Homework 5 -

1. Suppose Jeremy deposits $100,000 in Wisconsin Bank, and Jason borrows $75,000 from Wisconsin Bank to buy a car at the Ford dealership. Suppose the required reserve ratio for all banks (set by the Fed) is 25%. The Ford dealership deposits the money from Jason's car purchase in Madison Credit Union. Assume that there are no currency drains. 

(a) Draw T-accounts for Wisconsin Bank, and Madison Credit Union depicting the changes in assets and liabilities for these two institutions.

(b) What is the amount of required reserves held by Wisconsin Bank due to Jeremy's deposit? What is the amount of required reserves held by Madison Credit Union after the Ford dealership's deposit? Why are these amounts different?

Suppose the Fed buys $5000 worth of bonds from Barry, who banks at Badger Credit Union. In return for the bonds, it gives Barry a check for $5000.

(c) If Barry deposits this check into his checking account, and the credit union lends out the excess reserves from this transaction to Bobby, how much will Bobby borrow? Make a new balance sheet noting only the resulting changes to the assets and liabilities of Badger Credit Union.

(d) Suppose this process continues. Bobby deposits his money at University Bank, who then lends out excess reserves to Hank. Hank deposits his money at State Street Bank, who then lends out their excess reserves and so on and so forth. By the end of this money creation process, how much money is created from the Fed's initial Open Market Operation? Write out a formula for the multiplier in terms of the RR (required reserve) ratio. What is the money multiplier?

2. Suppose that demand for money in the country of Macroland depends on the interest rate, r. All other things equal, a higher interest rate increases the opportunity cost of holding money.

(a) Sketch the Money demand curve in Macroland with interest rate, r on the y-axis and quantity of money, M on the x-axis.

Suppose  the demand for money in Macroland is represented by M=20,000 - 40,000r. The supply of money in Macroland is M=15,000. Note: the interest rate, r , is written as a decimal (e.g., an interest rate of 10% would be written as .1 in the equation).

(b) Calculate the equilibrium interest rate and the equilibrium amount of money.

(c) Suppose the interest rate in the money market in Macroland is currently at 10%. What is the amount of excess supply of or excess demand for money? How will the market adjust back to the equilibrium?

(d) Suppose that the government of Macroland wants to maintain an interest rate of 10%. What action would the government of Macroland need to take in order to ensure an interest rate of 10% in equilibrium?

(e) Give a brief explanation as to why the interest rate and prices of bonds are negatively related.

3. A Keynesian economist suggests the following model for an economy:

Ms = 1,000

C = 2,000 + 0.8(Y-T) - 4P

Md = 3,000 - 40,000r                     

I = 5,000 - 1000r

G = 2,000                                            

T = 1,000 + 0.1Y

AS: P = 150

AD: Y = C + I + G

(a) What is the equilibrium interest rate?

(b) What is the equilibrium output in this model?

(c) Now, suppose the government decides to change government spending such that the level of GDP is around $25,000. What would G need to be for Y to equal 25,000?