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Economics 116b
Spring 2001
Problem Set 6
Suggested Answers
1. All other things being equal, how would each of the following affect the demand
for M1? Explain briefly.
(a) An increase in GDP: demand for M1 increases; more money is needed to
conduct (an increased number of) transactions
(b) An increase in the price level: demand for M1 increases; more money
required to conduct the same transactions
(c) A crack-down reduces the underground drug trade: demand for M1
decreases; the drug trade uses a lot of cash, and this crack-down will
lessen the demand for cash for these transactions
(d) Home equity lines of credit that allow homeowners to write checks against
the value of their homes are introduced: demand for M1 decreases; these
checks will be used in place of cash and traditional checkable deposits (the
components of M1)
2. The quantity of M1 is $12 million, currency held by the public is $2 million, and
the reserve-deposit ratio is 0.2. Find the quantity of bank deposits, bank reserves,
the monetary base, and the money multiplier.
Bank deposits:
Bank reserves:
Monetary base:
Money multiplier:
M1 – currency = 12 – 2 = $10 m.
res * deposits = .2 * 10 = $2 m.
currency + reserves = 2 + 2 = $4 m.
M1/MB = 12/4 = 3
3. Suppose the economy is initially in equilibrium. For each of the shocks listed
below, explain the effects on output and the price level. If you shift a curve,
please briefly explain. Assume the AS curve is upward sloping as discussed in
Samuelson-Nordhaus.
(a) A stock market crash reduces consumers’ desire to spend. In the multiplier
model, this decrease in C lowers the C+I+G curve, resulting in lower
output. AD shifts in, reflecting the lower output and indicating a decrease
in the price level.
(b) There is an outbreak of “irrational torpidity” (i.e. business expectations
about the future become more pessimistic). Recall problem set 4: this
pessimism reduces investment demand. This results in a shift in of the
investment demand curve (less investment for all interest rates). This fall
in I lowers the curve in the multiplier model. AD shifts in, reflecting the
lower output and indicating a decrease in the price level.
(c) A nuclear mishap in New Jersey wipes out ¼ of the country’s capital
stock. AS is a function of technology, land, labor and capital. This
reduction in capital stock will cause the AS curve to shift in, lowering
Economics 116b
Spring 2001
output and raising the price level. [Also note another effect of this
reduction of capital stock: lower levels of capital mean that the return on
capital is greater. Thus the investment demand curve shifts out. Higher
levels of investment cause a shift up of the curve in the multiplier model
(increasing output). AD shifts out, reflecting the higher output and
indicating an increase in the price level. Note, however, that on exams in
this class we are only going to shift one curve at a time.]
(d) Productivity increases. AS shifts out, increasing output and lowering the
price level. AS is a function of land, labor, capital, and technology;
increased productivity can be thought of as an increase in technology.
Increased productivity increases potential GDP.
Note: for these questions, it may be helpful to refer students to the “Components
of Aggregate Demand” figure on p. 131.
4. What happened to output and price level during the Great Depression? Would you
conclude the Great Depression was due to an aggregate demand shock or an
aggregate supply shock? Explain.
Output and price level both fell during the Great Depression. Thus it appears as
though the Great Depression was caused by an aggregate demand shock. A shift
in of the AD curve lowers output and prices.
P r ic e le v e l
Potential
output
AS
E
P*
E
AD
AD'
Q*
Real Output
5. Suppose faith in the U.S. banking system starts to deteriorate. (N.B. This
happened during the 1930s – see the graphs on the web.) Consequently,
households and firms reduce their bank deposits and hold a larger share of their
money in the form of currency.
Economics 116b
Spring 2001
(a) If this occurs and the Federal Reserve does nothing in response, what will
happen to the money multiplier for M1, the supply of M1, and the nominal
interest rate? Explain briefly.
The money multiplier for M1 decreases. One way of thinking about this is
as follows: the new desire to hold more currency means that any new bank
deposit will not be circulated through the banking system to the same
degree (the intuitive explanation of the money-supply multiplier relies on
people getting loans then re-depositing them so the banks can then re-lend
the money). As money is withdrawn from banks, the money supply
contracts (reverse multiplier process) and the supply of M1 thus decreases.
A decrease in the money supply will raise the nominal interest rate (Ms
shifts in).
(b) Suppose the Fed wants to keep output fixed at its current level. What, if
anything, should the Fed do to the monetary base in response to this desire
of households and firms to hold a larger fractions of their money in the
form of currency? Explain.
The Fed should utilize open market operations (the purchase of bonds) in
order to increase the monetary base. By shifting Ms out, this will
counteract the rise in interest rates described in part (a). Thus investment
levels can be maintained as they were before. This will prevent AD and
output from falling.