Homework #5

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. True or False
a. ___________ M1 is a measure of money that focuses primarily on money as a medium of exchange.
b. ___________ Credit cards are included in M2, but not M1.
c. ___________ M1 and M2 have equal liquidity.
d. ___________ Financial intermediation primarily provides a profit-making opportunity for those providing financial services.
e. ___________ Assets plus liabilities equals net worth.
f. ___________ Checking accounts are an asset.
g. ___________The percentage of demand deposits a bank is required by the Fed to hold as reserves is the required reserve ratio.
h. ___________ If the required reserve ratio is 10%, then a $100 open market purchase will increase the money supply by $1000.
i. ___________ The larger the required reserve ratio the larger the money multiplier.
j. ___________ It is always irrational for banks to hold excess reserves.
k. ___________ Fractional reserve banking refers to the idea that banks hold 100% of their deposits as reserves.
l. ___________ 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. _________ 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. __________ The Fed regulates the banking system, clears interbank payments, and serves as a lender-of-last-resort.
o. __________ The required reserve ratio is the Fed's primary monetary policy tool.
p. __________ New reserves are created when someone writes a check on one bank and it is deposited at another bank.
q. __________ The money demand curve will shift to the right if interest rates fall.
r. __________ An increase in the price level will cause the money demand curve to shift to the right.
s. __________ A decrease in income will cause the money demand curve to shift to the left.
t. __________ If interest rates are higher than the equilibrium interest rate, this implies money demand is greater than money supply.
u. __________ 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. __________ When the money demand is greater than the money supply, people demand more bonds and less money.
w. _________ 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. __________ The relationship between the interest rate and the level of investment demand is a positive one.
y. __________ Holding everything else constant, an open market purchase will increase the level of investment in an economy.
z. __________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. Fill in the t-accounts below.

b. What is the required reserve ratio? ___________________
c. Initially, the money supply equals ___________________
d. 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).

e. 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 ___________________

f. 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.)

g. After all adjustments to this open market purchase are made, what is the money supply equal to?

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.

a. What is the required reserve for this bank?

b. If the Fed changes the required reserve to 10%, what will the change in the money supply equal?

c. 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?

d. When a bank decides to hold excess reserves, what happens to the money multiplier?

e. 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? _________________________

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. What is the equilibrium level of interest rate for this economy? ________________________

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

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

d. At the equilibrium interest rate, what is the level of investment? ____________________________________________

e. What is the equilibrium level of aggregate output for this economy? _________________________________________

f. 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?
___________________________________

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

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

i. Given the change in (f), what will the new equilibrium level of output equal? (Hint: don't expect this to be a "nice" number)
_________________________

j. 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? __________________________________________________

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

l. 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?