Free Response

1. Free Response Macro Unit #5

2. 1) The Bank of Redwood has 1,000,000 in total reserves and the reserve ratio is 20%. • Draw a correctly labeled T-account which illustrates the current financial position at the Bank of Redwood assuming they have no excess reserves. • Bob deposits $10,000 of currency into Bank of Redwood High School • Show calculations for the change in money supply in the entire banking system caused from this deposit. • (assume no excess reserves are kept in the banking system) • The Federal Reserve purchases $20,000 worth of Government Securities (bonds) • Show calculations for the change in money supply created by this purchase • (assume no excess reserves are kept in the banking system) • State how much money supply changes if the Fed purchases $10,000 in bonds with a 100% reserve requirement? • Briefly explain your answer • ============================================================================ • 2) The U.S. economy is operating above full potential output • Draw a correctly labeled AD/AS model to illustrate the economic situation described above • show the current equilibrium price level & real GDP • Draw a correctly labeled Money Market graph to illustrate a current equilibrium • State the type of monetary policy the Federal Reserve should use in the described situation. • State how the Fed would adjust each tool of monetary policy listed below to solve our current economic problem • Reserve requirement • Discount rate- • Open Market Operations • Modify both the AD/AS graph and the Money Market graph for the effect of this monetary policy • Briefly Explain the reasons for any short run effect of this monetary policy on Aggregate Demand (AD) • Briefly Explain the short run effect of this monetary policy on unemployment & inflation • Clearly Explain how open market operations effects money supply and interest rates • Hint: Be sure to discuss the type of interest rate in the money market & it’s role in our economy • =================================================================================== • 3) Monetarism • Write the Equation of Exchange and state what each variable stands for • Clearly Explain what a monetarist economist believes when they say “ money is neutral” • Hint: describe what “monetarism” believes in…. • Holding everything else constant, if the Velocity of Money suddenly fell by 50%, briefly explain how the • Federal Reserve would most likely respond to this event. • ===================================================================================

3. d) a) $10,000 i) Banks can not lend out money with a 100% r.r. so there is no expansion in loans However, Fed money used in purchase of bonds is not currently in the $ supply, so MS ↑ $10,000 (magic money!) Required Reserves Deposits $200,000 $1,000,000 Loans $800,000 Total Assets Total Liabilities $1,000,000 $1,000,000 Assets Liabilities b) $10,000 Deposit $8,000 Excess Reserves 1/.20 = 5 Multiplier $8,000 * 5 = $40,000 c) $20,000 Purchase by FED $16,000 Excess Reserves 1/.20 = 5 Multiplier $16,000 * 5 = $80,000 + 20,000 = $100,000 Free Response Problem #1 25 pts

4. LRAS 1 SRAS 1 Price Level -------- P2 AD 1 Y2 Real GDP Free Response Problem #2 30PTS • Must show an inflationary Gap • F) AD shifts left B)Must have nominal i-rate E) MS must shift left MS MS Nominal 2 2 MS1 Interest Rate ------------ P1 --------- A i2 --------- B ----------- ---------- AD2 4% MD Y1 Qty of $ C) Contractionary D) i) R.R. increases ii) Disc. Rate increases iii) Sell Bonds F)When MS ↓ nominal interest rates ↑ => more expensive for business to borrow => business net investment (I) declines => decreases AD G) AD shifts left which lowers the price level and therefore inflation. Based on the short run Phillips Curve unemployment & inflation have an inverse relationship, so unemployment must ↑ H) Open Market Operations is when the Fed purchases or sell bonds in the open market. When they buy bonds money flows into the banking system from Fed’s vault & bonds flow into Fed. This “new” money causes MS to rise in the money market & nominal interest rates fall. Lower interest rates will make it less expensive to borrow money and therefore directly impact investment spending & AD. In this way, the Fed has an impact on the growth rate of an economy in the short run.

5. Free Response Problem #3 20 pts • a) MV = PY • Money Supply Velocity Price Level Real GDP(must say real or -2) • b) Monetarist economists believe that Money is Neutral. This means that money supply has no effect on real GDP. That is, printing money will not—by itself—increase a countries ability to produce goods and services (shift our PPF curve) • Monetarist believe in the Quantity Theory of Money where Velocity is constant. Therefore an increase in money supply (M) of 20% in the above equation will increase price level by the same amount.(one ↑ 20%, the other must ↑ 20%) (Money is neutral meaning it has no affect on real variables) • This increase will have no affect on real GDP as money is neutral! c) If the Velocity of money fell 50%, then the real money supply also declined by 50% So the Fed would double the money supply which would keep nominal output the same Example: M = 10 V =2 MV = 20 then V falls 50% so: M=20 V = 1 = MV = 20