1. Where does the money come from?

Here is a description of the process by which banks create money by loaning it.
How Banks Create Money

Banks can't lend out all the deposits they collect, or they wouldn't have funds to pay out to depositors. Therefore, they keep primary and secondary reserves. Primary reserves are cash, deposits due from other banks, and the reserves required by the Federal Reserve System. Secondary reserves are securities banks purchase, which may be sold to meet short-term cash needs. These securities are usually government bonds. Federal law sets requirements for the percentage of deposits a bank must keep on reserve, either at the local Federal Reserve Bank or in its own vault. Any money a bank has on hand after it meets its reserve requirement is its excess reserves.
     It's the excess reserves that create money. This is how it works (using a theoretical 20% reserve requirement): You deposit $500 in YourBank. YourBank keeps $100 of it to meet its reserve requirement, but lends $400 to Ms. Smith. She uses the money to buy a car. The Sav-U-Mor Car Dealership deposits $400 in its account at TheirBank. TheirBank keeps $80 of it on reserve, but can lend out the other $320 as its own excess reserves. When that money is lent out, it becomes a deposit in a third institution, and the cycle continues. Thus, in this example, your original $500 becomes $1,220 on deposit in three different institutions. This phenomenon is called the multiplier effect. The size of the multiplier depends on the amount of money banks must keep on reserve.

Source: State of Connecticut, Department of Banking

Please answer the following questions.

  1. If the banks' reserve requirement were 30%, what increase in money supply would result from the initial $500 deposit?
  2. If the banks' reserve requirement were 10%, what increase in money supply would result from the initial $500 deposit?
  3. Why are loans considered to be assets of banks?
  4. Why are deposits considered to be liabilities of banks?
  5. What would be the disadvantage for a bank in keeping more money on reserve than it was required to keep

2. Creating a Chart on the Misery Index

 Inflation rate 
1978   6.1
1979   5.9
1980   7.2
1981   7.6
1982   9.7
1983   9.6
1984   7.5
1985   7.2
1986   7.0
1987   6.2
1988   5.5
1989   5.3
1990   5.5
1991   6.7
1992   7.4
1978   7.6
1979   11.3
1980   13.5
1981   10.3
1982   6.2
1983   3.2
1984   4.3
1985   3.6
1986   1.9
1987   3.6
1988   4.1
1989   4.8
1990   5.4
1991   4.2
1992   3.0

The "Misery Index" is an economic index that was developed during the 1970s, when stagflation (simultaneous high rates of inflation and unemployment) was becoming a persistent problem. The Misery Index is simply the sum of the rate of unemployment and the rate of inflation in a given year. Using the data given, plot the misery index on the graph at right.

Please answer the following questions:

  1. What was the major component of the Misery Index in 1979? In 1982?
  2. In 1980 and 1992, an incumbent was defeated in the US Presidential election. What can you infer from this chart about the reason for voter dissatisfaction?
  3. Which would you consider to be worse for the economy, inflation or unemployment? Give reasons to support your choice.

3. Imagining Hyperinflation

The illustration above shows a series of German postage stamps from 1921 to 1923. Each stamp is worth ten times the value of the stamp to its left. During the worst of Germany's inflation crisis, employees were given wages twice each day, and then given a half-hour break to go out and buy things they needed, before their money lost too much of its value.

Write a narration of how you would spend a typical day during a period of hyperinflation of this sort.

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