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AK Macroeconomics – Chapter 12
CHAPTER TWELVE
Answers to Self-Test Questions
1. Whether the Bank of Canada buys bonds from chartered banks or from the public
makes no difference to the change in the commercial banks' reserves. If the
bonds are bought from the banks, there will be no change in the amount of demand
deposits and the extra reserves can all be lent out. However, if they are bought from
the public, then the amount of demand deposits at the chartered banks will increase as
the bond sellers deposit their Bank of Canada cheques. Here, the amount of excess
reserves will be slightly lower since the banks will want to keep a small fraction of
these increased deposits.
2. a) Balance sheets after the purchase of securities from the chartered banks (the
affected accounts are highlighted):
Assets
Reserves in vaults
On deposit with the
Bank of Canada
Securities
Loans
Totals
Assets
Securities
Totals
All Commercial Banks
Liabilities
$70
Deposits
12
118
600
800
Totals
Bank of Canada
Liabilities
$ 82
Notes in
Circulation
Deposits of banks
Other liabilities
82
800
800
65
12
5
82
3. As a result of the switch, the reserves and the deposits of the chartered bank will
increase by $100. Although the money supply is not immediately affected by the
switch, the bank will find itself over-reserved by 90 (increased actual reserves of 100
minus increased target reserves of 10% x 100 = 10). Loaning out these excess
reserves will result in an increase in demand deposits, which is part of the money
supply.
4. Economic growth and full-employment are compatible goals but both can come into
conflict with the goals of stable prices and a favorable balance of trade. In addition,
full-employment and stable prices are in conflict.
5. It should sell bonds.
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AK Macroeconomics – Chapter 12
6. Any attempt to change the money supply would prove to be impossible because it
would affect interest rates and this could not be allowed to happen. The reason for
this is that the central bank must maintain its interest rate at par with the other country
in order to defend the fixed exchange rate.
7. Both might be affected. A decrease in tax rates may increase people’s incentive to
work and this may increase productivity so that aggregate supply increases. In
addition, spending will definitely increase because of higher after-tax incomes
thereby increasing aggregate demand.
Answers to Study Guide Questions
1. True
2. True
3. False: notes in circulation are a liability to the Bank of Canada.
4. False: a decrease would be part of expansionary monetary policy.
5. True
6. False: it causes the AD to shift left.
7. False: monetary policy is more effective with a flexible exchange rate.
8. False: it includes both.
9. True
10. True
11. b
12. b
13. c
14. b
15. b
16. b
17. b
18. a
19. a
20. d
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21. b
22. a
23. a
24. b
25. a
89
26. b
27. e
28. c
29. b
30. b
31. d
32. a
33. d
34. e
35. d
AK Macroeconomics – Chapter 12
36A. Key Problem
a) Since the economy is in equilibrium, its present GDP is $400 (at a price level of
80). Since Corona is also enjoying full-employment, the potential GDP curve
must also be located at a GDP of $400. (See Figure 12.8).
Figure 12.8 (completed)
b) GDP: 380;
P: 88;
recessionary gap: 20
The cause of the stagflation was the increased price of a vital resource. Causing a
drop in aggregate supply and a leftward shift in the AS curve. Prices went up 10%
from 80 to 99 and GDP dropped by 5% from 400 to 380. There is now a
recessionary gap of $20 (the difference between the new GDP level and fullemployment GDP).
c) interest rate: 9%
Figure 12.8 (completed) shows that to reduce the price level to 80 requires a
leftward shift in the AD curve of $40 (so that it intersects the AS1 curve at a GDP
of $360). To reduce aggregate demand by $40 needs an increase in the interest
rate of 4% points (1% point for each $10.) The old interest rate was 5%;
therefore, the new interest rate would be 9%.
d) unemployment rate: 8%
Since the new GDP is $360 it is $40 billion below the full- employment level of
$400 (a recessionary gap). This represents a gap of 10% (40/400). According to
Okun’s Law, each 2 1/2% of “lost” GDP is the equivalent of 1% cyclical
unemployment. So 10% would translate to 4% cyclical unemployment. Since the
natural rate of unemployment is 4%, the actual rate of unemployment would be
4% + 4% = 8%.
e) new level of real GDP: $400;
new price level: 96
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AK Macroeconomics – Chapter 12
If you graphically shift the AD curve right by $40 (4 squares), it will intersect the
AS1 curve at the full-employment level of $400. This intersection is at a new
price level of 96.
f) rightward shift in the AS curve: $40;
price level: 80
To get back to the original full-employment GDP level of $400 from the present
$380 requires a rightward shift in the AS of $40 (4 squares). The new price level
will be 80, what it was before the onset of stagflation.
37A.
a) $30B (so that all three curves intersect at a GDP of 420).
b) 5% (20/400 x 100)
c) 16.67% (20/120 x 100)
38A.
a) no effect
b) increase of $1000B (The banks can increase loans and deposits by 10 times its
new excess reserves.)
