Answer Sheet Assignment-3 ECO-104

2. If the Fed wants to increase the supply of money with open-market operations, it purchases U.S. government bonds from the public on the open market. The purchase increases the number of dollars in the hands of the public, thus raising the money supply. The money creation process: Do it from textbook. 3. Banks do not hold 100% reserves because it is more profitable to use the reserves to make loans, which earn interest, instead of leaving the money as reserves, which earn no interest. The amount of reserves banks hold is related to the amount of money the banking system creates through the money multiplier. The smaller the fraction of reserves banks hold, the larger the money multiplier, because each dollar of reserves is used to create more money 4. a) The discount rate is the interest rate on loans that the Federal Reserve makes to banks. If the Fed raises the discount rate, fewer banks will borrow from the Fed, so both banks' reserves and the money supply will be lower. b) Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.

An increase in reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply. 5. The central bank cannot control the money supply perfectly because: (1) Central bank does not control the amount of money that households choose to hold as deposits in banks; and (2) Central bank does not control the amount that bankers choose to lend. The actions of households and banks affect the money supply in ways the central bank cannot perfectly control or predict. 6. The $100 is a deposit on which the bank must hold required reserves of $10 (10% of $100). The remaining $90 may be loaned out. The multiplier in this case is 1/0.10 = 10 so the maximum amount of deposits that can be created is $90 x 10 = $900. The assumes that there are no currency drains and that banks do not hold excess reserves. 7. With a required reserve ratio of 10%, the money multiplier could be as high as 1/.10 = 10, if banks hold no excess reserves and people do not keep some additional currency. So the maximum increase in the money supply from a $10 million open-market purchase is $100 million. The smallest possible increase is $10 million if all of the money is held by banks as excess reserves. 8. a. If people hold all money as currency, the quantity of money is $2,000. b. If people hold all money as demand deposits at banks with 100% reserves, the quantity of money is $2,000. c. If people have $1,000 in currency and $1,000 in demand deposits, the quantity of money is $2,000.

d. If banks have a reserve ratio of 10%, the money multiplier is 1/.10 = 10. So if people hold all money as demand deposits, the quantity of money is 10 x $2,000 = $20,000. e. If people hold equal amounts of currency (C) and demand deposits (D) and the money multiplier for reserves is 10, then two equations must be satisfied: (1) C = D, so that people have equal amounts of currency and demand deposits; and (2) 10 x ($2,000 C) = D, so that the money multiplier (10) times the number of dollar bills that are not being held by people ($2,000 C) equals the amount of demand deposits (D). Using the first equation in the second gives 10 x ($2,000 D) = D, or $20,000 10D = D, or $20,000 = 11 D, so D = $1,818.18. Then C = $1,818.18. The quantity of money is C + D = $3,636.36. 9. In this problem, all amounts are shown in billions. a. Nominal GDP = P x Y = $10,000 and Y = real GDP = $5,000, so P = (P x Y )/Y = $10,000/$5,000 = 2. Because M x V = P x Y, then V = (P x Y )/M = $10,000/$500 = 20. b. If M and V are unchanged and Y rises by 5%, then because M x V = P x Y, P must fall by 5%. As a result, nominal GDP is unchanged. c. To keep the price level stable, the Fed must increase the money supply by 5%, matching the increase in real GDP. Then, because velocity is unchanged, the price level will be stable. d. If the Fed wants inflation to be 10%, it will need to increase the money supply 15%. Thus M x V will rise 15%, causing P x Y to rise 15%, with a 10% increase in prices and a 5% rise in real GDP. 10. a. If people need to hold less cash, the demand for money shifts to the left, because there will be less money demanded at any price level. b. If the Fed does not respond to this event, the shift to the left of the demand for money combined with no change in the supply of money leads to a decline in

the value of money (1/P), which means the price level rises, as shown in Figure 1.

Figure-1 c. If the Fed wants to keep the price level stable, it should reduce the money supply from S1 to S2 in Figure 2. This would cause the supply of money to shift to the left by the same amount that the demand for money shifted, resulting in no change in the value of money and the price level. Figure-2

11. The federal government uses macroeconomic policies to offset the effects of the business cycle on the economy. When the economy is in recession, increases in government purchases or decreases in taxes will increase aggregate demand. Decreasing government purchases or raising taxes will slow the growth of aggregate demand and reduce the inflation rate.

12. a. The supply of labor will increase. The supply of labor curve will shift rightward. The supply of labor increases because at each real wage rate, the aftertax wage rate received by workers will be higher given a decrease in the tax rate on labor income.

Real Wage Rate Increase in the supply of labour

Labour

b. The demand for labor will remain the same. The demand for labor depends on the productivity of labor, which remains the same following the decrease in the tax rate on labor income. c. The equilibrium level of employment will increase. With the rightward shift in the supply of labor curve, the real wage rate decreases and the quantity of labor demanded increases along the demand for labor curve. Equilibrium employment increases.

Real Wage Rate Increase in the equilibrium employment

Labor

d. The equilibrium pre-tax wage rate will decrease. The rightward shift of the supply of labor curve leads to movement down along the demand for labor curve.

Real Wage Rate

Decrease in the equilibrium employment

Labour

e. The equilibrium after-tax wage rate will increase. The decrease in the tax rate on labor income decreases the wedge between the pre-tax wage rate and the after-tax

wage rate. The pre-tax wage rate decreases but not by as much as the decrease in tax. So the after-tax wage rate will increase.
LS+TAX LS(less tax) Real Wage Rate LS Increase in the equilibrium after tax wage rate

Labour

f. Potential GDP will increase. The equilibrium level of employment is the full employment. So as full employment increases, potential GDP increases along the production function.

Real Wage Rate

Labour
Real Wage Rate

Increase in Potential GDP

Labour

19. If inflation is running high, the Fed will raise interest rates, sell bonds on the open market, and raise the reserve ratio (if it comes to that. It rarely ever does). Raising interest rates makes money "more rare". Selling bonds decreases the reserves of banks, which decreases their lending capabilities (again, making money rarer). The reserve ratio is the "nuclear option" of monetary policy. It specifically changes how much money banks have to keep on hand. If it changes, the money multiplier changes. In other words, the Fed would raise the reserve ratio in order to fight inflation. A second opinion:

The Federal Reserve is in charge of the money supply. They can increase it or decrease it by three methods. Each bank may be required to adjust their Reserves on hand. Discount Rate maybe adjusted, the rate the fed pays banks for loans banks have that they wish to sell to the Fed. Usually a lower rate, so banks want more of them. Open Market Operations where the Fed sells treasury bills or bonds. Higher reserves takes money out of circulation, the Fed loans banks to increase the money supply, and lastly the Fed sells T Bills to decrease the money supply. More rare is not a function. They directly influence the quantity of money (M1, M2, & M3) circulating.