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Friday, 30 May 2014 11:57

Homework Assignment No. 2 Featured

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Homework Assignment No. 2

Qn. 1

In January 2010 the Bank de Japan (the Central Bank of Japan) reported that bills and coins outside the banks were 350 billion. Japanese banks had checkable deposits of 100 billion and savings deposits and time deposits of 1500 billion. Currency inside the banks was 30 billion. Japanese banks had deposits at the Bank of Japan of 296 billion. Calculate:

a. The bank’s reserves_____ 326 billion_________

=Currency + bank deposits

=30 billion + 296 billion

= 326 billion

b. The monetary base_______ 380 billion ________

=currency (bills and coins) + bank reserves

=350 billion + 326 billion

=676 billion

Monetary base = currency (bills and coins) + bank reserves

c. M1_______ 130 billion________

= checkable deposits + currency

=100billion + 30 billion

=130 billion

d. M2_______1630 billion ________

M2 = M1 + savings deposits, small time deposits, money market funds

= 130 billion + 1500 billion

Qn. 2

List the policy tools available to the Fed and sketch the way in which each tool works to change the supply of money.

  1. Open market operations
  2. Required reserve ratios
  3. Discount rate
    1. Plot the Phillips curve and the aggregate supply curve for 2008.
    2. Suppose the natural rate of unemployment is 6 percent in 2007. What is the expected inflation rate? ____ 1.93%_____
    3. Calculate Antarctica’s current account balance_____ -$100 billion ________
    4. Calculate Antarctica’s capital/financial account balance______ $70 billion________
    5. Even though the US offers very low interest rates, the US dollar has been appreciating with respect to currencies of developing countries. Why? Illustrate your answer with a graph.

This is the purchase or sale of government securities (treasury bonds and bills) in the open market by the Federal Reserve. It is used to increase or decrease the money supply.

     Government securities

                                                Money Supply

This is the percentage of deposits a bank must hold as reserves. An increase in the reserve ratio lowers the money multiplier and money supply.

                               Required Reserve Ratio


      Money Supply

Discount rate is the interest rate at which the Federal Reserve lends to commercial banks. A low discount rate makes increase money supply by making it cheaper for banks to borrow money from the Federal Reserve.

                              Discount Rate


                                                  Money Supply

Qn. 3

The First Student Bank has the following balance sheet (in millions of dollars)





Reserves at the Fed



Demand deposits


Cash in ATM's



Savings deposit


Government Securities







The required reserve ratio on all deposits is 5 percent

a. What, if any, are the bank’s excess reserves? ____ $21.5 million __________

Required reserves = $90 million × 5% = $4.5 million

Actual reserves = $25 million

Excess reserves = $25 million - $4.5 million

= $21.5 million

b. What is the bank’s deposit multiplier? _____20_________

The bank’s deposit multiplier = 1/r


= 20

 c. How much will the bank loan? _____ $21.5 million ________

The First student bank will loan its excess reserve, i.e. $21.5 million

d. How much money will be created from the funds loaned in c)? _____ $1 million________

Money created = 20 × 1/20

= $1 million

Qn. 4

The Fed conducts an open market purchase of securities. Indicate (up, down, unchanged etc) the effects of this action in the short-run.

a. The quantity of money supplied _____Up____________

b. The quantity of money demanded_______   UP__________

c. The nominal interest rate_______ Down__________

d. The real interest rate_______ Unchanged __________

Qn. 5

If the velocity of circulation is constant, real GDP is growing at 3 percent a year, the real interest rate is 2 percent a year, and the nominal interest rate is 7 percent a year.

a. What is the inflation rate? _____5%_________

Nominal interest rate = real interest rate + Inflation

Inflation rate = 7%-2%

= 5%

 b. What is the growth rate of money? ______ 8%________

Money growth + Velocity growth = Inflation rate + Real GDP growth

Since the velocity of circulation is constant = Money growth= Inflation + Real GDP growth


