General Business 765, Lecture 3 Student Name ___________________

Spring 2001 Student ID Number _______________

Answers to Homework #5

Due 5/2/01

Note: You may want to Xerox your answers so that you can compare them to the answer key prior to the final exam. Homework #5 will NOT be returned until the night of the final exam.

1. (2 points each) True or False

a. ____T_______ M1 is a measure of money that focuses primarily on money as a medium of exchange.

b. _____F______ Credit cards are included in M2, but not M1.

c. ____F_______ M1 and M2 have equal liquidity.

d. ____F_______ Financial intermediation primarily provides a profit-making opportunity for those providing financial services.

e. ____F_______ Assets plus liabilities equals net worth.

f. ____F_______ Checking accounts are an asset.

g. ____T_______The percentage of demand deposits a bank is required by the Fed to hold as reserves is the required reserve ratio.

h. ____T_______ If the required reserve ratio is 10%, then a $100 open market purchase will increase the money supply by $1000.

i. _____F______ The larger the required reserve ratio the larger the money multiplier.

j. _____F______ It is always irrational for banks to hold excess reserves.

k. _____F______ Fractional reserve banking refers to the idea that banks hold 100% of their deposits as reserves.

l. _____F______ The Federal Reserve shares monetary authority evenly among the Board of Governors, the Federal Open Market Committee, and the commercial banks that are members of the Fed.

m. ____F_____ The Fed has three monetary policy tools available: the discount rate, open market operations, and the actions of the twelve Federal Reserve District Banks.

n. _____T_____ The Fed regulates the banking system, clears interbank payments, and serves as a lender-of-last-resort.

o. _____F_____ The required reserve ratio is the Fed’s primary monetary policy tool.

p. _____F_____ New reserves are created when someone writes a check on one bank and it is deposited at another bank.

q. ____F______ The money demand curve will shift to the right if interest rates fall.

r. _____T_____ An increase in the price level will cause the money demand curve to shift to the right.

s. _____T_____ A decrease in income will cause the money demand curve to shift to the left.

t. _____F_____ If interest rates are higher than the equilibrium interest rate, this implies money demand is greater than money supply.

u. ____T_____ When interest rates are higher than the equilibrium level, people demand more bonds and less money; this will cause the price of bonds to increase and interest rates to fall.

v. ____F______ When the money demand is greater than the money supply, people demand more bonds and less money.

w. ____T_____ An open market sale, holding everything else constant, will cause a leftward shift of the money supply curve and a movement along the money demand curve.

x. _____F_____ The relationship between the interest rate and the level of investment demand is a positive one.

y. _____T_____ Holding everything else constant, an open market purchase will increase the level of investment in an economy.

z. ____F______Holding everything else constant, an open market purchase has no affect on aggregate output.

2. Use the following information to answer this question. Assume that there are no excess reserves (once all adjustments are made) and no currency drains. Furthermore, assume there is only one bank and the Fed in the scenario.

Suppose that the Bank has received $500 in demand deposits, has $100 in required reserves deposited at the Fed, and $400 in loans and securities. The Fed has $100 in securities.

a. (2 points) Fill in the t-accounts below.

Bank Fed

Assets Liabilities Assets Liabilities

Required Demand Securities 100 Reserves 100

Reserves 100 Deposits 500

Loans and

Securities 400

b. (2 points) What is the required reserve ratio? ____20%_______________

c. (2 points) Initially, the money supply equals ____$500_______________

d. (2 points) Suppose the Fed purchases $100 in T-bills from this bank. In the space below give the t-accounts for the Bank and the Fed showing just this change (no multiplier effect: hint the bank will have excess reserves).

Bank Fed

Assets Liabilities Assets Liabilities

Required Demand Securities 200 Reserves 200

Reserves 100 Deposits 500

Excess

Reserves 100

Loans and

Securities 300

e. (2 points) In (d), what is the level of excess reserves the Bank has with this Fed action? (Assume that the Bank has not adjusted fully to this transaction.) Excess reserves equal ____$100_______________

f. (2 points) In the space below, provide the T-accounts for the Bank and the Fed once all adjustments are made. (Hint: the Bank should have no excess reserves.)

