Money is whatever is generally accepted in exchange. Its three functions:
Commodity money has intrinsic value (gold). Fiat money — all modern currency — has value only because government declares it legal tender and, more fundamentally, because everyone accepts it. Nothing physical backs the dollar; acceptance does.
Liquidity = how quickly and cheaply an asset converts to spendable form. The monetary aggregates are nested by liquidity:
| Aggregate | Contents |
|---|---|
| M1 | Currency in circulation + checkable (demand) deposits (+ savings deposits under the current definition) |
| M2 | M1 + small time deposits (CDs) + money market funds |
Liquidity ranking, most to least: currency → checking deposit → CD (early-withdrawal penalty) → house (months to sell).
Not money at all: stocks, bonds, real estate, and credit cards. A credit card is a loan trigger — swiping it creates short-term debt that a deposit balance later pays off. Card limits appear in neither M1 nor M2. Currency sitting in a bank vault is not "in circulation," so depositing cash moves money between categories rather than creating it.
Banks keep only a fraction of deposits as reserves (vault cash + deposits at the Fed) and lend the rest:
A bank balance sheet after a $1,000 deposit with rr = 10%:
| Assets | Liabilities |
|---|---|
| Required reserves $100 | Checkable deposits $1,000 |
| Excess reserves $900 |
A single bank can lend only its excess reserves ($900 here) — never a multiple of them.
The banking system multiplies. Loans get spent, redeposited at other banks, and re-lent — each round smaller by the reserve fraction:
Money multiplier = 1/rr
[SCHEMATIC: The deposit-expansion chain (rr = 10%)
Round 1: $1,000 deposited at Bank A → $100 reserved, $900 lent
Round 2: $900 deposited at Bank B → $90 reserved, $810 lent
Round 3: $810 deposited at Bank C → $81 reserved, $729 lent
... each round = 90% of the last
Total deposits: $1,000 × (1/0.10) = $10,000; new money created: $9,000]
Two starting points, two answers — the exam's favorite trap:
The multiplier is a maximum. It shrinks if banks choose to hold excess reserves or if the public keeps cash out of the banking system.
The Fed is the central bank of the United States. Structure: a Board of Governors in Washington, 12 regional Federal Reserve Banks, and the Federal Open Market Committee (FOMC), which sets monetary policy. Its purposes: conduct monetary policy (next lesson), supervise banks, act as lender of last resort — lending reserves to solvent banks facing sudden withdrawals to prevent panics — clear payments, and serve as the government's bank. The Fed is not Congress (which controls taxes and spending), not the Treasury, and not a deposit insurer (that's the FDIC).
A dollar today is worth more than a dollar next year, because today's dollar can earn interest. With interest rate r:
Higher interest rates make future dollars worth less today — the logic behind comparing a pension buyout offer to its promised future payments.
1. D. Quoting and comparing prices in a common measure is the unit-of-account function — no transaction or holding is involved. A: medium of exchange requires an actual purchase. B: store of value means holding purchasing power over time. C: a commodity standard describes what backs money, not a function. E: "reserve asset" describes bank holdings, not a function of money.
Fix: Buying = medium of exchange; comparing = unit of account; holding = store of value.
2. B. M1's core is currency in circulation plus checkable deposits — funds spendable today. A: CDs are time deposits, in M2. C: stock shares are assets that must be sold first, not money. D: a credit limit is borrowing capacity, not money. E: bonds must be sold to spend — not money.
Fix: If you can spend it directly today, it's M1; if it must be converted or borrowed first, it isn't.
3. E. Currency is spendable now; checking is one card tap away; a CD carries an early-withdrawal penalty; a house takes months to sell. A: exactly reversed. B: puts the penalty-bound CD first. C: ranks a house above currency. D: inserts the least-liquid asset second.
Fix: Rank by how fast the asset becomes spendable cash without losing value.
4. B. Required reserves = 0.25 × $80,000 = $20,000; excess = $26,000 − $20,000 = $6,000. A: $20,000 is the required amount, not the excess. C: $26,000 is total reserves. D: $54,000 is deposits minus total reserves (the amount already lent, not lendable now). E: $6,500 applies the 25% to reserves instead of to deposits.
