Introduction to Finance

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LO 5.2 
There are four major policy maker groups: Federal Reserve 
System, the president, Congress, and the U.S. Treasury. The Fed is 
responsible for formulating monetary policy and the president and 
Congress determine fi scal policy. Debt management practices are 
established by the Treasury. 
LO 5.3 
The federal government provides social and economic services to 
the public that cannot be provided as effi
ciently by the private sector, and 
it is also responsible for guiding or regulating the economy. The presid-
ent and the Council of Economic Advisors prepare annual budgets and 
formulate fi scal policy. Congress reviews, makes changes, and passes 
legislation relating to budget expenditures. Funds are raised by the gov-
ernment by levying taxes, and when necessary, the Treasury borrows to 
cover budget defi cits. Government reaction to the 2007–09 perfect fi nan-
cial storm included the Fed providing rescue funds to institutions to help 
avoid bankruptcy and the Fed working with the Treasury to merge fi nan-
cially weak fi nancial institutions with stronger institutions. Congress and 
the president passed legislation to stabilize and grow economic activity.
LO 5.4 
The U.S. Treasury’s cash and general management respons-
ibilities include collecting taxes, paying bills, and managing its cash 
balances so that its day-to-day operations have a stable impact on 
bank reserves and the money supply. During fi nancial crises and eco-
nomic downturns, the Treasury may be called upon to help fi nancial 
institutions merge, and to administer government legislation intended 
to keep fi nancial institutions from failing.
LO 5.5 
The Treasury is responsible for fi nancing budget defi cits and 
for fi nancing and managing the national debt. The Treasury’s debt 
management goals include funding defi cits and refi nancing maturing 
debt at the lowest interest cost to taxpayers; managing the Treasury’s 
cash fl ows in uncertain economic, fi nancial market, and Fed policies 
environment; and managing risk associated with interest rate costs 
and the maturities of outstanding debt. The Treasury carries out its 
debt management policy by operating in a “regular and predictable” 
manner to minimize disruption in the fi nancial markets and to support 
fi scal and monetary policies.
LO 5.6 
The U.S. banking system is a fractional reserve system where 
depository institutions must hold funds at their regional Reserve 
Banks equal to a certain percentage of their deposit liabilities. Since 
an individual depository institution is required to hold only a portion 
of its deposits as reserves, the remaining funds from a new deposit can 
be lent to borrowers who, in turn, may deposit the funds they receive 
in the same or another bank in the banking system, and so forth. An 
estimate of the potential change in checkable deposits, a component 
of the M1 money supply, can be made by dividing the amount of an 
increase (or decrease) in excess reserves by the required reserves ratio.
LO 5.7 
The factors or transactions that aff ect bank reserves include 
changes in the demand for currency by the nonbank public; Fed trans-
actions, such as changes in the required reserves ratio, open-market 
operations, and changes in bank borrowings; and U.S. Treasury 
actions involving changes in Treasury spending from its accounts 
held at Reserve Banks and changes in its cash holdings.
LO 5.8 
The monetary base consists of banking system reserves plus 
currency held by the public, while the money multiplier is the number 
of times the monetary base can be expanded to produce a money sup-
ply level. Multiplying the monetary base times the money multiplier 
produces the amount of the M1 money supply. The velocity of money 
is the average number of times each dollar is spent on purchases of 
goods and services. By dividing nominal gross domestic product by 
M1 produces a measure of the velocity of money.
Key Terms
aggregate demand
automatic stabilizers
bank reserves
budget defi cit
budget surplus
crowding out
debt management
defi cit fi nancing
defi cit reserves
derivative deposit
excess reserves
federal budget 
Federal Reserve fl oat
fi scal policy
fractional reserve system
gross domestic product (GDP)
infl ation
monetary base
monetizing the debt
money multiplier
national debt
primary deposit
required reserves
required reserves ratio
tax policy
transfer payments
velocity of money
Review Questions