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CHAPTER 17 MONEY, THE FEDERAL
RESERVE, AND GLOBAL
FINANCIAL MARKETS
Answers to Review Questions
1. Money refers to any asset that can be used in making purchases (for example, cash
and checking account balances). People hold money despite its lower return precisely
because of its usefulness in transactions; a person who held no money and wanted to
make a purchase would either have to resort to time-consuming barter or else incur
the costs of selling other assets to obtain money.
3. In a banking panic, depositors rush to withdraw their deposits from the banking
system. With deposit insurance, which protects the full value of deposits, people
have no reason to make panicky withdrawals; however, prior to the introduction of
deposit insurance, a bank failure could mean that depositors lost all their savings.
Thus, news or rumors that a bank might fail (go bankrupt) prompted panics. Even a
bank that made sound loans had reason to fear a panic; because bank reserves are
only a fraction of deposits (the system of fractional-reserve banking), a large enough
panic could lead any bank to run out of cash and be forced to close.
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4. First, the financial system provides information about alternative investment
opportunities, helping to allocate saving to the most productive uses. For example,
banks specialize in evaluating the prospects of borrowers, on behalf of the depositors
whose funds are being lent. Similarly, professional stock and bond analysts
investigate the potential returns of companies seeking funding, directing resources to
the most attractive opportunities. Second, financial markets help savers share the
risks of individual investment projects, as when an individual saver is able to
diversify across a wide variety of stocks.
5. He will receive $1,000 for the bond only if the current one-year interest rate equals
the coupon rate (the rate promised when the bond was issued). For example, suppose
that the coupon rate and the current one-year rate are both 6%. Then the holder of the
bond will receive $1,060 (principal plus coupon payment) on maturation of the bond
in one year. If the current one-year interest rate in the financial market is 6%, another
financial investor will be willing to pay Arjay $1,000 today for the bond, as it will be
worth $1,060 (1.06 times $1,000) in one year.
However, if the coupon rate is greater than the current one-year interest rate, the bond
is worth more than $1,000 today. For example, if the coupon rate is 7% and the
current market rate is 6%, the holder of the bond will receive $1,070 in one year,
which is worth $1,070/1.06 = $1,009 today. Similarly, if the coupon rate is lower
than the market rate, the bond is worth less than $1,000 today.
6. Stock values are fairly volatile and so carry a risk premium. In other words, the
typical investor will hold stocks only if she expects to earn a higher return on average
holding stocks than holding a safer asset, such as government bonds. If the relative
riskiness of stocks does not bother you, then stocks are a good financial investment
because of the higher return that you can expect to earn (on average, but not for
certain) by holding them.
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7. A capital inflow leads to funds flowing into a country, which in turn can be used for
domestic investment in new capital goods. A capital inflow allows a country whose
productive investment opportunities are greater than domestic savings to finance
those investment opportunities by borrowing from abroad, increasing the total amount
of investment in new capital goods. Domestic countries who finance domestic capital
formation largely through capital inflows must pay interest and dividends to the
foreign lenders in the future, which could impose a future burden on the domestic
country. However, the hope is that the investment in new capital goods will increase
domestic productivity, allowing the borrowing country to pay back its loans and
benefit from increased output and incomes as well. Capital outflows have the
opposite effect on investment in new capital. A capital outflow leaves less domestic
savings to finance investment opportunities, leading to less investment in new capital
goods.
8. If a country imports a good or service, it must pay for that import somehow. If it pays
for the import by selling an export of equal value, then the trade balance is zero and
the capital inflow is also zero. If it pays for the import by selling a financial asset or
by borrowing from abroad, then the country experiences a capital inflow equal in
value to the import. Thus its net capital inflow equals its trade deficit.
Answers to Problems
1. a. Cigarettes were used in exchange for goods and services, so they functioned as a
medium of exchange. Since in prison price quotes were made in terms of
cigarettes, they fulfilled the requirement as a unit of account. Finally, since
prisoners hoarded cigarettes for future use, they were a store of value.
3
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c. Yes, a nonsmoking prisoner would certainly accept cigarettes as payment since he
could trade them for something else that he wanted. This is similar to our use of
paper money: we have no direct use for one dollar bills but we accept them
because we can trade them for things that we do want.
