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Practice Set - MT 2024

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25 views3 pages

Practice Set - MT 2024

Uploaded by

p24hardikb
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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1.

If the required reserve ratio is 8%, the excess reserve ratio is 2%, and the currency-
deposit ratio is 30%, by how much would money supply change if the Fed made open
market sales valued at $40 million?

The money multiplier is defined as: M/H = mm = (1 + cu)/(cu + re).

In this example the size of the money multiplier is equal to

mm = (1 + 0.3)/(0.3 + 0.08 + 0.02) = (1.3)/(0.4) = 3.25.

Since an open market sale valued at $40 million would decrease high-powered money
(H) by $40 million, money supply (M) would decrease by $130 million, since

M = mm(H) = (3.25)(-40) = - 130.

2. Assume money supply (M) is $1,200 billion, total bank deposits (D) are $800 billion
and the required reserve ratio is 10%. What would the Fed have to do to lower money
supply by 5%? Explain your answer.

We know that money supply is defined as M = CU + D

==> CU = M - D = 1,200 - 800 = 400.

If we assume that banks do not hold excess reserves, then R = (0.1)D = (0.1)800 =
80 and therefore

H = CU + R = 400 + 80 = 480.

The money multiplier can therefore be calculated as M/H = mm = 1,200/480 = 2.5.

If the Fed wants to reduce money supply by 5% (or $60 billion), it has to reduce high-
powered money (H) by $24 billion, by selling $24 billion worth of government bonds. In
other words,

M = mm(H) == > - 60 = 2.5(H) ==> (H) = - 60/2.5 = - 24

3. Assume that bank deposits are $3,200 billion, the required reserve ratio is 10%, and
currency outstanding is $400 billion. What can the Fed do to decrease the money
supply by $100 million?

If the Fed wants to decrease money supply by $100 million, bank reserves have to be
decreased by $20 million through the open market sale of government securities. This can
be shown as:

Ms = Cu + D = 400 + 3,200 = 3,600 and

H = Cu + R = Cu + (0.1)D = 400 + 320 = 720


==> money multiplier = Ms/H = mm = 3,600/720 = 5

==> Ms = mm(H) ==> - 100 = 5(H) ==> H = - 20

Note: We assume here that excess reserves are zero (XR = 0)

4. How does an increase in the currency-deposit ratio affect the money multiplier? What
is the effect of an increase in the reserve ratio?

The money multiplier is defined as mm = (1 + cu)/(cu + re), where

cu = CU/D = currency-deposit ratio, and


re = R/D = reserve ratio.

An increase in the currency-deposit ratio means that people are holding more currency
and banks have fewer funds available for loaning out and creating additional deposits. As
a result, the money multiplier and therefore money supply decreases. An increase in the
reserve ratio means that banks now hold more reserves, so fewer loans and deposits can be
created. Again the money multiplier and money supply decreases.

5. What is the transaction demand for money

People keep money on hand to make purchases. There is a tradeoff between the amount of
interest an individual forgoes by holding money and the costs of holding very small amount
of money. Cost of keeping very small amounts of money is the cost and inconvenience of
frequent transactions to convert bond/higher interest-bearing assets into money. As income
increases people need to more transactions, thus raising demand for money.

6. Suppose the economy is operating at equilibrium with Yo = 1,000, tax rate = 0.25, G =
200, C = 100+ 0.8Yd. If the government increases the tax rate by 0.05 and spending by
50, will the budget surplus/deficit go up or down?

Multiplier = 1/(1-c(1-t)) = 1/(1-0.8(1-0.25)) = 1/0.4 = 2.5


Since Y is 1000, total autonomous spending = 400
Now G increases by 50, and tax rates goes up by 5%
New A = 450, Multiplier = (1/(1- 0.8(1- 0.3)) = 1/0.44 = 2.27
Y = 450 * 2.27 = 1022.77
Income tax: 1022.77 * 0.3 = 306.81
Previous income tax = 250
Change in fiscal/budget surplus = 306.81 – 250 – 50 = 6.81

7. Money demand and supply are given by the equations (interest rate is measured as a
percentage)

(M/P)d = 0.25Y – 10 r
(M/P)s = 500
2
(i) Derive the LM relation for this economy.

Y = 2000 + 40r

(ii) As per quantity theory, money demand depends only on income. Derive the LM curve using
above equations and the QT assumption.

Try yourself

8. Consider the money market equilibrium and the LM curve. Due to uncertainty assume
that people would like to hold less money at any given level of income. As a result, the LM
curve will

(i) Shift to right/down


(ii) Shift to left/up
(iii) Not shift since money supply has not changed
(iv) None of the above

Ans: (i)

9. In the simple Keynesian model with MPC = 0.5, assume that autonomous
consumption and govt. expenditure both increase by an amount x. Then, [express all
answers in terms of x]

(i) Income will increase by =


(ii) Household saving will increase by =
(iii) Govt. saving will increase by =
(iv) Investment will increase by =

[4x, x, – x, 0]

10. In the simple Keynesian model assume that (only) MPC increases from 0.5 to 0.75.
Then,

(i) Income will increase/decrease/remain the same


(ii) Household saving will increase/decrease/remain the same
(iii) Household consumption will increase/decrease/remain the same
(iv) Investment will increase/decrease/remain the same

[increase, same, increase, same]

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