Fix: Compute required first (rr × deposits), then excess = actual − required.
5. A. Multiplier = 1/rr = 1/0.20 = 5. B: quotes the percentage itself. C: uses rr without inverting. D: divides by 10 instead of 5, a decimal slip. E: inverts the wrong way (0.20/4).
Fix: Money multiplier = 1/rr — convert the percent to a decimal, then invert.
6. C. Total deposits = (1/0.10) × $2,000 = $20,000; NEW money = $20,000 − $2,000 = $18,000, because the deposited cash was already money. A: $200 is the first-round required reserve. B: $2,000 is just the original deposit. D: $20,000 forgets to subtract the original deposit — it is total deposits, not new money. E: $1,800 is only the first-round loan, not the full chain.
Fix: New money from a cash deposit = (1/rr) × deposit − deposit.
7. C. A Fed purchase injects reserves that were not previously in the money supply, so the full multiplier applies: (1/0.20) × $5M = $25 million. A: ignores the multiplier entirely. B: wrongly applies the cash-deposit subtraction — nothing here was already money. D: $1M is the required-reserve slice of $5M. E: $4M is only the first-round lending capacity.
Fix: Fed injection → full multiplier × amount; cash redeposit → multiplier × amount − the original deposit.
8. A. Currency in circulation falls $3,000 and checkable deposits rise $3,000 — a composition change within M1, total unchanged. B/D: growth comes later, through the lending chain, not at the moment of deposit. C: nothing was destroyed. E: reserve arithmetic doesn't alter M1 at the instant of deposit.
Fix: Moving money between pockets (cash ↔ checking) never changes M1 by itself; only new lending creates money.
9. D. Reserves held idle break the lending chain: each round of deposit creation shrinks, so the realized multiplier falls below 1/rr. A/B: those are exactly the assumptions that keep the multiplier at its maximum. C: a lower requirement raises the ceiling. E: payment plumbing speed doesn't change how much is lent.
Fix: Two leaks shrink the multiplier — banks hoarding excess reserves and the public holding cash outside banks.
10. D. The Fed is the U.S. central bank: monetary policy through the FOMC, bank supervision, payments, and lender of last resort. A: Congress sets taxes — that's fiscal policy, a different institution. B: deposit insurance is the FDIC. C: the Fed is independent of the Treasury and does not print money to finance deficits. E: the Fed serves banks and the government, not household borrowers.
Fix: Fed = central bank = money and interest rates; Congress = taxes and spending; FDIC = deposit insurance.
11. C. FV = 1,000 × (1.10)² = $1,210 — year two earns interest on year one's interest. A: $1,100 stops after one year. B: $1,200 uses simple interest, ignoring compounding. D: $2,000 assumes the money doubles. E: $1,020 applies 1 percent-per-year-style arithmetic (a decimal slip on the rate).
Fix: Future value compounds: FV = PV × (1 + r)^t, not PV × (1 + r × t).
12. E. A card swipe creates a short-term loan from the card issuer; the money involved is the checking balance that later pays the statement. Neither the card nor its limit is in any monetary aggregate. A: acceptance matters, but what's accepted is a promise to pay — the loan, not money. B: credit limits are in no aggregate, let alone M1. C: M2 contains near-money deposits, not borrowing capacity. D: checkable deposits are the core of M1 — the claim is wrong, but not for this reason.
Fix: Credit = a loan trigger; debit = spending money (checkable deposits). Only the second is money.
1. D. Quoting and comparing prices in a common measure is the unit-of-account function — no transaction or holding is involved. A: medium of exchange requires an actual purchase. B: store of value means holding purchasing power over time. C: a commodity standard describes what backs money, not a function. E: "reserve asset" describes bank holdings, not a function of money. Fix: Buying = medium of exchange; comparing = unit of account; holding = store of value.
2. B. M1's core is currency in circulation plus checkable deposits — funds spendable today. A: CDs are time deposits, in M2. C: stock shares are assets that must be sold first, not money. D: a credit limit is borrowing capacity, not money. E: bonds must be sold to spend — not money. Fix: If you can spend it directly today, it's M1; if it must be converted or borrowed first, it isn't.