= 8%

c. What is the growth rate of nominal GDP? ______ 10%________

= Nominal inflation rate + Real GDP growth



 Qn. 6

Where does money come from? Watch the video to answer the question

The Federal Reserve creates money by lending imaginary amounts of money to commercial banks. As the money is lent through the monetary system, money is created. Alternatively, this can be explained using deposit. When an individual or any other entity makes a deposit at a bank, the deposit multiplies as it moves throughout the monetary system. For example, a $50 deposit can be transformed to a $1000. The multiplication depends on certain conditions, but this the process of how money is created.

  Qn. 7

In 2009, the United States is in a recession. Then the following measures are implemented: 

a. The Fed increases the quantity of money, and all other influences on aggregate demand remain the same. Illustrate the effect of the increase in the quantity of money on aggregate demand in the short-run. Indicate the change in real GDP, the price level and unemployment rate.

An increase in the quantity of money increases aggregate demand and shifts the aggregate demand curve rightward. Employment will increase.

  b. The federal government cuts taxes, and all other influences on aggregate demand remain the same. Illustrate the effect of the tax cut on aggregate demand in the short-run. Indicate the change in real GDP, the price level and unemployment rate.

 Tax cuts increases aggregate demand and consumption. From the resulting increase in investment employment also increases.


                                                 Ye          Yf

Qn. 8

In a deep recession, the FED, Congress, and the White House are discussing ways of restoring full employment. The President wants to stimulate aggregate demand but to do so in a way that will give the best chance of boosting investment and long-run economic growth.

 a. Would a tax cut best meet the President’s objectives? Explain

Yes. Tax cut is an expansionary fiscal tool.  Tax reduction will stimulate the aggregate demand more rapidly that increased government spending.  Unlike government spending, tax cuts have an immediate impact on the financial position of families. Projects associated with increased government spending takes time to implement and to have an impact. In addition, tax cuts are less likely to induce structural unemployment and reduced productivity like the case with government spending.  Households tend to purchase items that are valued higher than the cost of production as their spending increases due to reduced taxes.  The other aspect, it is easy to reverse tax rates once the economy recovers. Government projects are difficult to reverse. Lastly, taxes increase the incentive to earn, make investments, and participate in business activity and employ other people.

 b. Would an increase in government purchases best meet the President’s objectives? Explain

            An increase in the government purchases would help meet the president’s objective. The government purchase of items such as new highways, weapons, and other purchases increase aggregate demand. This is because an increase in government purchases increases the private sector growth due to increased government contracts to the private sector. This spurs employment, better wages, and increased consumption.

 c. Would an increase in the quantity of money and cut in the federal funds rate best meet the President’s objectives?

Reducing taxes and increasing the quantity of money would not be the best option for the president. This is because of the effect of the interest rate. The government will be required to increase its borrowing in order to cover for budget deficits that result from increased government spending. This leads to increased interest rates, which discourage aggregate demand and employment.

 Qn. 9

The California State government is proposing decreasing its expenditures and increasing taxes. Indicate the likely effect of this measure on:

a. Aggregate demand_____ Reduces_________

b. Real GDP________ Reduces______

c. Unemployment rate _______ Increases______

d. The government’s budget _____ Reduces_______

 Qn. 10

Some commentators argue that the economy can recover from the recession without increasing the money supply and government spending. Agree/Disagree. Explain.

I agree. This is because an increase in government spending and an increase in money supply cannot stimulate output and employment. For example, there is the effect of the interest rate. An increase in borrowing is required to finance budget deficits. The problem is that when governments increase their borrowing from the funds market, the interest rate will increase.  The increase in interest rate will discourage private investment and consumption.  This reduction in private investment and consumption is likely to offset the intended stimulus effects of increasing government spending. The result is an increase in government debts, which in turn lead to an increase in taxes to cover the cost of interest. Therefore, the expectation of future higher taxes will discourage private investment. Therefore, potency of expansionary fiscal policy in a recession is in question.

