HW07_IS_a.docFoundations of Economic AnalysisStratton

Homework #8Name ______

Objective: to provide practice and assessment of your understanding of the role of money and “money markets” in the U.S. Your ability to demonstrate understanding, insight and/or the ability to use the material is the primary purpose of the assessment. Thus full credit will only be earned if you follow the directions carefully and provide the explanation, description, and thought process as directed. Each numbered question is worth 2 points – total 50 points.

Instructions:In your own words compare and contrast or distinguish between the members of eachpair of termsin the space provided or attach additional sheets if necessary.

Terms:

  1. Money as medium of exchange and Money as store of value
  2. M1 and M2
  3. Commercial Banks and The Federal Reserve System
  4. The discount rate and the federal funds rate
  5. Federal Open Market Committee and The Federal Reserve Board of Governors
  6. Monetary base and M1
  7. Reserve requirement and the simple deposit multiplier

Short Answer Questions: Answer each question, indicating any assumptions you make, explaining your thinking, and showing all work where appropriate.

  1. Briefly describe how commercial banks create money.
  2. Explain the impact an increase in the reserve requirement on the money multiplier (mm).
  3. Cheryl decides to keep $1000 in her checking account at National City Bank rather than buy a $1000 government bond paying 7 percent per year. If the inflation rate is 4 percent per year, calculate Cheryl’s opportunity cost of holding the $1000 as money.
  4. Consider a money market in which a recent increase in the demand for money has caused the real current interest rate to be below the equilibrium real interest rate. Explain how this market will move toward equilibrium. [Hint: First determine if there is currently a shortage or surplus in this market, than use that information to explain the adjustment process.)
  5. The concept of elasticity measures how responsive one variable is to changes in another. We can define the interest rate elasticity of the demand for money as the ratio of the % change in Md caused by the % change in interest rates [% Md / %r]. How does the interest rate elasticity of the demand for money affect the responsiveness of changes in the real income (Y) to changes in the real interest rate along the LM curve?

Scenario 1:Use the following information for the all of the questions in this scenario. Answer each question, indicating any assumptions you make, explaining your thinking, and showing all work where appropriate.

For simplicity, assume that Akropolis has only 12 commercial banks and each bank begins with identical balance sheets. The non-banking public holds $100 million of currency and Federal Reserve requirement is 10%.

First National Bank is one of the 12 banks; it has the following simplified balance sheet.

First National Bank
Sheet #1
ASSETS / LIABILITIES
Cash in vault $2 million / Checkable Deposits $50 million
Reserves at Cleveland Fed $3 million
TOTAL Reserves
Loans $25 million
Gov’t. Securities $20 million / Owner’s Equity $25 million
Property & Equipment $25 million
Total $75 million / Total $75 million
  1. Calculate the value of total reserves held by your bank.
  2. Calculate the value of the bank’s required reserves.
  3. Remembering that there 12 banks and the public holds $100 million in currency, what is the total money supply in Akropolis?
  4. Calculate the simple deposit multiplier (d)..
  5. Calculate the actual money multiplier (mm) to 3 decimal places.

A customer deposits $1 millioninFirst National Bank. Assume this is some of the currency originally held by the non-banking public.

  1. What is the maximum dollar amount First National Bank can loan?
  2. What is the maximum change in the money stock (supply) caused by the $1 million deposit? [Hint: use the simple money multiplier]
  3. What is your best estimate of the actual change in the money stock (supply) caused by the $1 million deposit? [Hint: use the money multiplier (mm)]

Scenario 2:Use the following information for the all of the questions in this scenario. Answer each question, indicating any assumptions you make, explaining your thinking, and showing all work where appropriate.

For simplicity, assume that Akropolis has only 12 commercial banks and each bank begins with identical balance sheets. There are no excess reserves in the system. The non-banking public holds $120 million of currency and Federal Reserve requirement is 10%. Thus the current money stock (supply) is $720 million and the monetary base is $180 million.

First National Bank is one of the 12 banks; it has the following simplified balance sheet.

First National Bank
Sheet #2
ASSETS / LIABILITIES
Cash in vault $2 million / Checkable Deposits $50 million
Reserves at Cleveland Fed $3 million
TOTAL Reserves
Loans $25 million
Gov’t. Securities $20 million / Owner’s Equity $25 million
Property & Equipment $25 million
Total $75 million / Total $75 million
  1. Calculate the actual money multiplier (mm) to 3 decimal places.
  2. What is your best estimate of the potentialchange in the money stock (supply) caused by the federal open market committee purchase of $10 million of government securities.
  3. Independent of the previous question, calculate the potentialchange in the money stock (supply) caused by the increase in the reserve requirement to 10.5%. Assume all banks adjust their assets by selling government securities.

Scenario3:Explain impact of each of the following changes on real demand for money (RLMD), real money supply (RLMS) and real GDP suggested by the LM model.Be sure to answer the questions as completely as you can and to show your work!

  1. “The Conference Board Consumer Confidence Index, which had rebounded in August, plummeted in September. The Index now stands at 86.6 (1985=100), down from 105.5 in August. The Expectations Index fell to 71.7 from 93.3 last month.” (September 27, 2005)
  2. “After 11 straight quarter-percentage point steps, they [the federal funds rate] now stand at 3.75 percent and financial markets see them hitting 4.5 percent before the Fed calls off its rate-rise campaign.”October 20, 2005)

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