Download a. Depositors become concerned about the safety of depository

Macroeconomic Principles
Problem Set 3 Answer Key-Weeks 11, 12 and 13
1. Chapter 13, Problem 9, Page 389
For each of the following situations, determine whether the money supply will increase,
decrease or stay the same.
a. Depositors become concerned about the safety of depository institutions.
Depositors will withdraw reserves, so the money supply will decrease.
b. The Fed lowers the required reserve ratio.
Banks will find themselves with excess reserves, which they will lend out, so the
money supply will increase.
c. The economy enters a recession and banks have a hard time finding credit-worthy
borrowers.
Banks will decrease their lending and accumulate excess reserves; the volume of loans and
deposits will shrink, and the money supply will decrease.
d. The Fed sells $100 million of bonds to First National Bank of Ames, Iowa; banks never
hold excess reserves; and the public doesn't change its cash holdings.
This open market operation will take reserves out of the banking system; the money
supply will decrease.
e. The Fed buys $100 million of bonds of First National Bank of Ames, Iowa, but the interest
rate banks can earn from lending is the same as the interest rate the Fed pays on reserves.
The money multiplier is zero, because new reserves are just held as excess reserves.
2. Chapter 14, Problem 1, Page 419
Assume the money multiplier is 10 (RRR=0.1). For each of the following, state the impact on the
money supply curve (the direction it will shift , and the amount of the shift).
a. The Fed purchases bonds worth $10 billion.
The money supply curve shifts to the right, the money supply increases by $100
billion, and the nominal interest rate falls.
b. The Fed sells bonds worth $5 billion.
The money supply curve shifts to the left, and the money supply decreases by $50
billion, and the nominal interest rate rises.
3. Chapter 14, Problem 2, Page 419
Assume that the money multiplier is 7. For each of the following, state the impact on the money
supply curve and whether the nominal interest rate will rise or fall as a consequence.
a. The Fed purchases bonds worth $28 million.
The money supply curve shifts to the right, the money supply increases by $196
million, and the nominal interest rate falls.
b. The Fed sells bonds worth $17 million.
The money supply curve shifts to the left, the money supply decreases by $119
million, and the nominal interest rate rises.
4. Chapter 14, Problem 3, Page 419
A bond promises to pay its owner $500 one year from now. For the following prices, find the
corresponding interest payments and interest rates that the bond offers.
Amount Paid in 1
Interest
Price
Year
Payments
$375
$500
$125
$425
$500
$75
$450
$500
$50
$500
$500
$0
As the price of the bond rises, the interest rate falls.
Interest Rate
$125/375=33%
$75/425=18%
$50/425=11%
$0/500=0%
5. Chapter 14, Problem 8, Page 420
Suppose that there is just one interest rate in the economy. In an attempt to prevent the
economy from overheating, the Fed raises its interest rate target. Illustrate graphically, using a
diagram similar to Figure 7 (also in class), the effect on the money supply, interest rate and GDP.
Interest
Rate
M s2
2
M s1
E′
r
′
E
r
Md
Money
Real
Aggregate
Expenditur
e
AEr
E
AEr′
E′
4
Z 5°
Y2
Y1
Real
GDP
Initially, the economy is at point E in the top diagram. To raise the interest rate, the Fed
conducts an open-market sale of bonds. The money supply decreases to M2s and the
interest rate rises. As the interest rate increases, investment and consumption spending
decrease, causing the aggregate expenditure line to shift downward in the bottom
diagram. Consequently, the equilibrium GDP decreases from Y1 to Y2. In the new
equilibrium, the interest rate is higher and GDP is lower.
6. Chapter 15, Problem 2, Page 454
With a three-panel diagram-one panel showing the money market, one showing the aggregate
expenditures, and one showing the AD curve-show how a decrease in the money supply shifts
the AD curve leftward.
Initially, the economy is in equilibrium at points E, J, and S. A decrease in the money supply is
illustrated as a shift of the money supply from MS1 to MS2; the interest rate rises. The higher
interest rate causes aggregate expenditure to decrease, leading to a decrease in GDP. At any
price level, equilibrium GDP has decreased, and thus the AD curve shifts to the left. If the price
level remains unchanged, the economy will come to rest at points F, K, and T. The interest rate
is higher, real aggregate expenditure is lower, and the AD curve has shifted to the left.