2. a. After the 5,000,000 guilders are put into circulation the consolidated balance sheet
of Gorgonzolan commercial banks looks like the following (compare to Table 17.2):
ASSETS LIABILITIES
Currency 5,000,000 Deposits 5,000,000
b. The banks want to maintain a 20 percent ratio of reserves to deposits, so they lend
out 80 percent of their cash (4,000,000 guilders). Their consolidated balance sheet
becomes (compare to Table 17.3):
ASSETS LIABILITIES
Currency 1,000,000 Deposits 5,000,000
Loans 4,000,000
c. After the loaned-out funds are redeposited in the banking system the consolidated
balance sheet looks like this (compare to Table 17.4):
ASSETS LIABILITIES
Currency 5,000,000 Deposits 9,000,000
Loans 4,000,000
ASSETS LIABILITIES
Currency 5,000,000 Deposits 12,200,000
Loans 7,200,000
e. The process will not end until reserves equal 20 percent of deposits. Since reserves
at the end of each round equal 5,000,000, at the end of the process deposits must be
25,000,000 (5,000,000/.2). To make assets equal liabilities, loans must be 20,000,000.
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The final balance sheet of the commercial banks looks like this (compare to Table
17.6):
ASSETS LIABILITIES
Currency 5,000,000 Deposits 25,000,000
Loans 20,000,000
b. Let X = currency held by the public = bank reserves. Then the money supply
equals X + X/(reserve-deposit ratio); substituting what we know from the
problem:
$500 = X + X/0.25
$500 = 5X
X = $100
c. Since the money supply equals $1,250 and the public holds $250 in currency,
bank deposits must equal $1,000. If bank reserves are $100, the desired reserve-
deposit ratio equals $100/$1,000 = 0.10.
4. In December 1930 the money supply was $44.1 billion. In December 1931 it was
$37.3 billion (Table 17.7). Assuming no change in currency holdings by the public,
the Fed would have had to increase deposits by 44.1 – 37.3 = $6.8 billion in 1931 to
have stabilized the money supply. The reserve/deposit ratio in 1931 was 0.095 (Table
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17.7). So to increase deposits by $6.8 billion, the Fed would have had to increase
bank reserves by 0.095($6.8 billion) = $646 million.
Similarly, to raise the December 1932 money supply ($34.0 billion) to the level of
December 1930 ($44.1 billion), the Fed would have needed to induce an increase in
deposits of $10.1 billion. As the reserve/deposit ratio in 1932 was 0.109, this would
have required an increase in bank reserves (achieved through open-market purchases,
for example) of 0.109($10.1 billion) = $1.101 billion.
Follow the same logic to determine how much the Fed should have raised bank
reserves in 1933 to set the December 1933 money supply to the level of December
1930.
5. The Federal is a government agency; it cannot make a profit. The Fed focuses on
promoting public goals such as economic growth, low inflation, and the smooth
operation of financial markets. The Fed also has the power to control and regulate
banks in order to prevent bank panics, while also having the power to make loans to
banks.
6. a. The principal amount is $1,000, the term is 3 years, the coupon rate is 6 percent,
and the coupon payment is $60.
b. At the end of the second year, the only remaining payment is the final $1,060 to
be paid in one year. If the interest rate is 3 percent, the value of $1,060 one year
from today is $1,060/1.03 = $1,029. If the interest rate is 8 percent, the value of
the bond today is $1,060/1.08 = $981. And if the interest rate is 10 percent, the
value of the bond today is $1,060/1.10 = $964.
6
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7. a. In one year, the stock will be worth $105 ($5 in dividends plus $100 when the
share is sold). Thus, the share’s value today is $105/1.05 = $100.
b. At the end of the second year, the only remaining payment is the final $1,060 to
be paid in one year. If the interest rate is 3 percent, the value of $1,060 one year
from today is $1,060/1.03 = $1,029. If the interest rate is 8 percent, the value of
the bond today is $1,060/1.08 = $981. And if the interest rate is 10 percent, the
value of the bond today is $1,060/1.10 = $964.
c. Again, the share is worth $105 in one year. Now the interest rate over the year is
8 percent (the 5 percent safe interest rate plus the 3 percent risk premium). The
share’s value today is therefore $105/1.08 = $97.22. (Note: This confirms the
discussion in the text: an increase in the risk premium lowers the stock price.)
d. Part a: The value of the stock in one year will be $100. Thus, the share’s value
today is $100/1.05 = $95.24.
Part b: The value of the stock in one year will be $100. Thus, the share’s value
today is $100/1.10 = $90.91.
Part c: The value of the stock in one year will be $100. Thus, the share’s value
today is $100/1.08 = $92.59.
