No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 296 CHAPTER TWELVE ANSWERS 1. If the dollar coins are simply replacements for bills, there is no effect. But in general, even if they added coins to the bills, any effect is small—it is reserves that matter to the creation of money and the Federal Reserve must supply reserves to the banking system to initiate the fractional reserve banking system process. 2. Lowering the discount rate reduces the costs for banks to obtain the reserves they require to make loans, so this will expand the supply of loanable funds per Figure 12.8 and lower the rate of interest. However, since there are not additional goods and services, the increase in the supply of money with a constant money demand will result in a lower purchasing power of money, per Figure 12.6 (moving money supply fromMS1 to MS3, and lowering the purchasing power of money to PPM3). 3. Under this scenario, the demand for money will increase, as seen in Figure 12.5 (going fromMD 1 to MD 3 , and the purchasing power of money rising from PPM 1 to PPM 3 ). 4. It did not consider inflation in asset prices, such as real estate. Only later did prices begin to rise dramatically, but by that time significant capital misallocation had occurred. 5. Open Market Operations are very quick, flexible, reversible, and precise. The Fed’s two other tools (reserve ratio and discount window) have other limitations (too blunt in the case of reserve ratio, and the discount window can cause confusion in the Fed’s conduct of its lender of last resort function). 6. It’s impossible to tell unless you understand the inflation rate, so you can apply the Fisher equation to arrive at a real rate of return. It is the real rate which matters to savers and borrowers. 7. Asset inflation causes large distortions in the overall structure of the economy and therefore takes a long time to correct (and with much pain as labor and capital needs to be reallocated). 8. Rules: Pros: Constrains monetary authority, provides certainty in policy. Cons: Does not allow the monetary authority to react to external shocks to the economy. Discretion: Pros: Allows the monetary authority the flexibility to respond to external shocks. Cons: There is no effective ability to constrain unwise monetary expansion or contraction.