Chapter 26 — Exercises

Section A — What is money?

A1. Apply the three-functions test to: (a) U.S. dollars, (b) gold, (c) Bitcoin, (d) frequent flyer miles, (e) cigarettes in a prison. Which qualify as money?

A2. Why did humans move from commodity money to fiat money? What are the advantages of fiat?

A3. "Money works because everyone agrees it works." What happens when the agreement breaks down? Give a historical example.

Section B — Money creation

B1. With a reserve ratio of 10%, you deposit $5,000. Trace the first three rounds of lending. What is the total money created?

B2. If the reserve ratio rises from 10% to 20%, what happens to the money multiplier? To total money created?

B3. Why doesn't the actual money multiplier equal the theoretical maximum? (Hint: banks may hold excess reserves; borrowers may hold cash.)

B4. Look up U.S. M2 on FRED (M2SL). What is the current level? How has it changed since 2019?

Section C — The Federal Reserve

C1. What is the Fed's dual mandate? Why do the two goals sometimes conflict?

C2. Why is Fed independence important? What happened when Nixon pressured the Fed in the early 1970s?

C3. Who is the current Fed Chair? What is the FOMC?

Section D — Bank runs

D1. Explain the Diamond-Dybvig model in three sentences.

D2. How does FDIC deposit insurance eliminate the bank-run equilibrium?

D3. FDIC insurance creates moral hazard. Explain how, and name one regulation designed to limit this moral hazard.

D4. "It's a Wonderful Life" (1946) includes a famous bank-run scene. Apply the Diamond-Dybvig model: why do the depositors run? What stops the run?

Section E — The 2008 crisis

E1. Why was the 2008 crisis a "bank run" even though traditional banks with FDIC insurance were mostly fine?

E2. What is the "shadow banking system"? Give three examples.

E3. Why didn't Lehman Brothers have deposit insurance? Should it have?

Section F — Policy debate

F1. "We should eliminate fractional reserve banking — banks should hold 100% reserves." Evaluate. What would happen to lending? To the money supply?

F2. "The Fed should not be independent — it should answer to elected officials." Evaluate using the historical evidence.

F3. "Deposit insurance encourages banks to take too much risk." Is this true? What's the alternative?

Section G — Reflection

• Did you know your bank only holds a fraction of your deposits? Does this change how you think about banking?
• The chapter says "money is a social technology that works only because everyone agrees." Does this make money seem fragile?

Selected answers in appendices/answers-to-selected.md.