(Note: This confirms the discussion in the text: all else equal, a lower expected
dividend lowers the stock price.)
b. If the Democrats win, your dollar return is $50 (10 percent of the $500 invested in
DonkeyInc). If the Republicans win, your dollar return is $40 (8 percent of the
$500 invested in ElephantInc). Since the Democrats win with a probability of 40
percent and the Republicans win with a probability of 60 percent, your expected
dollar return is (.40)($50) + (.60)($40) = $44, or a 4.4 percent expected return on
your $1,000 initial investment.
c. The strategy in part b gives a lower expected return than the strategy in part a.
However, the strategy in part a is riskier, since you receive nothing if the
Democrats win. The advantage of the strategy in part b is that you receive a
7
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reasonable return no matter which party wins (that is, it is less risky, which
compensates for the lower expected return).
d. To achieve a guaranteed 4.4 percent return, you need a strategy that guarantees
you at least $44 no matter who wins the election. If you invest $550 in
ElephantInc and $450 in DonkeyInc, your return will be exactly $44 (8 percent of
$550) if the Republicans win and $45 (10 percent of $450) if the Democrats win.
e. Let D be the number of dollars you “bet” on the Democrats and $1,000 – D be the
number of dollars you bet on the Republicans. If the Democrats win you receive
a dollar return of (10%)(D). If the Republicans win you receive a dollar return of
(8%)($1,000 – D). You want these two returns to be equal:
(10%)(D) = (8%)($1,000 – D)
Solving for D:
(18%)(D) = $80
D = $80/(18%) = $444.44
9. a. The U.S. creates a trade surplus (NX > 0). The purchase of Israeli stock is a
capital outflow in the same amount (KI < 0). The capital outflow (negative
inflow) just offsets the trade surplus.
b. Here the U.S. import of oil creates a trade deficit (NX < 0). The Mexican
purchase of U.S. government debt is a capital inflow to the United States (KI > 0),
which offsets the trade deficit.
c. The import is offset by an export (drilling equipment) of equal value. Net exports
are zero, and there are no capital inflows or outflows so KI = 0 as well.
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10. a. An increase in investment opportunities (increasing the rate of return on
investment projects) will shift the investment curve (I) to the right, which leads to
an increase in investment and an increase in the domestic real interest rate. The
increase in the real interest rate will lead to an increase in both domestic savings
and capital inflows.
b. An increase in the government budget deficit shifts the saving curve (S + KI) to
the left, which leads to a decrease in investment and an increase in the domestic
real interest rate. The increase in the real interest rate will lead to an increase in
the capital inflow, which will help to partially offset the decline in national saving
brought about by the increase in the government budget deficit, but overall
investment will decline.
c. An increase in domestic saving will shift the saving curve (S + KI) to the right,
which leads to an increase in investment and a decrease in the domestic real
interest rate. The fall in the real interest rate will lead to a decrease in the capital
inflow.
d. If foreigners believe that the riskiness of lending money to the country has
increased, this will shift the saving curve (S + KI) to the left, leading to an
increase in the domestic real interest rate and a reduction in investment.
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back. After this no difficulty was experienced in reaching camp,
thanks to the foresight of Cortés, who had ordered the channels
filled.[1141] The other captains, Alvarado and Sandoval, had
performed their share in the day’s work, and although they do not
appear to have reached even the suburb, detained by the many
breaches and other obstacles on the causeways, yet the diversion
created by their attacks proved of great service to Cortés. One
reason for their slower advance was the want of coöperation from
the vessels, which had been of such great assistance on the
Iztapalapan road. This was at once remedied by the detachment of
three brigantines each for the Tlacopan and Tepeyacac camps.[1142]
FOOTNOTES
[1113] Several leading authors assume this to have occurred on the 28th of April,
when Cortés mustered his forces. He says nothing about the formal launch on that
occasion, and it is hardly likely that two such performances could have been
effected in one day.
[1114] ‘Las vanderas Reales, y otras vanderas del nombre que se dezia ser el
vergantin.’ Bernal Diaz, Hist. Verdad., 138. Ixtlilxochitl assumes that the flag-ship
was named Medellin, Hist. Chich., 313-14, but this appears to be based on a
misinterpretation of Herrera, who places Villafuerte ‘of Medellin’ at the head of the
list of captains. Vetancurt believes that the vessels were named after the apostles,
to whom Cortés was so devoted. Teatro Mex., pt. iii. 156. If so, the flag-ship may
have been called San Pedro, after his patron. When all were floated a storm came
which threatened to break them one against the other. Torquemada, i. 532.
[1116] The smallest was soon set aside as useless. There was some trouble in
obtaining rowers, owing in a great measure to the employment in Spain of
criminals in that capacity. Hidalgos shrank from anything that could be regarded as
common labor, and even ordinary sailors refused to handle a branded implement.