 Qn. 11

The Table below describes four possible situations that might arise in 2009, depending on the level of aggregate demand in this year.


Price level (2008=100

Real GDP (trillions of 2008 dollars)

Unemployment rate (percent labor force)

Inflation (calculated)


























Explanation: From the Phillips curve the inflation rate that corresponds to 6% unemployment is 1.93%.

  Qn. 12

The following data describes the economy of Antarctica in 2050:


Billions (Antarctica dollars)

Imports of goods and services


Exports of goods and services


Foreign investment in Antarctica


Antarctica's investment abroad




Explanation = the current Account Balance (CAB) = Exports-Imports=Net Exports (NX)

= $50-$150=-$100 billion Antarctica dollars

The Capital Account Balance = Foreign investment in Antarctica – Antarctica’s investment abroad

= $125billion-$55billion



c. Is the country experiencing a balance of payments crisis? Explain

The country is experiencing a balance of payment crisis. This is because the capital account balance cannot the current account balance by a positive margin. The country’s net interest payment is negative, i.e. $70 billion minus $100 billion is -$30 billion. The current account balance is in short of $30 billion to attain equilibrium.

Qn. 13: Foreign exchange market

a. Show graphically and explain the effect of an increase in US interest rates on the demand and supply of dollars. Indicate the resulting change in the exchange rate of Euros per U.S. dollars (appreciates, depreciates). 

Price level




                                                      AD1                              Real GDP

Explanation: An increase in interest rate decreases investment and consumption expenditure. In addition, it leads to a high U.S. exchange rate. For example, the U.S dollar appreciates, meaning that the dollar will gain against the Euro.  This is shown in the next graph. This decreases the U.S. net exports. The aggregate demand decreases, i.e. shifts to the left.

Exchange rate (Euros per dollar)




The developing countries have markets that are imperfect.  Due to a low interest rate in the U.S. production is stimulated. Countries in the developing world will increase their imports from the United States because of the low prices that they can pay for U.S. exports.  However, in order to remain competitive, producers in developing countries lower their prices. This will lead them to produce less, which affects the exchange rates, increasing the exchange rate of the developing country currency per unit of dollar.

Exchange rate (Developing Country currency per dollar)







  1. The current required reserve ratio is 0.1. It has not been changed for the last three years.
  2. The current discount rate is 0.75%. It has not changed for the last three years.
  3. Open market operations involve the purchase and sale of securities by the Federal Reserve.  The objective of this monetary tool is set by the Federal Open Market Committee.  It is used to adjust reserve balance supply, in order to keep the interest rate at the target established by the committee.
  4. Traditionally, the Federal Reserve has implemented monitory policy using open market operations as the primary tool. It has always involved the purchase and sale of the United States Treasury securities. Traditionally, the Federal Reserve has set an interest rate to seek to fulfill its statutory mandate of stable prices, maximum employment, and moderate long-term interest rates. However, recently, the approach has changed. The Federal response to the financial crisis utilized new approaches.  The Federal Reserve create additional methods of injecting reserves, liquidity, and credit into the financial system, as well as providing loans to institutions that are not banks. As conditions became normal, institutions that got loans during the recession period repaid them with interests. The response was satisfactory because it normalized institutions that would affect banks eventually.


  1. The data reflects the monetary base for January of every year between 2001 and 2013.


Adjusted Monetary Base



























  1. Graph
  1. Adjusted monetary base is the total sum of currency, including coins, in circulation outside the U.S Treasury and the Federal Reserve Bank. From the graph, it can be seen that the adjusted federal monetary base has been increasing over the years. Until 2008, the increase has been moderate, but afterwards there was a sharp annual increase in the adjusted monetary base.  Perhaps this reflects the financial crises that the country witnessed starting 2008. This indicates an increase in government spending over the last years.
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