Exam 2 Study Guide

printer friendly version here.  Some practice questions are embedded at the bottom of this post.  Some of the practice questions do not have answers given, these are typically questions related to definitions that you should not have too much difficulty finding the answer to.

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)^t to calculate a missing value given the other three.

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.

How can we use a PPF to quantify opportunity costs?

Every action we take has an opportunity cost.  It can sometimes be hard to see that because so many of our costs are hidden.  What's the cost of talking a walk on a sunshiney day?  It's free isn't it?  No.  Certainly you could have done something else with your time.  Take a nap.  Do your laundry.  Study econ.  Whatever.  Just because you didn't pay any money doesn't mean that you didn't pay an opportunity cost.

The problem with these hidden opportunity costs is that, well, they're hidden.  They are extremely difficult to measure and to compare.  You might be able to tell me that you would rather talk a walk than study your econ, but how much more exactly do you prefer it?

One way to look at opportunity costs is to use a Production Possibilities Frontier (PPF).  A PPF is useful precisely because it allows us to measure the size of implicit opportunity costs.  The PPF shows the trade offs we face between 2 competing alternatives.  The additional wrinkle is that the PPF shows us that we don't have to choose only one thing or the other.  We can have some of one thing and some of another.  The trade off tells us, for each value, exactly how much of one good we have to give up in order to get one more of the other.

**Warning, math concepts ahead.  Put on your math brain**

Here's a simple PPF

This shows the trade off between making guns and making butter.  If we make 100 units of butter, we can't make any guns.  If we make 50 units of guns, we can't make any butter.  Notice that the graph is linear, and therefore has a constant slope.  The slope of the curve (we always call it a curve even if it's straight) is the trade off we make.  For every quantity of guns or butter, we always trade 2 units of butter for 1 unit of guns.

We usually use a slightly more realistic model of PPF.  This graph (click on it to see a larger version) shows the trade off between making DVD players and MP3 players.  Notice that the graph is not linear and that therefore the slope is not constant.  Because the slope of the line represents the trade off between making the two goods, the trade off depends on how many DVD or MP3 players are being produced.  For example, moving from point A to point B means we give up 30 DVD players (80-50) and gain 20 (100-80) MP3 players.  30 DVD players represents the opportunity cost of 20 MP3 players.  The average opportunity cost for 1 MP3 player is 30/20 = 1.5 DVD players.  

Moving from point B to point C, however, we trade 30 DVD players (50-20) for just 10 MP3 players (110-100).  On this region of the PPF, 30 DVD players represents the opportunity cost of 10 MP3 players.  That means the average opportunity cost for a single MP3 player is 30/10 = 3 DVD players.  A PPF curve like this one shows increasing costs.  The more MP3 players we want to make, the more each one costs.

The graph above also shows us another nifty use for PPFs.  The curve represents the most productive combinations of goods.  At any point on the line, it is not possible to produce more of one good without producing less of the other.  Inside the line, at point D for example, it is possible to produce both more DVD players and more MP3 players.  Because we are obviously not using our resources optimally at point D, we refer to that point as inefficient.  Point E, on the other hand, is outside the PPF.  It is not possible to produce that combination of DVD and MP3 players.

One note about PPF's and reality.  Obviously we have more choices than just the two presented in these PPFs. We could construct a more complex PPF in 3 dimensions to show the trade off between 3 options.  Or an abstract n-dimensional PPF to show the trade offs between n different options.  But that's way more complicated than we need to get.  The simple 2 dimensional model is sufficient to illustrate the idea that the trade offs between two competing alternatives can be quantified by a PPF.