Unit 9: Money, Banking, and the Federal Reserve
What actually makes a dollar bill valuable, how a bank turns one deposit into many loans, and how the Fed sets interest rates today.
9 topics · 29 questions
Each topic is a path, not a menu: work down it in order and every question builds on the one above. Click any of them to watch the answer draw itself.
What Makes Something Work as Money
- How it worksHow do the three functions, medium of exchange, unit of account, and store of value, define what counts as money?
- Common mistakeWhy isn't money required to be backed by gold or any other physical commodity to work?
- Going furtherWhat happens to a currency's usefulness as money once it starts losing value every single day?
Your turn1 of 2
Why can't you just pay your rent in baseball cards even if you and your landlord both value them?Measuring the Money Supply: M1 and M2
- How it worksHow does M1 count only the most spendable forms of money while M2 adds in savings accounts and other near-money?
- Common mistakeWhy isn't all the money sitting in savings accounts included in the narrowest measure of the money supply?
- Going furtherWhat happens to M1 the moment money moves out of a checking account and into a savings account?
Your turn1 of 2
In an economy, currency in circulation is 1196 billion dollars, checking account deposits are 1579 billion, savings deposits are 2864 billion, and money market fund balances are 367 billion. Using M1 equals currency plus checking deposits, what is M1?How a Bank Creates Money by Lending
- How it worksHow does a bank lending out most of a deposit while keeping only a fraction in reserve create new money?
- Worked exampleFind the reserves a bank must hold and the amount it can lend out from a 5000 dollar deposit at a 10 percent reserve requirement.
- Common mistakeWhy doesn't a bank keep every depositor's money sitting untouched in a vault?
Your turn1 of 2
A bank receives a deposit of 5875 dollars. The required reserve ratio is 0.18. How much of the deposit can the bank lend out?The Money Multiplier in a Limited-Reserve System
- How it worksHow does the money multiplier, one divided by the reserve ratio, describe money creation in a limited-reserves system?
- Worked exampleFind the maximum increase in the money supply from a 2000 dollar deposit at a 10 percent required reserve ratio.
- Common mistakeWhy doesn't every bank actually lend out the full theoretical maximum the money multiplier describes?
Your turn1 of 2
A deposit of 3786 dollars is made into the banking system, where the required reserve ratio is 0.18. Using the money multiplier, what is the maximum increase in the money supply?The Structure of the Federal Reserve
- How it worksHow do the Board of Governors, the twelve regional Reserve Banks, and the FOMC divide up the Federal Reserve's work?
- Common mistakeWhy isn't the Federal Reserve owned and directed by the President the way a cabinet department is?
- Going furtherWhat happens to interest rate decisions when the Federal Open Market Committee meets and votes?
Your turn1 of 2
Why does the United States hand control of the money supply to an institution that isn't a normal part of the government?Interest on Reserve Balances: How the Fed Sets Rates Today
- How it worksHow does the interest rate the Fed pays banks on reserves set a floor that pulls interest rates across the whole economy along with it?
- Worked exampleFind where the federal funds rate settles when the Fed sets interest on reserve balances at 5 percent and the banking system holds ample reserves.
- Common mistakeWhy doesn't the Fed control interest rates today by adjusting the reserve requirement and squeezing the money supply?
- Ties togetherHow does the FOMC voting on the interest rate paid on reserves connect back to the Federal Reserve's structure of governors and regional banks?
Your turn1 of 2
The Fed sets interest on reserve balances at 4 percent. The banking system holds ample reserves. Where does the federal funds rate settle?Open Market Operations and the Fed's Balance Sheet
- How it worksHow do open market purchases add reserves to the banking system while open market sales drain them?
- Common mistakeWhy doesn't an open market purchase involve the Fed printing cash and physically handing it to banks?
- Ties togetherHow do open market operations connect to the interest on reserves that actually sets the federal funds rate today?
Your turn1 of 2
The Fed buys 36 billion dollars of government bonds, adding that amount in new reserves to the banking system. The required reserve ratio is 0.18. Using the money multiplier, what is the maximum increase in the money supply from this purchase?Expansionary Monetary Policy in a Downturn
- How it worksHow does expansionary monetary policy lower interest rates to encourage borrowing, investment, and spending?
- Worked exampleFind the direction investment, aggregate demand, and output move after the Fed cuts its target interest rate from 5 percent to 3 percent.
- Common mistakeWhy doesn't cutting interest rates change borrowing and spending the instant the Fed announces it?
Your turn1 of 2
The Fed cuts its target interest rate from 5 percent to 3 percent as the economy slides toward a recession. Why does the Fed cut interest rates the moment the economy slides toward a recession?Contractionary Monetary Policy Against Inflation
- How it worksHow does contractionary monetary policy raise interest rates to cool borrowing and pull inflation back down?
- Worked exampleFind the direction of the interest rate, investment, and output after the Fed raises interest on reserve balances from 4 to 5 percent.
- Common mistakeWhy doesn't raising interest rates to fight inflation come without any cost to jobs and output?
- Ties togetherHow does raising interest rates to cool inflation work alongside the contractionary fiscal policy tools of cutting spending or raising taxes?
Your turn1 of 2
Why would the Fed deliberately raise interest rates while the economy still looks like it's booming?