worth only $1/1.10 =$0.91. But when the interest rate is
2%, $1 arriving one year from today is worth $1/1.02 =
$0.98, a sizable increase. As a result, project B, which has
a benefit one year from today, becomes more attractive.
And project C, which has a cost one year from today,
becomes less attractive.
Tackle the Test:
Multiple-Choice Questions- e
- b
- c
- d
- b
Tackle the Test:
Free-Response Questions - a.$1,000 ×(1.05)^3 =$1,000 × 1.16 =$1,157.63
b.$1,000/(1.05)^3 =$863.84
Module 25
Check Your Understanding- Even though you know that the rumor about the bank is
not true, you are concerned about other depositors
pulling their money out of the bank. And you know that
if enough other depositors pull their money out, the bank
will fail. In that case, it is rational for you to pull your
money out before the bank fails. All depositors will think
like this, so even if they all know that the rumor is false,
they may still rationally pull their money out, leading to
a bank run. Deposit insurance leads depositors to worry
less about the possibility of a bank run. Even if a bank
fails, the FDIC will currently pay each depositor up to
$250,000 per account. This will make you much less like-
ly to pull your money out in response to a rumor. Since
other depositors will think the same, there will be no
bank run. - The aspects of modern bank regulation that would frus-
trate this scheme are capital requirements andreserve
requirements.Capital requirements mean that a bank has
to have a certain amount of capital—the difference
between its assets (loans plus reserves) and its liabilities
(deposits). So the con artist could not open a bank with-
out putting any of his own wealth in because his bank
would need the required amount of capital—that is, it
needs to hold more assets (loans plus reserves) than
deposits. So the con artist would be at risk of losing his
own wealth if his loans turn out badly. - Since they have to hold only $100 in reserves, instead of
$200, banks now lend out $100 of their reserves.
Whoever borrows the $100 will deposit it in a bank (or
spend it, and the recipient will deposit it in a bank),
which will lend out $100 ×(1− rr)=$100 ×0.9=$90.
The borrowed $90 will likewise find its way into a bank,
which will lend out $90 ×0.9=$81, and so on. Overall,
deposits will increase by $100/0.1 =$1,000. - Silas puts $1,000 in the bank, of which the bank lends
out $1,000 ×(1−rr)=$1,000 ×0.9=$900. Whoever
Module 23
Check Your Understanding
- The defining characteristic of money is its liquidity: how
easily it can be used to purchase goods and services.
Although a gift certificate can easily be used to purchase
a very defined set of goods or services (the goods or serv-
ices available at the store issuing the gift certificate), it
cannot be used to purchase any other goods or services. A
gift certificate is therefore not money since it cannot eas-
ily be used to purchase all goods or services. - Again, the important characteristic of money is its liquid-
ity: how easily it can be used to purchase goods and serv-
ices. M1, the narrowest definition of the money supply,
consists only of currency in circulation, traveler’s checks,
and checkable bank deposits. CDs aren’t checkable–and
they can’t be made checkable without incurring a cost
because there’s a penalty for early withdrawal. This makes
them less liquid than the assets counted in M1. - Commodity-backed money uses resources more efficient-
ly than simple commodity money, like gold and silver
coins, because commodity-backed money ties up fewer
valuable resources. Although a bank must keep some of
the commodity—generally gold and silver—on hand, it has
to keep only enough to satisfy demand for redemptions.
It can then lend out the remaining gold and silver, which
allows society to use these resources for other purposes,
with no loss in the ability to achieve gains from trade.
Tackle the Test:
Multiple-Choice Questions
- d
- c
- e
- a
- b
Tackle the Test:
Free-Response Questions
- a.its official status given by the U.S. government
b.fiat money
c.commodity money–money that has intrinsic value in
other uses.
Commodity-backed money–money that has no intrinsic
value but can be converted into valuable goods on
demand.
Module 24
Check Your Understanding
- a.The net present value of project A is unaffected by the
interest rate since it is money received today; its present
value is still $100. The net present value of project B is
now −$10 +$115/1.02 =$102.75. The net present value
of project C is now $119 − $20/1.02 =$99.39. Project B
is now preferred.
b.When the interest rate is lower, the cost of waiting for
money that arrives in the future is lower. For example, at
a 10% interest rate, $1 arriving one year from today is
S-14 SOLUTIONS TO AP REVIEW QUESTIONS