Chapter 34 - Money, the Federal Reserve, and Interest Rates
Chapter 34 - Money, the Federal Reserve, and Interest Rates
McConnell Brue Flynn 23e
1. What are the three basic functions of money? Describe how rapid inflation can
undermine money’s ability to perform each of the three functions. L O34.1
People will only accept money in exchange for goods and services and for the
work they perform if they can be reasonably certain that the medium of exchange—
money—will retain its value until they are ready to spend it. In runaway inflations of
the thousands or tens of thousands of percent a year, people revert to barter.
Again, drastic inflation greatly reduces money’s use as a measure of value (unit of
account), for it is impossible to adjust instantaneously all prices strictly in line with
their relative values. Thus, opportunities are afforded to speculators to profit at the
expense of the less sophisticated who, eventually, will learn to distrust money’s
usefulness as a measure of value.
Finally, and most obviously, money’s usefulness as a store of value is destroyed
in a drastic inflation. The “rule of 70” is instructive here. By dividing the absolute
inflation rate into 70, one can estimate how long it takes one’s dollar savings to lose
half their purchasing power. At 7 percent inflation, the dollar will be worth half as
much in ten years.
34-1
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
Chapter 34 - Money, the Federal Reserve, and Interest Rates
2. A goldsmith has $2 million of gold in his vaults. He issues $5 million in gold
receipts. His gold holdings are what fraction of the paper money (gold receipts)
he has issued? LO34.6
a. 1/10
b. 1/5
c. 2/5
d. 5/5
His holdings = Gold amount / issued gold receipts
= $2 million/ $5 million
= 2/5
3. Assume that Jimmy Cash has $2,000 in his checking account at Folsom Bank
and uses his checking account card to withdraw $200 of cash from the bank’s
ATM machine. By what dollar amount did the M1 money supply change as a
result of this single, isolated transaction? L O34.2
The answer is zero. Jimmy withdrew $200 from his checking account, so his
checkable deposits are now $1800. This results in a decrease in M1 by an equal
amount. However, Jimmy now has $200 in cash, which increases M1 by $200.
34-2
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
Chapter 34 - Money, the Federal Reserve, and Interest Rates
4. Suppose a bond with no expiration date has a face value of $10,000 and annually
pays $800 in fixed interest. In the table provided, calculate and enter either the
interest rate that the bond would yield to a bond buyer at each of the bond
prices listed or the bond price at each of the interest yields shown. What
generalizations can you draw from the completed table? L O34.7
The interest rate of 8% will yield $800 annually for a bond with a face value of
$10,000.
- At $8000 of bond price, the interest yield is 10%.
i
x 8000 = 800
100
i = 10%
- At 8.9% of the interest yield, the bond price is $8989.
8.9
x P = 800
100
P = $8989
- At $11,000 of bond price, the interest yield is 7.2%.
i
x 11000 = 800
100
i = 7.2%
- At 6.2% of the interest yield, the bond price is 12,903.
6.2
x P = 800
100
34-3
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
Chapter 34 - Money, the Federal Reserve, and Interest Rates
P = $12903
Bond Price Interest Yield, %
$ 8,000 10
$ 8,989 8.9
$ 10,000 8.0
$ 11,000 7.2
$ 12,903 6.2
34-4
© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