3. E. Currency is spendable now; checking is one card tap away; a CD carries an early-withdrawal penalty; a house takes months to sell. A: exactly reversed. B: puts the penalty-bound CD first. C: ranks a house above currency. D: inserts the least-liquid asset second. Fix: Rank by how fast the asset becomes spendable cash without losing value.
4. B. Required reserves = 0.25 × $80,000 = $20,000; excess = $26,000 − $20,000 = $6,000. A: $20,000 is the required amount, not the excess. C: $26,000 is total reserves. D: $54,000 is deposits minus total reserves (the amount already lent, not lendable now). E: $6,500 applies the 25% to reserves instead of to deposits. Fix: Compute required first (rr × deposits), then excess = actual − required.
5. A. Multiplier = 1/rr = 1/0.20 = 5. B: quotes the percentage itself. C: uses rr without inverting. D: divides by 10 instead of 5, a decimal slip. E: inverts the wrong way (0.20/4). Fix: Money multiplier = 1/rr — convert the percent to a decimal, then invert.
6. C. Total deposits = (1/0.10) × $2,000 = $20,000; NEW money = $20,000 − $2,000 = $18,000, because the deposited cash was already money. A: $200 is the first-round required reserve. B: $2,000 is just the original deposit. D: $20,000 forgets to subtract the original deposit — it is total deposits, not new money. E: $1,800 is only the first-round loan, not the full chain. Fix: New money from a cash deposit = (1/rr) × deposit − deposit.
7. C. A Fed purchase injects reserves that were not previously in the money supply, so the full multiplier applies: (1/0.20) × $5M = $25 million. A: ignores the multiplier entirely. B: wrongly applies the cash-deposit subtraction — nothing here was already money. D: $1M is the required-reserve slice of $5M. E: $4M is only the first-round lending capacity. Fix: Fed injection → full multiplier × amount; cash redeposit → multiplier × amount − the original deposit.
8. A. Currency in circulation falls $3,000 and checkable deposits rise $3,000 — a composition change within M1, total unchanged. B/D: growth comes later, through the lending chain, not at the moment of deposit. C: nothing was destroyed. E: reserve arithmetic doesn't alter M1 at the instant of deposit. Fix: Moving money between pockets (cash ↔ checking) never changes M1 by itself; only new lending creates money.
9. D. Reserves held idle break the lending chain: each round of deposit creation shrinks, so the realized multiplier falls below 1/rr. A/B: those are exactly the assumptions that keep the multiplier at its maximum. C: a lower requirement raises the ceiling. E: payment plumbing speed doesn't change how much is lent. Fix: Two leaks shrink the multiplier — banks hoarding excess reserves and the public holding cash outside banks.
10. D. The Fed is the U.S. central bank: monetary policy through the FOMC, bank supervision, payments, and lender of last resort. A: Congress sets taxes — that's fiscal policy, a different institution. B: deposit insurance is the FDIC. C: the Fed is independent of the Treasury and does not print money to finance deficits. E: the Fed serves banks and the government, not household borrowers. Fix: Fed = central bank = money and interest rates; Congress = taxes and spending; FDIC = deposit insurance.
11. C. FV = 1,000 × (1.10)² = $1,210 — year two earns interest on year one's interest. A: $1,100 stops after one year. B: $1,200 uses simple interest, ignoring compounding. D: $2,000 assumes the money doubles. E: $1,020 applies 1 percent-per-year-style arithmetic (a decimal slip on the rate). Fix: Future value compounds: FV = PV × (1 + r)^t, not PV × (1 + r × t).
12. E. A card swipe creates a short-term loan from the card issuer; the money involved is the checking balance that later pays the statement. Neither the card nor its limit is in any monetary aggregate. A: acceptance matters, but what's accepted is a promise to pay — the loan, not money. B: credit limits are in no aggregate, let alone M1. C: M2 contains near-money deposits, not borrowing capacity. D: checkable deposits are the core of M1 — the claim is wrong, but not for this reason. Fix: Credit = a loan trigger; debit = spending money (checkable deposits). Only the second is money.