Unit 1: Money and the Financial System

Answer: B — The correct answer is B. The stipend in the savings account is classified as part of M2 but NOT M1. M1 includes only the most liquid assets: currency in circulation and funds in checking accounts (demand deposits). M2 is a broader measure that includes everything in M1 plus near-money assets such as savings accounts, money market deposits, and small time deposits. Because the savings account earns interest and is not a checking account, it lacks the immediate, frictionless spending ability that defines M1 components. However, it remains part of M2 because it can be converted to cash or checking funds relatively quickly (typically within days) and serves as a store of value. Distractor A (misconception: liquidity confusion) incorrectly assumes that any accessible money belongs to M1. This conflates M1's defining characteristic—immediate spendability without withdrawal delay—with mere accessibility. A savings account, while accessible, requires an extra step (transfer or withdrawal) before use, placing it outside M1. Distractor C (misconception: functional overlap) reflects the mistaken belief that money in different accounts serves the same monetary function and thus belongs in both aggregates simultaneously. In reality, M1 and M2 are nested categories: M1 is a subset of M2. An asset is counted in M2 precisely because it is NOT in M1. Distractor D (misconception: interest-bearing exclusion fallacy) incorrectly assumes the Fed excludes interest-bearing deposits from money supply measures. In fact, most savings accounts and money market accounts ARE included in M2 regardless of interest rates. The distinguishing feature is liquidity and spendability, not whether interest is paid.

Answer: A — The primary function of money is to serve as a medium of exchange, allowing individuals and businesses to trade goods and services with one another. This function enables the division of labor and specialization, as individuals can focus on producing a specific good or service and exchange it for other goods and services they need or want. In this way, money facilitates economic efficiency and growth.

Answer: A — The correct answer is A) The money supply (M1) will increase by $10 billion. When the Fed increases the monetary base through an open market purchase, it injects additional reserves into the banking system, which encourages commercial banks to increase their lending and deposits. As a result, M1, which includes currency and checkable deposits, will increase. M2, which includes M1 plus other components, may also increase, but the correct answer focuses on the direct effect on M1.

Answer: B — The correct answer is B. This question tests understanding of how financial intermediaries expand the money supply through fractional reserve banking. With a 20% reserve requirement, banks keep $100,000 and lend $400,000. That $400,000 becomes a deposit elsewhere, where another bank keeps $80,000 and lends $320,000, and so on. The money multiplier equals 1 ÷ 0.20 = 5, meaning the initial $500,000 deposit eventually supports $2,500,000 in total money supply (deposits + initial cash). Distractor A (policy direction swap) reflects a common misconception that deposits don't create money—they do, through lending. Distractor C (fed tool mix-up) confuses the reserve requirement with money destruction; reserves are set aside but don't reduce money supply, they enable lending. Distractor D (money supply confusion) fails to recognize that demand deposits ARE part of M1 money supply and that bank lending creates additional deposits. This scenario exemplifies how financial intermediaries act as multipliers of the monetary base.

Answer: A — The increase in the federal funds target rate will make borrowing more expensive, leading to a decrease in borrowing and spending in the money market. This is because the increased cost of borrowing will reduce the demand for loans and other financial instruments in the money market, causing the money market to contract.