Practice Homework 7-
Multiple Choice Questions:
1. Which of the following is NOT a function of money?
(a) It facilitates the barter system.
(b) It serves as a store of wealth.
(c) It serves as a unit of value.
(d) It serves as a medium of exchange.
2. The Required Reserve Ratio (RR) is a percentage set by the Federal Reserve System that requires banks to:
(a) Lend the RR percent of the bank's customer Demand Deposits (DD) to the public.
(b) Hold the RR percent of the bank's customer DD in the form of cash in their vault or in accounts at the Federal Reserve.
(c) Pay RR percent of the bank's customer DD to the Federal Reserve as an annual membership fee.
(d) Hold the RRR percent of the bank's customer DD in the forms of cash in their vault.
3. An open market operation (OMO) refers to:
(a) The purchase of goods and services by the Fed.
(b) An announcement about the level of the money supply in the economy.
(c) The process of printing more money and distributing it to the public.
(d) The purchase or sale of bonds to influence the level of the money supply in the economy.
4. Which of the following actions by the government is most likely to increase the money supply in an economy? (Hint: it is probably better to first answer Q3 of the problems)
(a) Decreasing the RRR while selling bonds in the market.
(b) Increasing the RRR while selling bonds in the market.
(c) Buying bonds in the market.
(d) None of the above would have any effect on the money supply.
5. Money Demand, when plotted against the interest rate, is downward sloping because:
(a) At higher interest rates the opportunity cost of holding money is lower.
(b) Banks typically want more savings when the interest rate is higher.
(c) At higher interest rates the opportunity cost of holding money is higher.
(d) Individuals dislike putting money in the bank.
6. Which of the following events does not shift the money demand curve?
(a) An increase in the interest rate.
(b) Citizens expect bank runs on major banks.
(c) The real income of the economy increases.
(d) The price level increases.
Problems:
1. Suppose the country of Econometallica has the following monetary asset information as of April 2004:
Cash in hands of the public = $300b (where 'b' represents billion)
Demand Deposits (DD) = $400b
Other Checkable Deposits = $150b
Traveler's checks = $50b
Savings Type accounts = $2000b
Money Market Mutual Funds (MMMF) = $1000b
Small Time Deposits = $500b
Large Time Deposits = $450b
(a) Calculate M1 for Econometallica.
(b) Calculate M2 for Econometallica.
(c) Using the definition of the money supply in chapter 11 of Hall and Lieberman, what is the money supply for Econometallica?
(d) Which item is not included in the calculations of M1 and M2?
2. Suppose Moey deposits $100,000 in Bank 1 and Ming borrows $80,000 from Bank 1 to buy a Dodge Viper. The required reserve ratio for all banks (set by the Fed) is 20%. Dodge deposits the money from Ming's Viper purchase in Bank 2. Assume that there are no currency drains.
(a) Fill in the following balance sheets, for Bank 1 and Bank 2, respectively:
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Bank 1 's Balance Sheet
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Assets
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Liabilities
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Reserves:
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Demand Deposits:
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Loans:
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Bank 2's Balance Sheet
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Assets
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Liabilities
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Reserves:
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Demand Deposits:
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Loans:
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(b) What is the level of required reserves Bank 1 must hold after Moey's deposit?
(c) What is the level of required reserves Bank 2 must hold after Dodge's deposit?
(d) Are these two Required Reserves the same? If so, why? If not, why not?
3. This question will test your understanding of the DD multiplier (or money multiplier).
Suppose the Fed buys $5000 bonds from Bob. In return for the Bonds it gives Bob a check for $5000. Suppose Bob banks with Bank A, and the RR ratio for all banks is 20%. Assume there are no currency drains in this question and that banks do not hold excess reserves. Answer the following questions.
(a) What will be the change in DD on the balance sheet of Bank A?
(b) What is the total change in required reserves and excess reserves on the balance sheet of Bank A?
(c) Suppose Bank A lends out all their ER to George. What will be the amount of the loan (Hint: Q2 multiple choice might help?)
(d) Suppose that George deposits the loan in Bank B, and Bank B again loans out all its ER from George's deposit to Pete. Again, what will be the amount of the loan? What will be the change in DD on the balance sheet of Bank B?
(e) If this process repeats itself again and again (i.e. Pete deposits all his money in Bank C and Bank C loans out all its ER from Pete's deposit to say, Jay, etc), we need to know the money multiplier. Write out a formula for the money multiplier in terms of the RR ratio.
(f) How much will the money supply increase/decrease in the economy due to this purchase of bonds by the Fed? (Hint: to convince yourself, look at problem 1(c): What happens to the money supply when DD increase/decrease?)
(g) Suppose that instead of having an RR ratio of 20%, the government wants to use a purchase of $5000 worth of bonds to reach an overall increase in the money supply of $35,000. What will be the RR ratio need to be in order to reach that goal?
(h) Finally, suppose that the same goal ($35,000) is to be achieved, but this time the RR ratio is fixed at 20%. How many bonds will the government need to purchase in order to reach their goal?
4. Suppose that the money market of Econometallica has the following money supply and demand equations:
Money Supply: M = 8000
Money Demand: M= 10,000 - 40,000r
Where money is in billions of dollars and interest rates, r , is written as a decimal (e.g., an interest rate of 10% would be written as .1 in the equation).
(a) Sketch the money supply and demand curves, putting the quantity of money on the horizontal axis and the interest rate (in percent) on the vertical axis. Indicate the slope and intercept of each curve.
(b) Calculate the equilibrium interest rate and amount of money.
(c) Give a brief explanation as to why the interest and prices of bonds are negatively related.
(d) Suppose the interest rate in the money market in Econometallica 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?
(e) Suppose that the government of Econometallica likes the interest rate at 10%. What is the amount of increase or decrease in its money supply that will allow it to reach such an interet rate in equilibrium?