Intro to Finance Questions

Problem 1

How do our banks “create money”? And do our banks have unlimited money creation powers? Fully explain your answers.

Banks create money from bank deposits. The money that people put into their bank accounts in the bank, the banks in turn uses to loan out and in the process creates new money off the interest associated with those loans.

Banks do not have unlimited money creation power. They can only make money given the amount of money they have available in excess reserves for bank loans. If the bank does not have excess reserves then they cannot make loans and cannot make any new money. Also the amount of money they can make is based on how much money they have on hand in their excess reserves. The more excess reserves they have the more they can potential make in new money.

Problem 2

If inflation became more problematic than the unemployment rate, what should be the Fed’s strategy with regard to Monetary Policy? (Your answer should address the Fed’s objectives with regard to the money supply, and how the Fed’s “three monetary policy tools” could be used to achieve this goal.)

If the goal is to control or reduce inflation and not focus so much on the unemployment rate then the fed should have implement a strategy to contract the economy. They can do this by increasing the reserve requirements of the banks, increase the discount rate, and decrease the amount of open market operations. This strategy will contract the economy by reducing the money supply and slowing or reducing inflation.

Problem 3

Explain how the Fed’s efforts to reduce inflation often produce higher interest rates.

If inflation becomes an issue then the tool that the Fed can use in regards to Monetary Policy is the discount rate. The discount rate is the interest rate the Reserve Banks charge commercial banks for loans. To help control inflation the Fed increases the discount rate, which increases the amount of interest it charges to commercial banks for money. This means that...