Download AP Macroeconomics Unit 4 Review Session Money Market

AP Macroeconomics Unit 4 Review Session
Money Market
1.
Draw the money market, indicating the equilibrium interest rate and quantity.
2.
Use the following table to answer this question.
Change
Decrease in aggregate price level
Increase in interest rate
Effect on real money demand
Has no effect
Causes movement along the real money
demand curve
Change in regulation so that interest is
Shift real money demand curve to the
now allowed on checking accounts
right
a. In the table above, enter how each scenario will affect nominal money demand and real money demand.
b. Explain why a change in the aggregate price level affects the nominal demand curve differently from the way it
affects the real money demand curve. When the agg price level changes, the nominal money demand curve does
not automatically take into account the effect of this change in prices on the nominal demand for money. For
example, as the aggregate price level rises, people will find that, due to the increase in the aggregate price level,
they need to hold greater amounts of money in order to make their transactions. This causes the nominal money
demand curve to shift to the right; people demand a greater quantity of nominal money at every interest rate. In
contrast, the real money demand curve automatically takes into account any change in the agg price level; a
change in the agg price level requires a proportionately equal change in the nominal quantity of money in order
that the real quantity of money is unchanged.
3.
Effect on nominal money demand
Shift nominal money demand to left
Cause movement along the nominal
money demand curve
Shift nominal money demand to right
Use the following figure of the nominal demand and money supply curves to answer these questions. Assume this market is
initially in equilibrium with the nominal quantity of money equal to M 1 and the interest rate equal to r1.
a.
Suppose the Federal Reserve engages in an open-market purchase of Treasury bills. Holding everything else
constant, what happens to the equilibrium quantity of money and the equilibrium interest rate? Sketch a graph
illustrating these changes. Money supply increases, resulting in a decrease in equilibrium interest rate and increase
in equilibrium quantity.
b.
Suppose the Fed engages in an open-market sale of Treasury bills. Holding everything else constant, what happens
to the equilibrium quantity of money and the equilibrium interest rate? Sketch a graph illustrating these changes.
MS shifts left. Interest rates increase and quantity of money decreases.
c.
Suppose the aggregate price level increases. Holding everything else constant, what happens to the equilibrium
quantity of money and the equilibrium interest rate? Sketch a graph illustrating these changes.
Money demand curve shifts to the right, causing interest rates to decrease while equilibrium quantity of money is
unchanged.
Loanable Funds Market
4.
Draw the loanable funds market, indicating the equilibrium interest rate and quantity.
5.
For each of the following situations, state the effect on the equilibrium interest rate and the equilibrium quantity of
loanable funds. In your answer, make reference to how the demand and supply curves in the loanable funds market are
affected. Hold everything else constant.
a. Capital inflows into a country increase. Shift supply of loanable funds to the right.
b. The government reduces the government deficit. Demand for LF from the government has diminished. This will
cause Dlf curve to shift to the left, resulting in a decrease in both interest rate and quantity. But because interest
rate is now lower, the quantity of LF for private investment spending will increase.
c. There is an increase in the expected inflation rate. (Comment on both real and nominal interest rate in your
answer.) Both demand and supply curves for LF will shift due to changes in expected inflation. D shifts right,
reflecting fact that borrowers are willing to borrow just as much as they did at the original nominal interest rate as
they are now willing to borrow at the higher nominal interest rate. (Remember that the real interest rate is the
nom interest rate minus inflation rate). S shifts left because lenders now are willing to lend the same amount of
funds only if the nominal interest rate they receive reflects the new higher expected inflation rate. Both curves
shift, resulting in the nom interest rate rising by the amount of the change in expected inflation. No change in Qlf.
d. Private savings increase. S shifts right
e. Perceived business opportunities decrease. D shifts left
Monetary Policy
6.
The economy of Macroland is initially in long-run equilibrium. Then the central bank of Macroland decides to reduce
interest rates through an open-market operation.
a. Draw an AD-AS graph representing the initial situation in Macroland. On your graph, be sure to include the SRAS,
LRAS, and AD. Mark the equilibrium aggregate price level and the aggregate output level as well as potential
output.
b.
Draw a graph of the money market depicting Macroland’s initial situation before the central bank engages in
monetary policy, as well as the effect of the monetary policy actions. Be sure to indicate the initial equilibrium, as
well as the equilibrium after the monetary policy.
c.