In this dilemma a list was made of all natives of seaports, and of those known to
be able fishermen, and finally the selected number were ordered to take the oar,
regardless of caste.
[1117] So says Cortés, Cartas, 208. Bernal Diaz as usual implies a smaller number
by stating that Cortés sent to ask for only 20,000 men from the republics. Hist.
Verdad., 137-8. The Cholultecs, he says, who had maintained a neutral attitude
since the massacre there, sent a small force under their own captain. Gomara
allows 60,000 allies to come; Vetancurt 90,000, of whom 60,000 are Tlascaltecs;
Clavigero limits the arrival to 50,000 Tlascaltecs, the whole number of allies
swelling gradually to over 200,000, while Herrera makes that number arrive within
two days; Ixtlilxochitl names thirteen chiefs, who commanded the 50,000
Tlascaltecs (a misprint gives 5000), and some of those leading the 10,000
Huexotzincas; he also allows 10,000 Cholultecs; of his own Tezcucans he claims
over 200,000 to have come, 50,000 each being furnished by the provinces of
Tezcuco, Otumba, Tziuhcohua, and Chalco, with Tepeaca, Quauhnahuac, etc.;
8000 chiefs or nobles joined besides from Tezcuco, and 50,000 laborers in
addition, it seems. Hist. Chich., 313; Hor. Crueldades, 20.
[1119] Cortés, Cartas, 206. Gomara agrees, Hist. Mex., 191, but Bernal Diaz gives
the number as 84 horsemen, 650 soldiers with swords, shields, and lances, and
194 archers and arquebusiers. loc. cit.
[1120] Some half a dozen towns furnished 8000 each within eight days. The
feathers were fastened by the archers with glue from the cactle root. They kept
two strings and as many catches, and maintained their skill by target practice. Id.
[1122] ‘Iva a tomar por fuerça el Cacicazgo, e vassallos, y tierra del mismo
Chichimecatecle,’ Bernal Diaz, Hist. Verdad., 139, which must be an idle rumor.
[1123] Some time later when Ojeda went to Tlascala for supplies he brought back
the confiscated property, including a quantity of treasure, and 30 women, the
daughters, servants, etc., of Xicotencatl. Torquemada, i. 558. The Tlascaltec laws
were severe, ‘E l’odio particolare, che portavano a quel Principe, il cui orgoglio
non potevano più soffrire.’ Clavigero, Storia Mess., iii. 195. Some Tlascaltecs say
his father had warned Cortés against his son, and urged his death. Bernal Diaz,
loc. cit. Herrera observes that he could hardly have been seized without Tlascaltec
aid. dec. iii. lib. i. cap. xvii.
[1124] Ojeda, in Herrera, loc. cit. Solis, Hist. Mex., ii. 379, thinks that it would have
been hazardous to hang him at Tezcuco, where many Tlascaltecs were gathered;
but he forgets that nearly all this people had already set out for Mexico. His
supposition is based on Bernal Diaz, who intimates that he was not hanged in
Tezcuco. Alvarado had pleaded for his life, and Cortés, while pretending
compliance, secretly ordered the alguacil to despatch him. Hist. Verdad., 139.
[1125] Cortés divided the lordship of the chieftain afterward between his two sons,
and the name of Xicotencatl has been perpetuated by more than one line, as
Camargo shows in his Hist. Tlax. Two officers of that name figured during the
American invasion of 1847 in defence of their country. Brasseur de Bourbourg,
Hist. Nat. Civ., iv. 447.
[1126] Most writers say the 10th, misled by an error in Cortés, Cartas, 208; and
this error causes Prescott, among others, to fall into more than one mistake, which
he upholds with vain arguments. On earlier pages in the Cartas are given dates in
connection with religious festivals which show that Whitsunday fell on the 19th of
May, and the departure took place three days later. Bernal Diaz gives the 13th,
and says that the Xicotencatl affair had detained them a day. He afterward varies
the date.
[1127] They passed round Zumpango Lake, through Quauhtitlan and Tenayocan.
Cortés, Cartas, 210; Bernal Diaz, Hist. Verdad., 139.
[1128] ‘Jamàs quisieron Paz [the Aztecs]; y aunque à la postre la recibieron, el Rei
no la aceptò, porque al principio, contra su Consejo, la rehusaron.’ Torquemada, i.
