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Eco 202
Test 2
Name_______________________________
31 March 2005
100 points. Please answer questions in ink. Use pencil to draw graphs.
1. Consider the T-account below.
First Terrier Bank
Assets
Treasury Bills
Liabilities
$130,000 Checkable Deposits
$300,000
137,500
Loans
Reserves
125,000
45,000
37,500
a. Assume that the required reserve ratio (rD) is 10 percent. What amount can First Terrier
Bank (FTB) lend? $15,000
b. As a result of this loan, what is the potential change in the level of deposits in the banking
system? Explain whether this potential amount is likely to be realized.
∆D = 1/rD * ∆R
∆D = 10 * $15,000 = $150,000. Money supply will not rise by this amount because depositors
withdraw currency, and some banks hold excess reserves.
c. If the Federal Reserve System (Fed) wants to cut in half the potential increase in the quantity
of money, what must the Fed do before FTB makes the loan?
Fed must sell a $7,500 bond to FTB.
d. Complete the T-account by writing in the new entries as they would appear as the result of
the Fed's action. Note: Not all items in the balance sheet above must change in value.
2. Use the quantity theory of money to explain why many economists believe that "Inflation is
always and everywhere a monetary phenomenon?" What is meant by money neutrality? Does it
mean that an increase in the money supply won't cause an increase in the price level in the long
run? According to the quantity theory of money a change in the price level is caused by a
change in the quantity of money. Because velocity (V) is assumed to remain constant (at least in
the short run), and changes in the quantity of money do not affect output (Y) in the long run
(money neutrality), any change in the quantity of money (M) leads directly to a change in the
price level (P). A continual increase in the quantity of money means a continual increase in the
price level, which is inflation. See: http://www.answers.com/topic/velocity-of-money
Money neutrality means that changes in the money supply cannot affect real variables in the
long run. Because the quantity of money is a nominal variable, changes in the quantity of money
can affect nominal variables only. An increase in the quantity of money can cause real GDP to
increase in the short run, but in the long run, real GDP is not affected by money growth. In the
long run an increase in the quantity of money causes the price level to rise. So the answer to the
last question is no. http://www.answers.com/topic/neutrality-of-money
3. The Economist, an international news magazine, regularly collects data on the price of a
McDonald's Big Mac hamburger in different countries, in order to examine the theory of
purchasing power parity (PPP).
a. Why is purchasing power parity thought to be a theory of exchange rates? What underlying
principle is used to justify using PPP to explain exchange rates? PPP is based on the law on one
price, which says that the same (homogeneous) product must sell for the same price regardless of
where it is sold or purchased. If a good sold for less in one location than another, a person could
make a profit by buying the good in the location where it is cheaper and selling it in the location
where it is more expensive (arbitrage). Applying this same logic to currencies means a U.S.
dollar should buy the same quantity of goods and services in the United States and Japan; a
Japanese yen should buy the same quantity of goods and services in the United States and Japan.
b. Why might the Big Mac be a good product to use for this purpose? The Big Mac is
essentially a homogeneous product. A Big Mac is the same burger wherever it is sold.
c. Based on the Big Mac data, PPP appears to hold roughly across some countries, though not
across others. Why might the assumptions underlying the theory of PPP not hold exactly for Big
Macs? Two reasons help to explain why PPP does not hold: (1) Many goods are not easily traded
(e.g., haircuts in Paris versus haircuts in New York). Big Macs are too perishable for arbitragers
to take advantage of price differences. (2) Tradable goods are not always perfect substitutes
when they are produced in different countries (American cars versus German cars). There is no
opportunity for arbitrage here, because the price difference reflects the different values the
consumer places on the two products. See:
http://www.answers.com/purchasing%20power%20parity
4. Economists agree that increases in the money supply growth rate increase inflation and that
inflation is undesirable. So, why have there been hyperinflations and how have they been
ended? Hyperinflation occurs when money growth becomes excessive. The most common
cause of the excessive money growth is central bank financing of government budget deficits.
When government spending outpaces tax revenues, the central bank is pressured to print money
to pay for government expenditures.
