moves with the discount rate). Who participates in the federal funds market? Banks who borrow/lend to each other at the federal funds rate. Demand for Money and the Money Market 16. What is the opportunity cost for holding money? Interest rate on small time deposits. 17. What does the Money Demand curve represent and why is it downward sloping? Represents the quantity of money held in the economy in relation to the interest rate. A higher interest rate leads to a higher opportunity cost of holding money and reduces the quantity of money demanded. 18. What circumstances will cause a shift in the demand for money? Changes in aggregate price level, real GDP, technology, and institutions. Which of these circumstances will cause a proportional increase in the quantity of money demanded? Price level.

3 19. Draw a graph depicting the money market. a. Label the point equilibrium. What does this point on the graph represent? Where supply & demand meet b. If the current interest rate was above equilibrium, what would eventually happen to interest rates? If interest rates rise above equilibrium quantity demanded for money will be less than quantity supplied (surplus); market forces will eventually bring interest rates back down to equilibrium. c. If the current interest rate was below equilibrium, what would eventually happen to interest rates? If interest rates fall below equilibrium quantity of money supplied will be less than quantity demanded (shortage); market forces will eventually bring interest rates back up to equilibrium. Banking and Money Creation 20. Why is there a money multiplier and what is its formula? Banks can create are large money supply by loaning out checkable deposits. Mm = 1/rr. Why in reality is it smaller than in theory? In reality, determining the money supply depends not only on the ratio of reserves to bank deposits but also on the fraction of the money supply that individuals choose to hold in the form of currency. That s why the money multiplier in the US is around 1.9, not Suppose the reserve requirement is 15% and you deposit a $5,000 bonus you just received in your checking account. How much of the deposit is the bank required to keep in reserves? $750 = 15% of $5,000 How much can the bank loan out? $4,250 = $5,000 - $750 What is the possible maximum expansion in the money supply? Mm = 1/.15 = 6.67 x $4,250 = $28, What will happen to the money supply under the following circumstances in a checkable-deposit-only system? What is the multiplier in each scenario? (Assume the banking system does NOT hold excess reserves.) a. The required reserve is 25% and a depositor withdraws $700 from his checking account. MM=4, of $700 withdrawn, 25% was held in reserve, so, $525 loaned X 4 = -$2,100 effect on banking system (decrease) b. The required reserve is 5% and a depositor withdraws $700 from his checking account. MM=20, of $700 withdrawn,5% was held in reserve, so $665 loaned X20= -$13,300 effect on banking system (decrease) c. The required reserve ratio is 20% and a customer deposits $750 to her checking account. MM=5, Of $750 deposited, 20% is held in reserve, so $600 loaned X 5 = $3,000 d. The required reserve ratio is 10% and a customer deposits $600 to her checking account. MM=10, Of $600 deposited, 10% is held in reserve, so $540 loaned X 10 = $5, A commercial bank holds $700,000 in demand deposits and $100,000 in reserves. If the required reserve ratio is 10%, what is the maximum amount by which this bank may increase its loans? What is the maximum amount by which the banking system may increase loans as a result? With $700,000 on deposit, the bank must hold $70,000 (10%) in reserve. Therefore, they can loan out $30,000 ($100,000 70,000). MM = 10, so the banking system may increase loans by $30,000 X 10 = $300,000. *If you were at the review session I explained this incorrectly and I apologize. However, it s not on the test, it was just put in for extra practice. As long as you are comfortable with #21 and 22, you will do well on the questions that go along with those concepts on the test. 24. What is the difference between the money supply and the monetary base? Which is a component of both? (Draw the Venn diagram to help!) Money Supply (in its most liquid form) = checkable bank deposit +currency in circulation; Monetary Base (controlled by Fed) = bank reserves + currency in circulation 25. When the required reserve ratio is lowered, the potential for money creation (increases/decreases). When the required reserve ratio is raised, the potential for money creation (increases/decreases). 26. Where can a bank choose to store its reserves? Either 1) bank s vault as cash or 2) bank s account at the Fed The Federal Reserve and Monetary Policy 27. What are the functions of the Fed? 1) provide financial services, 2) supervise and regulate the banks, 3) maintain financial stability, 4) conduct monetary policy In what ways is it the banker s bank? Holds reserves, clears checks, provides cash and transfers funds for banks 28. What are the tools of the Federal Reserve? 1) reserve requirements, 2) discount rate, 3) open-market operations Which tool does the Fed utilize most often? Open-market operations!

4 29. Explain how the Federal Reserve uses open market operations to increase/decrease the monetary base. Buy Treasury Bills increases monetary base by liquefying assets and increasing bank s excess reserves, which can then be lent (and multiplied) Sell Treasury Bills decrease monetary base by illiquefying assets and decreasing bank s excess reserves, reducing lending capability 30. Why is the discount rate higher than the set by the Fed purposely higher than the federal funds rate? The discount rate is slightly higher than the federal funds rate (usually 1% higher) to discourage banks from directly borrowing from the Fed. 31. Complete this chart depicting the impact of Fed open market operations: Operation Bank (Excess) Reserves Money Supply Interest Rates Buying Bonds Selling Bonds 32. Complete this chart depicting Federal Reserve monetary policy options: Response to Type of Monetary Policy Reserve Requirements Discount Rate Open Market Operations Impact on Aggregate Supply & Demand High Inflation Contractionary Sell Bonds Aggregate Demand Recession Expansionary Buy Bonds Aggregate Demand 33. Complete this chart depicting economic impacts of monetary policy: Type of Monetary Policy Interest Rates Private (Business) GDP Employment Investment Contractionary Expansionary The Market for Loanable Funds 34. What is the real interest rate? How is it related to the nominal interest rate? Real interest rate = nominal interest rate expected inflation rate. 35. What is the rate of return? How is it utilized in project evaluation? Return must outpace interest rate Rate of return = revenue cost of project x 100 Cost of project 36. What circumstances will cause a shift in the demand for loanable funds? 1) perceived business opportunities, 2) government borrowing 37. What circumstances will cause a shift in the supply of loanable funds? 1) saving behavior, 2) capital inflows, 3) monetary policy (increasing/decreasing money supply will increase or decrease the supply of loanable funds) 38. Illustrate and explain: a. The Fisher effect: the expected real interest rate is unaffected by the change in expected future inflation

5 b. Crowding Out: occurs when a government deficit drives up the interest rate and leads to reduce investment spending 39. Complete this chart depicting the Loanable Funds Market: LF Market response to Shift in supply or demand or in supply or demand Interest rates Total amount borrowed (Quantity of LF) Government budget deficit Demand Government budget surplus Demand Increase in private savings Supply Decrease in private savings supply 40. Using the table below. Possible Investment Projects Project Rate of Return on Investment Cost of Investment F 20% $500 G H 16 1,000 I J 12 2,000 K 10 1,500 L 8 1,200 M a. Assume the market interest rate is 15%.What is the last project undertaken? H (all other projects rates of return will be less than the interest rate; if the return is not a positive number, the business will not choose that project.) What is the amount of planned investment spending? $1,800 = $500 + $300 + $1,000 (All of these projects with an interest rate of 15% or higher will be chosen.) b. Assume the market interest rate is 11%. What is the last project undertaken? J What is the amount of planned investment spending? $4,000 = $500 + $300 + $1,000 + $200 + $2,000

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