How does this monetary policy action affect the aggregate economy in the short run? Explain, including a graph of
the AD-AS model to illustrate your answer. Agg demand increases and causes the AD curve to shift to the right. In
the short run, this causes output and price level to increase.
How does this monetary policy action affect the aggregate economy in the long run? The economy must return to
producing its potential output. This occurs as SRAS shifts to the left, eliminating the inflationary gap, restoring
economy back to potential output.
d.
7.
The economy of Macroland is initially in long-run equilibrium. Then the central bank of Macroland decides to sell Treasury
bills on the open market.
a.
b.
c.
d.
Draw a graph representing the initial situation in Macroland. In your graph, be sure to include the SRAS, LRAS, and
AD. On your graph, mark the equilibrium aggregate price level and aggregate output level, as well as potential
output. AD decreases due to consumer and investment spending decreases.
Draw a graph of the money market depicting Macroland’s initial situation before the purchase of Treasury bills, as
well as the effect of the purchase. Be sure to indicate the initial equilibrium as well as the final equilibrium. MS
increases, interest rates increase.
How does the purchase of Treasury bills affect the aggregate economy in the short run? AD shifts to the left
How does the purchase of Treasury bills affect the aggregate economy in the long run? Economy must return to
producing its potential output. This occurs as SRAS shifts to the right, eliminating the recessionary gap.
8.
Suppose that when the central bank reduces the interest rate by 1%, it increases the level of investment spending by $500
million in Macroland. If the marginal propensity to save equals 0.25, what will be the total rise in real GDP, assuming the
aggregate price level is held constant? Explain your answer. The action of the Fed effectively creates a change in
autonomous investment spending of $500 million. This change in autonomous investment spending will cause real GDP to
increase by a larger, multiplied amount due to the multiplier process. Since the multiplier equals 1/(1-MPC) or, in this case,
4, we can compute the total change in real GDP as 4 x $500 million, or $2 billion
9.
For each of the following situations, determine the appropriate central bank monetary policy.
a. The central bank adopts an interest target of 5%. Currently the interest rate in the economy is at 8%. Central bank
wants to decrease interest rates. It can accomplish this goal by engaging in open-market purchases of T-bills.
b. The central bank adopts an inflation target of 3%. Currently the inflation rate is 4%. Central bank wants to reduce
inflation rate. It can do this by increasing the interest rate because this will slow the economy and result in a
smaller output gap, which will help to pull the interest rate, and therefore, the rate of inflation down. The central
bank should engage in open-market sales of T-bills.
c. The central bank adopts an inflation target of 4%. Current inflation is 4%. However, this quarter the central bank
expects data to reveal that the economy is entering a recession and has a projected negative output gap. Because
central bank anticipates a slowdown, it also anticipates downward pressure on the agg PL as the level of spending
in the economy falls. Central bank can stabilize the agg PL by engaging in expansionary monetary policy; central
bank should engage in open-market purchases of T-bills.
d. Current unemployment is greater than the natural rate of unemployment. Because the current rate of
unemployment is greater than the potential rate of unemployment, economy is in recession. The central bank will
want to engage in expansionary monetary policy unless it is actively seeking to reduce the targeted rate of inflation
and the actual rate of inflation of the economy.
Time Value of Money
10. You have won the lottery and can receive your winnings as a single payment of $2 million in cash now or you can receive a
payment of $500,000 a year for five years starting now. The interest rate is constant at 10% per year. Which payment plan
do you prefer? Compare the present value of the future payments to the single payment now. The present value is
$500,000 + ($500,000)/(1.1) + ($500,000)/(1.1)² + ($500,000)/(1.1)³ + ($500,000)/(1.1)⁴ = $2,086,164, which is greater than
$2 million.
Banking and Money Creation
11. Suppose Fantasia has a single bank that initially has $10,000 of deposits, reserves of $2,000, and loans of $8,000. To
simplify our example, we will assume that bank capital is zero. Furthermore, Fantasia’s central bank has a required reserve
of 10% of deposits. All monetary transactions are made by check; no one in Fantasia uses currency.
a. Construct a T-account depicting the initial situation in Fantasia. In your T-account, make sure you differentiate
between required and excess reserves and that your T-account’s assets equal its liabilities.
b.
c.
d.
e.