7. Chapter 15, Problem 4, Page 454
With an AD and AS diagram only, explain the short-run and long-run effects of a decrease in the
money supply on real GDP and the price level. Assume the economy begins at full employment.
Initially, the economy is at point E. If the money supply decreases, the interest rate begins to
rise, and the aggregate expenditure line shifts downward. Real GDP at any price level declines,
indicated by a leftward shift of the AD curve to AD2. In the short run, the economy comes to
rest at point G, with a lower price level and a lower real GDP. But at point G, output is below
the full-employment level, and unemployment is high. In the long run, wages will fall, pushing
unit costs down and causing the AS curve to shift downward. The new long-run equilibrium is
at point H, with equilibrium GDP equal to its initial, full-employment value, and a lower price
level.
8. Chapter 15, Problem 5, Page 454
Use an AD and AS graph (and other relevant graphs if needed) to explain the short-run and longrun effects on real GDP, the price level and the interest rate of an increase in autonomous
consumption spending. Assume the economy begins at full employment.
The increase in autonomous consumption shifts the aggregate demand curve rightward from
AD1 to AD2, increasing both the price level and real GDP in the short run (from point A to point
B). In the absence of government intervention, the aggregate supply curve would eventually
shift leftward from AS1 to AS2, moving the economy to point C. In the long run, an increase in
autonomous consumption would lead to a higher price level with no net change in real GDP.
9. Chapter 15, Problem 12, Page 455
During the 1990s, because of technological change, the AS curve was shifting downward, butexcept for a few months-the price level did not fall. Why not? (Hint: What was the Fed doing?)
The Fed countered the downward AS curve shift by increasing the money supply, which led to
an increase in AD. Although the shift of aggregate supply put downward pressure on the price
level, this was offset by the upward pressure on the price level from the increase in aggregate
demand.
10. Use an AD and AS graph (and other relevant graphs if needed) to explain the short-run and longrun effects on real GDP, the price level and the interest rate of an increase in autonomous
consumption spending. Assume the economy begins at full employment.
The increase in autonomous consumption shifts the aggregate demand curve rightward from
AD1 to AD2, increasing both the price level and real GDP in the short run (from point A to point B).
In the absence of government intervention, the aggregate supply curve would eventually shift
leftward from AS1 to AS2, moving the economy to point C. In the long run, an increase in
autonomous consumption would lead to a higher price level with no net change in real GDP.
11. Using the graph of the Phillips Curve (figure 9), show what would happen in the future if the Fed
tried to keep the unemployment permanently at a level like ULO, below the natural rate.
Inflation
Rate
The Fed would have to increase the money supply more rapidly in each successive year. This
year, for example, it could increase the money supply by enough to hit the unemployment rateinflation rate combination of U2 and 9%. But, as the Phillips curve shifts rightward to PCbuilt-in
inflation = 9%, the Fed would have to increase the money supply even more next year, in order to
move the economy to point K. But this, in turn, would make the Phillips curve shift rightward
again. The inflation rate would rise continuously.
12. Using the AD-AS model, suppose the economy is at the true natural rate of unemployment, so
that the GDP is at its potential level. Suppose, too, that the Fed wrongly believes that the natural
rate of unemployment is higher (potential GDP is lower) and acts to bring the economy back to
its supposed potential. What will the Fed do? What will happen in the short run? If the Fed
continues to maintain output below potential, what will happen over the long run?
Assume the economy is initially in equilibrium at point E. If the Fed wrongly believes that
the natural rate of unemployment is higher and acts to bring the economy back to its
supposed potential, it will decrease the money supply. This will cause the interest rate to
rise from r1 to r2, causing the AD curve to shift leftward from AD1 to AD2. The economy
will experience a lower price level and higher unemployment (at point F). With no more
intervention, wage rates will eventually fall, causing the AS curve to shift rightward from
AS1 to AS2, returning the economy to full employment (at point G). If the Fed, however,
continues to decrease the money supply in an effort to maintain output below potential,
the public will come to expect deflation in the future, and the economy will experience
ongoing deflation.