DSST Money and Banking common mistakes
DSST Money and Banking · Understand the traps and how to avoid them.
Treating M1 and M2 as interchangeable and answering questions about 'the money supply' with whichever aggregate comes to mind, instead of identifying which aggregate the question specifies.
Candidates memorize one definition of money and never internalize the component lists, so they miss that M1 is currency plus checkable deposits and traveler's checks (plus a small savings-deposit allowance), while M2 adds savings deposits, small time deposits, and retail money market funds. Questions hinge on where a specific asset sits.
What to do instead
Build a two-column chart of M1 and M2 components from memory and practice sorting items: a negotiable order of withdrawal account, a retail MMMF share, a $5,000 CD, currency held by a bank's vault, and currency held by a household. Note explicitly that vault cash is not part of the public money stock and that large CDs are in neither M1 nor M2.
Describing the Fed's three tools as equally powerful and equally used, and claiming the discount rate is the primary tool or that the reserve requirement is changed frequently.
Textbook lists give the tools equal billing, so candidates never learn the operational hierarchy: open market operations are the everyday, precise tool; the discount window is a backstop with a limited and stigma-laden role; reserve requirements are rarely adjusted because of their blunt effect on bank funding.
What to do instead
For each tool, write down the mechanism, the direction of the effect on reserves and the federal funds rate, and one sentence on why it is or is not used actively. Practice the distinction between the target federal funds rate (set by the FOMC) and the discount rate (set by the boards of the regional Reserve Banks, subject to Board review).
Assuming the Fed sets the federal funds rate directly by decree, rather than managing it by adjusting the supply of reserves to hit a target within a corridor.
Media shorthand ('the Fed raised rates') obscures the implementation, so candidates cannot answer questions about open market sales, reserve supply shifts, or why the rate is determined by the interaction of reserve supply and demand rather than by an administrative announcement.
What to do instead
Draw the reserve market: a downward-sloping demand curve, a vertical supply curve, and show how an open market sale shifts supply left and raises the equilibrium rate. Then label the corridor formed by the discount rate (ceiling) and the interest rate on reserve balances (floor) and explain how each bounds the market rate.
Mixing up the direction of bond price and interest rate movements, or confusing the coupon rate with the yield to maturity, when answering valuation questions.
Candidates learn the inverse relationship as a slogan but never apply it, and they conflate the fixed coupon printed on the bond with the market-determined return. This collapses on questions about premium and discount bonds.
What to do instead
Work numerical examples: price a bond at par, then reprice the same cash flows at a higher and lower market rate. State the rule in your own words: when the market rate exceeds the coupon, the bond trades below par. Also practice the distinction between current yield and yield to maturity for a bond trading at a discount.
Confusing the money multiplier with the deposit multiplier and treating either as a fixed constant that predicts actual money creation.
Simple textbook formulas imply a mechanical relationship, but the realized multiplier depends on currency holdings by the public, excess reserves held by banks, and the reserve requirement. Candidates who memorize one formula cannot explain why the multiplier fell sharply when banks held large excess reserves.
What to do instead
Write the multiplier as a function of the currency ratio, the excess reserve ratio, and the required reserve ratio, and explain what happens to it as each rises. Then reason through a scenario: banks hold abundant excess reserves, so additional reserves sit idle and the multiplier is small. Practice explaining the difference between the maximum deposit expansion and the realized expansion.
Answering questions about the Fed's balance sheet without distinguishing assets from liabilities, for example placing Federal Reserve notes in circulation on the asset side.
Candidates memorize line items as a list without a balance-sheet mental model, so they cannot reason about what an asset purchase does to both sides or why currency outstanding is a liability.
What to do instead
Rebuild the balance sheet from first principles: assets are securities held and loans to banks; liabilities are currency in circulation, reserve balances, and the Treasury's account. Then trace an open market purchase: securities up, reserves up, both sides expand. Practice explaining why an increase in currency in circulation drains reserves.
Treating the required reserve ratio as the fraction of all deposits a bank must hold, forgetting that reservable deposit categories differ and that vault cash counts toward reserves.
Simplified teaching presents one ratio applied to all deposits, which breaks on questions involving nonpersonal time deposits, eurocurrency liabilities, or the role of vault cash.
What to do instead
Memorize the reservable categories and note that vault cash satisfies reserve requirements. Practice a small calculation: given checkable deposits, nonpersonal time deposits, vault cash, and a reserve balance at the Fed, compute required reserves and excess reserves, and state whether the bank meets its requirement.
Confusing a bank's liquidity management with its capital management, or answering a liquidity question with a capital-adequacy answer.
Both involve buffers and both appear in bank-management material, so candidates blur them. Liquidity is about meeting cash outflows on time; capital is about absorbing losses on the asset side.
What to do instead
Write a one-line contrast for each and then classify concrete actions: holding Treasury securities, borrowing in the federal funds market, and holding excess reserves are liquidity moves; issuing equity or retaining earnings is a capital move. Practice identifying which risk (run risk versus insolvency risk) each buffer addresses.
Mixing up nominal and real exchange rates, or inverting the quoted rate when converting between currencies and getting the direction of appreciation backwards.
Exchange-rate conventions are easy to state and easy to reverse under time pressure, and candidates often forget that a rise in the quoted price of foreign currency means the domestic currency has depreciated.
What to do instead
Adopt one convention and state it explicitly before computing: price of foreign currency in domestic units. Then practice conversions both ways with a numerical example, and for each answer say in words which currency appreciated. Add the real exchange rate formula and work one example showing how a nominal depreciation with higher domestic inflation can leave the real rate unchanged.
Reciting the quantity theory equation of exchange without being able to use it, for example failing to predict the inflation implication of a given money growth rate and velocity change.
Candidates memorize MV = PY as a string and never manipulate it, so questions that require solving for the inflation rate from money growth, velocity growth, and real output growth defeat them.
What to do instead
Rewrite the equation in growth rates: money growth plus velocity growth equals inflation plus real output growth. Then solve a set of small problems for the missing variable, including cases with falling velocity. Pair this with a plain-language statement of why the long-run link between money growth and inflation holds.