The best resources to use if you want to know what kind of questions will be on the exam are your problem sets and the reading quizzes. If you are missing any problem sets, each one is linked below. The problem sets are due on Friday.
There are 7 main topics that you need to be familiar with.
2.1: The Definition of Money. You need to know that money is a medium of exchange, unit of account, and store of value. The better job it does at those things, the more like money it is. It has to be able to do all 3 things. Something that is an excellent medium of exchange and unit of account but doesn't store value is not very much like money at all.
2.2: Present Value. You need to understand that because people would rather have money now than money later, a future payment is worth less than its face value today. The degree to which a person values the present over the future is referred to as their discount rate. This discount rate represents the point at which a person would switch from being a borrower to being a lender - at an interest rate less than the discount rate it makes sense to borrow money, while it makes sense to lend money if the interest rate is above the discount rate. You need to be able to use the formula FV=PV(1+r)
2.3: The Money Creation Process. You need to understand the process by which the banking system creates money by loaning it out. Someone deposits money in the bank and the bank keeps some of this money just in case the person wants some of it back later. The proportion they keep is the reserve ratio. Laws in the US set a minimum proportion to hold back, this is the required reserve ratio. The rest they loan out. This money is spent and makes its way back into the banking system as people deposit their earnings. Part of this is loaned out. Rinse and repeat.
Example:
A bank starts with no deposits, reserves, or loans.
Assets | Liabilities
Reserves: $0 Deposits: $0
Then someone deposits $1000 cash into the bank. The customer's deposit is a liability for the bank because the bank must pay out the money whenever the customer asks for it. But the bank has an extra $1000 in reserves from the cash, which is an asset.
Assets | Liabilities
Reserves: $1,000 Deposits: $1,000
Assume that the bank is required to keep 5% in reserves.
Assets | Liabilities
Required Reserves: $50 Deposits: $1,000
Excess Reserves: $950
Since the bank has more money in reserves than they are required to, they can loan the excess out. The loans are an asset because it is money somebody else owes to the bank.
Assets | Liabilities
Required Reserves: $50 Deposits: $1,000
Excess Reserves: $0
Loans: $950
People don't borrow money in order to keep it under their mattress, so this loan will get spent. That spending is income for somebody else, who deposits it into the bank. This increases Deposits by $950 and Reserves by the same amount.
Assets | Liabilities
Reserves: $1000 Deposits: $1,950
Loans: $950
Once again, the bank has excess reserves
Assets | Liabilities
Required Reserves: $97.50 Deposits: $1,950
Excess Reserves: $902.50
Loans: $950
So it loans them out
Assets | Liabilities
Required Reserves: $97.50 Deposits: $1,950
Excess Reserves: $0
Loans: $1,852.50
Once again, this money comes back into the system, increasing deposits and reserves
Assets | Liabilities
Reserves: $1000 Deposits: $2,852.50
Loans: $1,852.50
Excess again
Assets | Liabilities
Required Reserves: $142.63 Deposits: $2,852.50
Excess Reserves: $857.37
Loans: $1,852.50
Another Loan
Assets | Liabilities
Required Reserves: $142.63 Deposits: $2,852.50
Excess Reserves: $0
Loans: $2,709.87
Which becomes another deposit.
Assets | Liabilities
Reserves: $1000 Deposits: $3,709.87
Loans: $2,709.87
Notice how every time the money gets redeposited into the bank, the total reserves go back up to $1000, which was the initial deposit. You should also notice that the Deposits, Required Reserves, and Loans are all increasing throughout this process. You should notice that this increase is occurring at a decreasing rate, so eventually, we will get to a point where it is not possible make any new loans.
Assets | Liabilities
Required Reserves: $1000 Deposits: $20,000
Excess Reserves: $0
Loans: $19,000
The maximum total increase in loans will be equal to the size of the initial loan * 1/RRR where RRR is the required reserve ratio ($950 * 1/0.05 = $19,000). The maximum total increase in the money supply depends on the source of the initial deposit that allowed the initial loan. If the initial deposit was already in the money supply (say you found a shoebox full of cash), the maximum total money supply increase will be equal to the amount of new loans created. If the initial deposit was outside the money supply (say a wizard conjured it), the maximum total money supply increase will be equal to the initial deposit plus the amount of new loans created.
You need to be able to relate the values for an initial deposit, reserve ratio, maximum increase in loans, and maximum increase in the money supply. Given some of these values, you need to be able to calculate (without a calculator) one or more missing values.
2.4: Money Demand. You need to understand that there is an opportunity cost to holding money. Every dollar that you keep in your pocket or your checking account is a dollar that you are not earning interest on. Because holding money is not free, people will not want to hold an infinite amount of money. The higher the nominal interest rate is, the less likely people will be to hold on to their money (since the opportunity cost is higher). The inverse relationship between nominal interest rate and quantity of money demanded results in a demand curve for money that is downward sloping,
2.5 Money Market. You need to understand that the money supply is controlled by a country's central bank and is vertical. You need to be able to understand the relationship between money demand, money supply, nominal interest rates and quantity of money. Given a scenario, you need to be able to determine and correctly diagram a change in any one or more of these values.
2.6: Real Interest Rates and the Loanable Funds Market. You need to understand that when we borrow or lend money, we are not interested in the nominal rate of interest, but the real rate, which can be estimated by subtracting the rate of inflation from the nominal interest rate. If real interest rates are high, we want to loan money (by saving it), while we want to borrow money when real interest rates are low. In other words, the supply of savings is directly proportional to the real interest rate, while investment demand (the demand for borrowed money) is inversely proportional to the real interest rate. We can diagram this relationship in the loanable funds market.
You need to understand the relationship between investment demand, savings supply, real interest rates, and quantity of loanable funds. Given a scenario, you need to be able to determine and correctly diagram a change in any one or more of these values.
2.7: The Quantity Theory of Money. You need to understand the equation of exchange, MV = PY, which is an accounting identity and is true by definition. You need to understand the assumption of the quantity theory of money. You need to understand that when we make those assumptions, any increase in the money supply leads directly to an increase in the price level. You need to be able to use the equation of exchange to calculate M, V, P, or Y given the other three values. You need to be able to use the simple quantity theory of money to determine what will happen to inflation given a change in the money supply. You also need to be able to use the simple quantity theory of money to determine what policy the Federal Reserve should follow if they want a particular level of inflation.
