Economics 102: Prof. Kelly                                            Student Name:

Spring 2000                                                                   ID#:

Homework #5                                                               T.A. Name:

Due May 8 (Monday)                                                    Section #:

 

Note: If asked to graph please use 1/4" graph paper.  Label this paper with your name, id#, T.A. name, and the number of your discussion section. All homework paper should be stapled together.

 

Question 1. (13 points)    All Banks are required to hold $1 in reserves for every $10 of deposits in this economy. Assume that all accounts were previously equal to 0 (or that we are only looking at changes), and that there are an infinite number of banks in this economy.

 

a)      (2 points) Suppose that Susan deposits $3000 in cash in Bank #1. Fill in the following table for Bank #1 immediately after Susan has made her deposit. Be sure to label all entries.

 

Bank #1’s Balance Sheet

Assets

Liabilities
Reserves  $3,000
Demand Deposits  $3,000

 

 

b)      (3 points) Because Susan deposits $3000 in cash in Bank #1, Bank #1 has

 

i.                     Total Reserves = $3,000

ii.                   Required Reserves = $300

iii.                  Excess Reserves =  $2,700

 

c)      (5 points) Now suppose that Bank #1 lends out any excess reserves to Bill. Bill uses the entire loan to buy a TV from Best Buy, who deposits his payment in Bank #2. Fill in the following table for Bank #1 and #2 immediately after Best Buy has deposited his payment (Bill’s loan) in Bank #2. Be sure to label all entries.

 

Bank #1’s Balance Sheet

Assets

Liabilities
Reserves  $300
DD $3,000
Loans  $2,700
 

 

Bank #2’s Balance Sheet

Assets

Liabilities
Reserves  $2,700
DD $2,700
 
 

 

                                                     

d)      (3 points) Suppose that Bank #2 lends out all of its excess reserves to Fred, and Fred’s loan ends up being deposited in Bank #3, and so on. Fill in the following table for All Banks Combined, after this lending cycle has happened many times. (Assume there are no currency drains.)

 

                                                         Combined Bank Balance Sheet

Assets

Liabilities
Reserves  $3,000
DD  $30,000
Loans  $27,000
 

 

Question 2. (6 points)  

a)      (2 points) The FED sells $1,000 of T-bills on the open market. What will be the total change in the money supply if the reserve ratio is 25%? Money multiplier =1/.25=4 Þ DMs = -$1000*4=-$4,000.

b)      (2 points) The FED buys $2,000 of T-bills from a bank in Chicago. What will be the total change in the money supply if the reserve ratio is 25%? Money multiplier =1/.25=4 Þ DMs = $2000*4= $8,000.

c)      (2 points) Suppose David deposits his paycheck of $1,000 in a bank in Green Bay. What will be the total change in the money supply if the reserve ratio is 25%? The increase in reserves at a bank in Green Bay will be equal to the decrease in reserves at David’s employer’s bank, so that DMs =0.

 

Question 3. (21 points) Assume the following simple economy:

 

            MS = 70                                                            C = 500 + 0.8(Y-T)

            MD = 100 – 100r                                    I = 400 – 1000r

            G = 2000

T = 1000

 

where r is the interest rate expressed as a decimal (i.e., 5% is 0.05 in the equations).

a)      (2 points) What is the equilibrium level of the money stock (M) and the interest rate (r) in the money market? MS = MD  Þ 70 = 100 – 100r Þ M = 70  r = 0.3 or 30%

b)      (2 points) What is the equilibrium level of income (Y) in the output market? Y= 9,000

Y = C + I + G = 500 + 0.8(Y-1000) + 400 – 1000(0.3) + 2000

 

Now suppose that the Fed increases the MS to 90 (new MS = 90).

c)      (3 points) Draw the money supply and demand curves, and find the new equilibrium levels of the money stock (M) and the interest rate (r) in the money market. Label all lines, axes, and intercepts clearly. M = 90  r = 0.1 or 10%

d)      (2 points) What is the new equilibrium level of income (Y) after the Fed increases the MS to 90?

Y = 10,000

 

e)      (6 points) The classical economist then suggests the following model:

            MS = 70                                                            C = 500 + 0.8(Y-T) – 4P          

            MD = 100 – 100r                                    I = 400 – 1000r

            AS:  Y = 5000                                     G = 2000

            AD: Y = C+I+G                                    T = 1000 + 0.1Y

 

After the Fed increases the MS to 90 (new MS = 90), the new equilibrium level of income (Y) in the output market of the classical model will (increase, decrease, not change, be indeterminate) and the new equilibrium price (P) will (increase, decrease, not change, be indeterminate). (Please circle one, and then provide the numerical values of Y and P.) Y = 5,000  P = 100  Þ P’ = 150

 

f)       (6 points) A Keynesian economist suggests the following model:

            MS = 70                                                            C = 500 + 0.8(Y-T) – 4P          

            MD = 100 – 100r                                    I = 400 – 1000r

            G = 2000

            AS:  P = 100                                        T = 1000 + 0.1Y

            AD: Y = C+I+G

 

Now suppose that government decides to change government spending in order to increase the level of GDP to 7000. Then by how much will the government increase G? Does the equilibrium price increase or decrease? Why? (Hint: Do not use multipliers.) DG = 560  P=100 (P is constant)       

Y = C + I + G Þ 7000 = 500 + 0.8(7000-1000 – 0.1(7000)) – 4(100) + 400 – 1000(0.3) + 2000+ DG