Hyperinflations end when the central bank stops issuing money. Part of a credible
commitment to ending inflation includes: tying the currency to gold or to another currency like
the dollar, and limiting the government’s ability to spend more than it collects in taxes—a
balanced budget.
http://www.econlib.org/library/Enc/Hyperinflation.html
Eco 202
Test 2
Name_______________________________
31 March 2005
100 points. Please answer questions in ink. Use pencil to draw graphs.
1. Consider the T-account below.
First Terrier Bank
Assets
Treasury Bills
Liabilities
$30,000 Checkable Deposits
$100,000
35,000
Loans
50,000
Reserves
20,000
15,000
a. Assume that the required reserve ratio (rD) is 10 percent. What amount can First Terrier
Bank (FTB) lend? $10,000
b. As a result of this loan, what is the potential change in the level of deposits in the banking
system? Explain whether this potential amount is likely to be realized.
∆D = 1/rD * ∆R
∆D = 10 * $10,000 = $100,000. Money supply will not rise by this amount because depositors
withdraw currency, and some banks hold excess reserves.
c. If the Federal Reserve System (Fed) wants to cut in half the potential increase in the quantity
of money, what must the Fed do before FTB makes the loan?
Fed must sell a $5,000 bond to FTB
d. Complete the T-account by writing in the new entries as they would appear as the result of
the Fed's action. Note: Not all items in the balance sheet above must change in value.
2. Explain the relationship between the quantity theory of money and the Fisher equation. Be
sure to explain both concepts in your answer. The quantity theory of money is intended to show
the relationship between money and inflation. The Fisher equation shows the relationship
between inflation and the nominal interest rate. According to the quantity theory of money,
velocity (V) is constant and money does not affect real GDP (Y) in the long run. Since both V
and Y are constant, the quantity of money (M) and the price level (P) must change one-for-one.
That is, if M rises by 20 percent, P must rise 20 percent. A continually rising money supply
means a continually rising price level, which is inflation. The Fisher equation says that the
nominal interest rate (i) is equal to the sum of the real interest rate (r) and the inflation rate (π).
Combining the quantity theory of money with the Fisher equation tells us that a continually
increasing money supply will cause the nominal interest rate to rise. See:
http://www.econlib.org/library/Enc/bios/Fisher.html
3. Explain the relationships between: (i) money and inflation in the long run, and (ii) money and
economic growth in the long run.
According to the quantity theory of money a change in the price level is caused by a change in
the quantity of money. Because velocity (V) is assumed to remain constant (at least in the short
run), and changes in the quantity of money do not affect output (Y) in the long run (money
neutrality), any change in the quantity of money (M) leads directly to a change in the price level
(P). A continual increase in the quantity of money means a continual increase in the price level,
which is inflation. See: http://www.answers.com/topic/velocity-of-money
Money neutrality means that changes in the money supply cannot affect real variables in the
long run. Because the quantity of money is a nominal variable, changes in the quantity of money
can affect nominal variables only. An increase in the quantity of money can cause real GDP to
increase in the short run. In the long run, however, real GDP is not affected by money growth.
In the long run an increase in the quantity of money causes the price level to rise. So, as a first
approximation, there is no relationship between money growth and economic growth in the long
run. If there is any relationship between money growth and economic growth in the long run it is
probably negative. High money growth causes high inflation. Inflation causes resources to be
misallocated for several reasons—relative price distortion, shoe leather and menu costs,
confusion and inconvenience, and the inflation tax. These costs reduce the rate of economic
growth. http://www.answers.com/topic/neutrality-of-money?hl=money&hl=neutrality
4. The Economist, an international news magazine, regularly collects data on the price of a
McDonald's Big Mac hamburger in different countries, in order to examine the theory of
purchasing power parity (PPP).
a. Why is purchasing power parity thought to be a theory of exchange rates? What underlying
principle is used to justify using PPP to explain exchange rates?
b. Why might the Big Mac be a good product to use for this purpose?
c. Based on the Big Mac data, PPP appears to hold roughly across some countries, though not
across others. Why might the assumptions underlying the theory of PPP not hold exactly for Big
Macs?
See answer #3 above.