- Which one of the following is a function of the Federal Reserve?
A. Printing money
B. Collecting taxes
C. Controlling the election process
D. Electing the members of the board
E. Examining banks
Mini- Review Answers
1. C.
2. D.
3. E.
The Demand for Money
Individuals want money for various reasons. While we can accept that everyone wants money, let’s now examine,
in a general sense, what people want money for. People need to pay bills, as well as purchase goods and services like
movies, food, concerts—the list goes on and on. When people want money for these types of expenses, they have a
transaction demand for money. A transaction demand for money is essentially wanting money to spend it. Spending
money is not demanding it; it is exchanging money for a good or service.
Theprecautionary demand for moneyexists because of the potential of unexpected events. People never know when
an unexpected expense will arise or when actual expenditures will exceed planned expenditures.
Thespeculative demand for money is the demand created by uncertainty of value of other assets. If an individual
wants to buy stock but he believes that the value of the stock will fall in the near future, he will hold his money until the
price falls. The speculative demand for money is the practice of holding money while waiting for a price to become
more conducive to your liking.
The Money Creation Process
As you know, the Fed does not print currency; rather, it controls the money supply. We refer to this process as money
creation. Using the fractional reserve banking system creates money. The Fed controls the money supply by regulating
how much member banks can lend out and how much they are mandated to keep in their vaults. Member banks must
keep a percentage of each deposit in their vaults to cover withdrawals customers may want to make. The money that is
not kept in the vault is lent out to people in the form of home loans, car loans, or any other type of loan the bank may be
offering. The ability to lend out excess reserves allows member banks to create revenue based on customer deposits by
charging consumers interest on loans.
The amount of money created by an initial deposit is called the money multiplier. The formula for the money multi-
plier is:
1
Reserve RequirementIf our reserve requirement is 20 percent (0.20), then an initial deposit of $20,000 will lead to a total of $200,000 in
money supply.
On the AP exam, you will be asked what portion of this scenario is an increase in the money supply. To answer this
question, you must understand that the original deposit of $20,000 was already a part of the money supply, so when you
calculate the money multiplier, you must subtract the $20,000 from the total amount to determine what part of the de-
posit was created by the banking system. In our example, $180,000 was created by the banking system, not $200,000,
because you must subtract the amount that already existed when the deposit was made.
Monetary Policy