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Answers to Text Questions and Problems in Chapter 13 Answers to Review Questions 1. Money refers to any asset that can be used in making purchases, such as cash and chequing account balances. People hold money despite its lower return precisely because of its usefulness in transactions; a person who held no money and wanted to make a purchase would either have to resort to time-consuming barter or else incur the costs of selling other assets to obtain money. 2. If the public reduces its currency holdings by, say, \$1 million, and the central bank takes no action, banks will have an extra million dollars in reserves. They will lend out these reserves, initiating a many- round process of lending and re-deposit in the banking system. Ultimately bank deposits will grow by much more than a million dollars. (Remember that bank deposits equal bank reserves divided by the reserve/deposit ratio; if the reserve/deposit ratio is less than one, bank deposits will be larger than bank reserves.) The increase in deposits will outweigh the decline in currency held by the public, leading to an overall increase in the national money supply. 3. M2 is the most commonly-used measure of money supply in Canada. It includes currency outside banks, personal deposits, and non-personal demand and notice deposits. 4. There are three ways that central banks can change commercial bank reserves. The first is through changing reserve requirements; an increase in the required reserve ratio raises bank reserves. The second technique is open-market operations, when the central bank buys or sells financial assets; open-market sales reduce bank reserves, while open-market purchases raise reserves. The third technique is government deposit shifting; shifting deposits to private banks raises reserves, and shifting deposits from private banks lowers reserves. 5. The quantity equation states that money times velocity equals the price level times real GDP, or M × V = P × Y . In a hyperinflation, if we assume that the velocity of money and real GDP are constant, this equation implies that any percentage increase in the money supply translates into the same percentage increase in the price level. So, the rate of growth of the money supply equals the rate of inflation. Answers to Problems 1a. Cigarettes were passed hand to hand in exchange for goods and services, hence they were a medium of exchange. Prices were quoted in terms of cigarettes, so they were a unit of account. Finally, as prisoners held hoards of cigarettes for future use, they functioned as a store of value. b. Cigarettes are relatively durable (chocolate melts) and low enough in value to be useful in small transactions (with highly valuable boots, there is no way to purchase a small item or “make change”). Other advantages of cigarettes include their portability and their relative uniformity in value (one pair of

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