Bank Fed

Assets Liabilities Assets Liabilities

Required Demand Securities 200 Reserves 200

Reserves 200 Deposits 1000

Loans and

Securities 800

g. (2 points) After all adjustments to this open market purchase are made, what is the money supply equal to? _______$1000__________________

3. Suppose there are several banks in this small economy. In particular, we will focus on the bank whose t-account is given to you. This bank is currently not holding excess reserves. Assume there are no currency drains.

Bank

Assets Liabilities

Reserves $200,000 Demand Deposits $1,000,000

Loans $800,000

a. (2 points) What is the required reserve for this bank? __________20%_______________

b. (2 points) If the Fed changes the required reserve to 10%, what will the change in the money supply equal? ____________$1,000,000_________________

c. (2 points) Suppose that the Fed does not change the required reserve ratio. Instead, the bank decides to hold $100,000 in excess reserves. How will this impact the money supply? __It will decrease the money supply. Since fewer dollars are lent out this reduces the money multiplier’s effect on the money supply

d. (2 points) When a bank decides to hold excess reserves, what happens to the money multiplier? __In our simple money multiplier if would not change the money multiplier, but it would reduce the amount of reserves that get multiplied by the multiplier. In a more complex model, one could model the excess reserves as part of the multiplier and that would make the multiplier smaller as the percentage of deposits held as excess reserves increases.

e. (2 points) Suppose that the Bank no longer is holding excess reserves (we are back to the initial t-account). Suppose Donald deposits his paycheck of $10,000 in his checking account at this bank. Assume that his employer writes the check off another bank in this economy. Assuming that there are no excess reserves and no currency drains in this economy, what will the change in the money supply equal with this deposit? __0_______________________

4. Use the following information to answer this question. Suppose you are given a Keynesian model with the following information:

C = 100 + .5 (Y – T)

T = 10 + .2Y

I = 100 – 400r

Where r is the interest rate expressed as a percent (i.e., if the interest rate is 10%, it would be .10 in the equation)

G= 75

X- M = 50

Money demand = 100,000 –1,000,000r

where r is the interest rate expressed as a percent (i.e., if the interest rate is 10%, it would be .10 in the equation)

Money supply = 50,000

a. (2 points) What is the equilibrium level of interest rate for this economy? _______5%_________________

b. (2 points) If the interest rate equals 8%, what do you know about the money market?

The money market is not in equilibrium: the money supply is greater than the money demand.

c. (2 points) Given the situation in (b), what adjustments do you anticipate will occur in the money and the bond markets?

People will not want to hold money: this will increase the demand for bonds which will cause the price of bonds to increase and the interest rate to decrease. The interest rate will decrease in the money market and return to the equilibrium level.

d. (2 points) At the equilibrium interest rate, what is the level of investment?

I = 80

e. (2 points) What is the equilibrium level of aggregate output for this economy?

The equilibrium level of output is equal to 500

f. (2 points) Suppose that the Fed makes an open market sale of $1000 and that the required reserve ratio is equal to 10%. Furthermore, suppose that there are no currency drains and no excess reserves in this economy. What will the new level of the money supply equal?

The money supply is equal to 40,000

g. (2 points) Given the change in (f), what will the interest rate equal?

6%

h. (2 points) Given the change in (f), what will the new level of investment equal?

The new level of investment equals 76

i. (2 points) Given the change in (f), what will the new equilibrium level of output equal? (Hint: don’t expect this to be a “nice” number)

493.3

j. (2 points) Suppose that the Fed does not make the open market operation in (f). Instead the Fed would like to help this economy reach the full employment level of output. If the full employment level of output is 520, what kind of open market operation should the Fed perform?

The Fed should purchase T-bills

k. (2 points) Given the information in (j), what must the money supply equal in order for this economy to reach the full employment level of output?

$80,000

l. (2 points) Given the information in (j), how many t-bills will the Fed (buy, sell) in order to bring this economy to the full employment level of output?

The Fed should purchase $3,000 worth of T-bills