572. Gomara says the same, but Duran, the historian of his dynasty, declares that
he loved too much to rule and to display his personal valor ever to listen to peace
proposals. Hist. Ind., MS., ii. 490. On the following pages he gives a speech by
this ruler, painting the shame and evil of surrender. Before this, according to the
native records of Sahagun, Cortés had invited Quauhtemotzin, under promise of
security, to a conference, in order to explain his motives for the campaign. Not
wishing to appear afraid, the Aztec monarch came to the rendezvous near
Acachinanco, in a state barge, attended by several nobles. Cortés arrived in a
brigantine. He reviewed the allegiance tendered to the Spanish sovereign, the
revolt, precipitated by Alvarado’s effort to anticipate the murderous plot, and the
subsequent slaughter of Spaniards and robbery of treasures. These unjustifiable
and inhuman outrages he had come to avenge; and he would not stay his hand till
the enemies of his king and God had been driven forth. Quauhtemotzin merely
replied that he accepted war, and thereupon returned to the city. Sahagun, Hist.
Conq. (ed. 1840), 147-50. Torquemada, i, 543, and Brasseur de Bourbourg adopt
this story, the latter stating that the Aztec ruler proposed to consult his council. But
Clavigero rightly assumes that the interview never took place. All other records
say that Quauhtemotzin persistently refused ever to speak with Cortés, even from
behind his walls.
[1129] Many captives had been secured during recent raids on Chalco and
Tezcuco, and other parts, so that there was no lack. The native victims numbered
4000, it is said. Herrera, dec. iii. lib. i. cap. xvii. ‘All boys,’ says Oviedo, iii. 515. ‘Yo
bien creo que fuerõ muchas, mas no tantas.’ Gomara, loc. cit. The limbs of the
Spaniards were sent to different provinces to frighten the inhabitants. Bernal Diaz,
Hist. Verdad., 135.
[1130] Ixtlilxochitl states in one place that his namesake remained at Tezcuco to
raise troops and to arrange for regular trains of supplies for the Spanish camps. In
another relation he allows him to accompany Cortés with 16,000 canoes. Hor.
Crueldades, 21; Relacion, 314. The canoes which now attended the fleet appear
to have served chiefly as transports.
[1131] Owned even under republican rule by the heirs of Cortés, as a tetzontli
quarry.
[1132] Cortés, Cartas, 211. Bernal Diaz raises the number to 4000, Peter Martyr to
5000, while Vetancurt assumes that the 500 were merely the van. Teatro Mex., pt.
iii. 158.
[1133] Oviedo writes that they were sacrificing boys to propitiate the gods. iii. 516.
‘La flota q̄ les parecio no dar batalla con tan pocas y cansadas,’ observes
Gomara, Hist. Mex., 194.
[1134] Alvarado advanced as far as the first wide bridge, but lost three men.
Bernal Diaz, Hist. Verdad., 141.
[1135] Probably behind the great southern levee. See Native Races, ii. 564.
[1136] Gomara calls it wrongly Xaltoca, and Robertson confounds it, singularly
enough, with Tezcuco. Hist. Am., ii. 114.
[1137] Cortés, Cartas, 216-17. The greater number of the allies came daily from
their camp at Coyuhuacan to join Cortés as warriors and sappers. Digging and
similar work was done chiefly by Tezcucans. Herrera states that the vessels of
Flores and Ruiz de la Mota were placed at a broken causeway between the
camps of Alvarado and Sandoval. dec. iii. lib. i. cap. xvii.
[1138] ‘Asserrador ... trabajò mas que mil Indios.’ Herrera, dec. iii. lib. i. cap. xviii.
[1140] Ixtlilxochitl allows his namesake and Cortés to figure in this scene, the
former cutting off the idol’s head while the general secured the mask. He states
that the temple was captured during the first entry into the court. When the
Mexicans rallied, Ixtlilxochitl managed to kill their general, which so enraged them
that they rushed madly on and drove back the Spaniards till the horse arrived. Hor.
Crueldades, 29-30. His version is adopted in the main by Prescott and others; but
there are several discrepancies. The death of a general as a rule discouraged
native armies. Cortés, who would not have failed to claim the overthrow of the idol,
states that it was effected by four or five Spaniards, after the second capture of the
court. Cartas, 218. His presence was needed below to direct operations.
Gomara’s text must have misled Ixtlilxochitl and others. Hist. Mex., 197-8. Herrera
and Torquemada adhere better to Cortés.
[1142] Cortés, Cartas, 221. Bernal Diaz states that Alvarado received four and
Sandoval only two. Hist. Verdad., 141.
CHAPTER XXXIII.
CONTINUATION OF THE SIEGE.
June-July, 1521.