Advanced monetary theory
1. (a) consider a hypothetical ABC economy in which the narrowly-defined measure of the money supply (M1), as defined in the Canadian sense, in existence is 1250$ million. Assuming the economy's banking system behavior may be characterized by the following simple broad money-multiplier model in which all the variables are as defined in class:
MB= C+RR+ER (equilibrium condition)
C=0.25D (currency holdings of the non-bank public)
RR=RRd+RRt
RRd=0.05D (required reserves against demand deposits)
RRt=0.02T (required reserves against term deposits)
T=0.8D (definition of term deposits)
ER=ERd+ERt
ERd=0.002D (ratio of excess reserves to demand deposits)
ERt=0.001T (ratio of excess reserves to term deposits)
The economy, however, is facing inflationary pressures. To deal with the macroeconomic problem, the government uses expansionary fiscal policy to decrease taxes and, as an indirect effect, the currency/deposit ratio (cd), decreases by 10%. Given the above information,
(i) Find the monetary base and calculate the percentage changes in the equilibrium values of the narrow (M1) and broad money (M2) supplies as a result of the government's policy stance. Explain and illustrate your answers with the appropriate diagrams, where necessary.
(ii)Calculate the percentages changes in the equilibrium values of both the narrowly-defined and broadly-defined money supply if the central bank had used instead both quantitative easing and an expansionary monetary policy by purchasing private sector and federal government securities in the financial market worth $20million. Explain and illustrate your answers with the appropriate diagrams, where necessary.
(iii) Which of the two policies will have the most effect on the equilibrium interest rate? Why? Explain and illustrate your answers with the appropriate diagrams, where necessary.
(iv)If both policies are used simultaneously to deal with the problem in this economy, calculate the percentage changes in (a) the monetary base; (b) total bank deposits; (c) total currency holding of the non-bank public; (d) total bank reserves; (v) the deposit multiplier; and (vii) the money multiplier.
(v)What will be the likely effect of a sudden increase in expected inflation on the money supply of this economy? Explain carefully.
1.(b) Now suppose that in the above economy, banks hold borrowed reserves (BR) according to the following relation:
Where R and b are respectively the market interest rate and the bank rate (measured in fractional units). If the bank rate is 3 percent and the market rate of interest is 6 percent, calculate the percentage changes in the values of both borrowed reserves (BR) and non-borrowed reserves (NBR) as a result of the use of the two policies in question (iv) above.
1 Choose ONLY one complete question
2a.Under specified assumptions, derive the square-root formula of the Baumol-Tobin’s inventory model of transactions demand for money and briefly describe the effect of a one period increase in the price level on the demand for money. How would your answer change if real transaction costs decrease simultaneously with the one-period increase in the price level? Explain carefully and illustrate your answers with a diagram.
OR
2b.The monetarists have demonstrated that the early Keynesians were wrong in saying that money doesn’t matter at all to economic activity. Therefore, we should accept the monetarist position that money is all that matters”. Do you agree? Why? Why not?