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QUIZ 5: Macro – Spring 2009 Name: ______________________ Section Registered (circle one) T/Th 8:30-10:00 T/Th 10:00-11:30 T 6:00-9:00 Question 1 (12 points – 3 points each) In this question, we will explore the link between the banking system and the aggregate money supply in the economy. Given the assumptions below, you should answer the subsequent parts to this question. All answers are numbers. Lastly, throughout the problem, assume the bank can adjust total loans (TL) freely if they want (i.e., they can make new loans and call in old loans at will). Put your answer in the box. No work need be shown. All answers will be either awarded full credit (3 points) or no credit (0 points). There is little (if any) math that needs to be done to answer these questions. Most of the questions can be answered with simple intuition or simple arithmetic (adding, multiplying, etc.). Calculators are allowed (but you shouldn’t need them). Baseline assumptions: 1. 2. 3. 4. The required reserve ratio (m) equals 5%. Banks only hold required reserves (m* = m). No one in the economy holds cash outside the banking system (TC = 0). Total deposits in the entire banking system equals $1 trillion (TD = $1 trillion). a. Given the baseline assumptions, what is the monetary base (Base) in this economy? b. Suppose the required reserve ratio declines to 2.5%. Relative to the baseline scenario, how much will total reserves (TR) change as a result of the change in the reserve ratio (inclusive of the subsequent change in banking lending that results)? Assume all other baseline assumptions hold (aside from m now equaling 2.5%). c. Suppose we return to the original baseline scenario (m = 5%). Now suppose that the only change to the baseline assumptions is that banks now hold excess reserves such that the desired reserves held by the banks equal 10% of total deposits (m* = 10% > m = 5%). Assume all other baseline assumptions hold. Given the change in bank behavior (inclusive of their subsequent change in total loans), what would be the new level of the money supply (MS) in the economy? d. Suppose we return to the original baseline scenario (banks now hold no excess reserves). Suppose that households are fearful that the banking system will collapse and pull out $1 billion from the banking system (i.e., $1 billion of reserves (TL) leave the banking system while total currency held outside the banking system (TC) increases by $1 billion). How much would the money supply (MS) change if households removed $1 billion from the banking system? Question 2 (4 points – 2 points each) Circle all the true statements below pertaining to the Murphy model (as discussed in class). a. All else equal, an increase in the marginal propensity to consume out of current income (holding permanent income constant) will increase the net benefits of increasing government spending during large recessions (Y << Y*). b. A prominent argument against increasing government spending during recessions is the government spending diverts resources from the private sector and that the government then uses those resources inefficiently (relative to the private sector). Question 3 (4 points) The article “And the Money Comes Pouring In” (Economist (7/15/2006)) recounts that by the end of fiscal year 2006 (which is September 30 2006) budget deficits were 30% lower than predicted 6 months prior. The reason that deficits were lower resulted from an increase in total tax revenues and not from changing government spending or transfers. The article then discussed how President Bush promptly proclaimed that the lower deficits were the result of his tax policy (he believes that he was on the right side of the Laffer Curve and that by cutting labor income tax rates he actually increased total tax revenues). The article disagrees with President Bush’s claim. List one reason (as described in the article) why it is unlikely that the President’s tax cuts caused government budget deficits to fall. The article gives many reasons - you just need to describe one. Your answer should not be more than one sentence (it could even be less than one sentence).