Economics 102

L. Stone

Spring 2003

Quiz 8

1. Carefully explain how banks “create” money. (15 points)

Banks create money through the multiple deposit expansion process. Banks take in deposits, and must keep a fraction of their deposits as reserves. The remainder is loaned out. The new loans will eventually be deposited in banks, and then banks loan funds, etc…. Thus the total deposits of the banking system will expand by (1/reserve requirement)(initial deposit), and the money supply (which equals currency plus deposits) expands.

(Alternatively, you can do this by showing T-accounts, but that must cover all ideas above.)

2. What does it mean to say that money acts as a store of value, and why is this important? (5 points)

Money allows you to produce things now and consume them later… in other words, it allows you to save. If money does not act as a store of value, then you can’t save, and without savings, there cannot be investment.

3. What does it mean to say that money acts as a medium of exchange, and why is this important? (5 points)

Money is accepted as a medium of exchange in economic transactions, which is far more efficient than barter transactions (which require a mutual coincidence of wants). Without an acceptable medium of exchange, people cannot completely and efficiently specialize, which reduces the output (income) and efficiency of the economy.