Question 1. Suppose an economy in which there are two kinds of bonds.  Bond A pays a 10% nominal interest rate.  Bond B is an indexed bond and its real interest rate is 5 percent.  Which one yields a higher return if people expect inflation to be 2 percent?  What if the expected inflation is 8 percent?  In which bond would you prefer to have $1,000 if you lived in Switzerland?  What could be your answer if you live in Brazil?

Question 2. In the Baumol-Tobin model, suppose the effects of the following events on the desired real money balances of households:

a. Real income rises by 5 percent.

b. Interest rates go down by 10 percent.

c. The interest rate and real income rise by 10%.  Examine also what happens to the proportion of monetary balances to real income.

Question 3. Suppose that the ratio of reserves to deposits is 0.2 and the ratio of currency to deposits is 0.25.

a. Evaluate the money multiplier?

b. The central bank decides to increase the money supply (M1) by $200 million through an open market operation.  How much should it buy in bonds?

c. How would your answer to (a) and (b) change if the ratio of reserves to deposits were 0.1?  Why?