Explain how you calculated the level of excess reserves in Fantasia. Excess reserves are equal to total reserves
minus required reserves, or $1,000. To find required reserves, multiply deposits by the required reserve ratio
($10,000)(0.1) = $1000
Suppose the bank in Fantasia lends the excess reserves you calculated in part (b) until it reaches the point at which
its excess reserves equal zero. How does this change the T-account?
Did the money supply in Fantasia change when the bank loaned out the excess reserves? Yes, because the money
supply is defined as bank deposits plus currency in circulation. Explain your answer. Because Fantasia has no
currency in circulation, we need to consider only what happens to bank deposits. Initially, deposits equaled
$10,000, and after the lending out of all the excess reserves, bank deposits equaled $20,000. Thus, the money
supply increased by $10,000.
What is the value of the money multiplier in Fantasia? Using the money multiplier, compute the change in
deposits. Money multiplier is 1/rr, or 10. The change in deposits equals the money multiplier times the change in
reserves or, in this case, the change in deposits equal (1/0.1)($1,000) = $10,000.
12. You are provided the following T-accounts for the central bank of Economia and the only commercial bank in Economia. In
Economia, all financial transactions occur within the banking system; no one holds currency. The required reserve ratio
imposed by the central bank is 20% of deposits.
a.
Suppose the central bank in Economia purchases $2,000 of treasury bills from the commercial bank. Provide a Taccount for both the central bank and the commercial bank showing the immediate effect of this transaction. Be
sure to differentiate between required and excess reserves for the commercial bank.
b.
Provide a T-account for the commercial bank once the commercial bank lends out tis reserves and all adjustments
have been made through the money multiplier process.
c.
What happens to the money supply when the central bank purchases $2,000 of Treasury bills from the commercial
bank? The money supply increases from $100,000 to $110,000. Recall that the money supply equals checkable
deposits plus currency in circulation; because Economia has no currency in circulation, the money supply equals
the level of deposits.
How does the change in money supply relate to the money multiplier? The change in the money supply equals the
money multiplier times the change in the monetary base. In this problem, the money multiplier is 5, and the
change in the monetary base is the $2,000 increase in reserves that occurs when the central bank purchases the Tbills.
What was the monetary base initially? The monetary base equals reserves plus currency in circulation. In
Economia, currency in circulation is zero, so the monetary base is equivalent to reserves. Initially, the monetary
base was $20,000.
What is the monetary base after all adjustments to the central bank’s monetary policy have taken effect? Increases
to $22,000.
d.
e.
f.
13. Use the following information about Macroland to answer these questions.
Bank deposits at the central bank
$100 million
Currency in bank vaults
50 million
Currency held by the public
75 million
Checkable deposits
600 million
Traveler’s checks
5 million
a. What are the total bank reserves in Macroland? Bank reserves = currency in bank vaults plus bank deposits at the
central bank, or $150 million.
b. Suppose banks hold no excess reserves in Macroland. Given the information in this table, what is the required
reserve ratio? rr= ration of required reserves to checkable deposits. Because there are no excess reserves in
Macroland, the bank reserves calculated in part (a) equal the required reserves: thus, $150 million/$600 million
equals a required reserve ratio of 0.25.
c.
d.
If the public does not change its currency holdings, what will happen to the level of checkable deposits in
Macroland, relative to their initial level, if the central bank of Macroland purchases $10 million worth of Treasury
bills in the open market? Provide the numerical answer and explain. When central bank of Macroland purchases
$10 million in T-bills, the level of reserves in the banking system increases by $10 million. This increase in reserves
starts the multiplier process; the change in the money supply is calculated as the increase in reserves times the
money multiplier, or ($10 million)(4) = $40 million. Thus, the money supply increases by $40 million when the
Central Bank purchases T bills on the open market.
If the public does not change its currency holdings, what will happen to the level of checkable deposits in
Macroland, relative to their initial level, if the central bank of Macroland sells $5 million in Treasury bills on the
open market? Explain your answer. Using the concept explained in part (c), this sale of T bills by the central bank
will decrease the money supply by $20 million. We can see this by recalling that the change in the money supply
equals the changes in reserves times the money multiplier or (-$5 million)(4), or -$20 million.
Adapted from Strive for a 5: Preparing for the Macroeconomics AP Examination (Margaret Ray and David Mayer)