39A. a) see the Table 12.2 (completed) A and B (column 1) below:
Table 12.2 (completed)
A: Central Bank of Beckland
(1)
Assets
Treasury
$190
$191
bills
Short-term
5
5
loans to
banks
Liabilities
Notes in Circulation
Government
Deposits
Deposits of
banks
$185
(1)
$185
6
6
4
5
B: Beckland's Banking System
(1)
(2)
Assets
Reserves:
In vaults
in Bank of
Beckland
Securities
Liabilities
Deposits
8
4
8
5
8
5
30
29
29
Loans to customers
90
90
100
b) no effect in the money supply
c) excess reserves of $1B
d) see Table 12.2B (completed) column (2)
e) + $10B
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Short-term loans
from Bank of
Beckland
Equity
120
(1)
120
(2)
130
5
5
5
7
7
7
AK Macroeconomics – Chapter 12
40A.
a) Pabst: 6% Kokanee: 7%
b) Pabst: + 40 Kokanee: + 10
c) Pabst: + 80 Kokanee: + 20
d) Pabst
41A.
Using the formula:
P=
P=
365
# days to maturity
365
# days to maturity
365
365
91
365
91
x
F
+ r
x 100 000
=
+ 0.05
401 100
4.061
= $ 98 769
The market price will therefore be $98 769 and the discount $1231 ($100 000 - $98 769)
42A. When a treasury bill is sold at a discount it means that is sold for a price below its
face value. The buyer earns a return on the bill because it will be redeemed at its face
value.
43A. The Bank of Canada has five main functions:
 the sole issuer of currency
 to act as the government’s bank and the manager of the country’s foreign
currency reserves
 to act as the bankers’ bank and as the “lender of the last resort”
 to act as the auditor and inspector of the commercial banks
 to act as the regulator of the economy’s money supply
44A. Contractionary monetary policy would reduce the money supply, which would
push up the interest rate, and this would, in turn, reduce the level of investment
spending. The lower investment spending would reduce the level of aggregate
demand and thus shift the AD curve to the left. This would cause a drop in prices,
thus reducing inflationary pressure.
45A. $4 / $96 X 100 X 4 (quarters) = 16.7%
$4 / $96 X 100 X 6 (2 month periods) = 25%
Thus, the rate of return has increased by 8.3% points
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46A.
a) GDP = 850
P = 105
b) GDP = 900
P = 110
c) GDP = 850 (This is the value of potential GDP; AS will decrease until it
intersects AD at this value.)
P = 115 (Given the new higher AD this
will be the price corresponding to a GDP of $850)
d) GDP = 800
P = 110
e) GDP = 850 (Again, in the long-run the economy will return to the potential
level of GDP.)
P = 105 (And AS will also return to its previous level.)
47A. growth rate: 2.5%
(A 5% inflation rate means that the price level can only increases to 126. A shift in
the AD to this price results in a real GDP of $410. The growth rate is 10 / 400 X
100).
48A. Expansionary monetary policy would reduce the interest rate and this would lower
the cost of production. As a result, exporting firms may well be able to sell more
goods abroad and this would increase net exports. On the other hand, the higher
level of National Income (greater aggregate demand) would increase the level of
imports and this would reduce net exports.
49A. A contractionary monetary policy implies a leftward shift in the aggregate demand
curve because a reduction in the money supply will cause an increase in the interest
rate. This, in turn, will reduce investment spending and aggregate expenditures thus
causing GDP to be lower at each price level.
50A. If the money supply is expanded too rapidly the result will be inflation. This is
because it will be impossible for increases in production to keep pace with the
increase in the money supply. The result will be a case of “too much money chasing
too few goods” – the cause of most inflations.
51A
a) Beckland: interest rate ↓ by 1%
P: increases 4 points
→ (I & XN) ↑ by 20 → AD ↑ by 40 →
GDP: increases $20
Heineken: : interest rate ↓ by 2% → (I & XN) ↑ by 20 → AD ↑ by 60 →
P: increases 12 points
GDP: increases $18
52A. The crowding out effect is caused by expansionary fiscal policy pushing up the
interest rate. If expansionary monetary policy is pursued at the same time then the
interest would not rise.
53A. If a country has an exchange rate fixed to that of another country it means that it
must also fix the value of its interest rate to that of the other country. The reason for
this is that since investors no longer need worry about the exchange rate changing, it
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AK Macroeconomics – Chapter 12
is as safe for them to invest in the other country as in their own. Therefore, even the
smallest difference in interest rates would cause money to flood out of the country
with the lower rate. This being the case, if the major country lowers its interest rate
for example, then the other country must also lower its – irrespective of whether
that’s a wise thing to do or not.
54A. Keynesian monetary policy, it is thought, is more effective when dealing with an
inflationary gap than with a recessionary gap. This because in either instance, the
policy operates through the banking system and it is easier for banks to call in loans
to help cool an inflationary boom than it is for them to extend loans to help boost the
economy during a recession. In the latter case, there will be few applicants of
sufficient credit-worthiness who would be willing to get into debt during a recession.
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