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Solutions to Problems
Chapter 27
1
Given that in the monetary system of the Nocoin economy:
Bank reserves; R = $15b
Currency; C = $30b
Deposits; D = $300b.
1a. The monetary base is $45 billion.
The monetary base is the sum of notes with the non-bank private sector, and banks’ deposits at the central bank.
MB = C + R
= 30 + 15
= $45b.
1b. The currency drain is 9.09 percent.
currency drain is the percentage of the quantity of money that is held as currency by households and firms.
C/MS = C/(C + D) x 100
= 30/330 x 100
= 9.09%
1c. The quantity of money is $330 billion.
In Nocoin, deposits are $300 billion and currency is $30 billion, so the quantity of money is $330 billion.
1d. The money multiplier is 7.33.
mm = MS/MB
= (C + D)/(C+R)
= (30 + 300)/(30 + 15)
= 330/45
= 7.33
3.
The money supply increases by $7.33 billion.
The money multiplier is the ratio of the money supply to the monetary base, which equals $330 billion divided by $45
billion, which equals 7.33.
MS = MB x mm
= 1 x 7.33
=$7.33b
5a. Expansionary monetary policy.
The contraction in major world economies would reduce Australian exports, a reduction in aggregate demand and a shift of
the AD curve to the left (from AD0 to AD1 in figure 1). The new short-run equilibrium, with out Reserve Bank intervention,
is below full employment real GDP (at c in figure 1). To avoid unemployment the appropriate policy for the Reserve Bank is
to lower interest rates by increasing the money supply.
5b. Contractionary monetary policy.
The surge in business confidence would increase investment in Australia, an increase in aggregate demand and a shift of the
AD curve to the right (from AD0 to AD2 in figure 1). The new short-run equilibrium, with out Reserve Bank intervention, is
above full employment real GDP (at b in figure 1). To avoid inflation the appropriate policy for the Reserve Bank is to
increase interest rates by decreasing the money supply.
5c. Neutral monetary policy.
The expansion in overseas economies has already started an expansion in domestic aggregate demand with out Reserve
Bank intervention. The economy is moving from the below full employment equilibrium c in figure 1 towards the full
employment equilibrium a and prices are beginning to rise. To avoid risking further inflationary pressure from lowering
interest rates or choking off the expansion from higher interest rates the appropriate policy for the Reserve Bank is to
maintain a neutral monetary stance.
5d. Monetary policy is ineffective!
Being ‘stuck’ in an unemployment equilibrium (c in figure 1) suggests a liquidity trap where lowering the interest rate has
no effect on AD and so perhaps expansionary fiscal policy is more appropriate. (Note: Liquidity trap has not been covered
in the text and instructors may prefer a simple expansionary policy approach).
Price level
Monetary Policy  Problems 5&6
LAS
SAS0
P2
P0
P1
•
c
•b
•a
AD2
AD0
AD1
Y1 Yp
Y2
Real GDP
Figure 1
7a. The interest rate increases from 4% to 5%.
During the expansionary phase of the cycle, as real GDP increases from $20 billion to $30 billion, the transactions demand
for money also increases. The demand for money curve moves to the right in figure 2, from MD(Y=$20b) to MD(Y=$30b).
The equilibrium interest rate, with money supply constant increases from 4% to 5%.
7b. The interest rate decreases from 4% to 3%.
During the contractionary phase of the cycle, as real GDP decreases from $20 billion to $10 billion, the transactions demand
for money also decreases. The demand for money curve moves to the left in figure 2, from MD(Y=$20b) to MD(Y=$10b).
The equilibrium interest rate, with money supply constant decreases from 4% to 3%.
Figure 2
Figure 3
Minland – Problem 8
Interest rate
Interest rate
Minland – Problem 7
MS
7
6
MS1 MS0
7
6
5
5
4
4
3
3
2
2
1
MD(Y=$30b)
MD(Y=$20b)
MD(Y=$10b)
0
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
Quantity of money
1
MD0
MD1
0
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
Quantity of money
9a. The price level is 130 and real GDP is $200 billion.
The intersection of the aggregate demand curve, AD, and the short-run aggregate supply curve, SASA, determines the price
level and real GDP.
9b. Freezone has an unemployment problem.
Potential GDP is $300 billion, but actual real GDP is $200 billion. When real GDP is less than potential GDP, resources are
not fully employed. Unemployment exceeds the natural rate.
9c. Eventually, the real GDP will increase and full employment will be restored. The price level will fall.
With unemployment exceeding the natural rate of unemployment, the money wage rate will eventually fall. The SAS curve
will shift rightward, the price level will fall, and real GDP will gradually increase to potential GDP. At potential GDP, the
economy is at full employment. This automatic adjustment could take a long time to occur.
9d. Expansionary monetary policy to increase aggregate demand, and return the economy to full employment.
Currently real GDP is less than potential GDP and the economy is at a below full-employment equilibrium. If the central
bank buys securities on the open market, then the quantity of money will increase, interest rates will fall and the aggregate
demand will increase. The economy returns to full employment but the price level will rise, the economy will experience
inflation.
11. The central bank purchase of securities on the open market which increases the money supply and worsens inflation.
If the Reserve Bank purchases securities on the open market and increases the money supply, interest rates will fall and
increase the inflationary pressure. The lower interest rates will increase aggregate demand and the AD curve moves from
AD0 to AD1 in figure 4. The price level increases from P0 to P1 and real GDP and the inflationary gap will increase.
Inflation is not avoided.
Inflation  Problem 11
Unemployment  Problem 12
LAS
Price level
Price level
In the long run the money wage rate will begin to rise and the short-run aggregate supply curve will begin to shift leftward.
The price level will rise and inflation will occur. The money wage rate will continue to rise until the inflationary gap
disappears. That is, the SAS curve will shift leftward from SAS0 to SAS1 in figure 4, the price level will rise from P1 to P2,
and real GDP will gradually decrease until it returns to potential GDP. At potential GDP, the inflationary gap will no longer
exist. Inflation has been higher.
SAS1
SAS0
P2
P1
P0
•a
LAS
SAS0
SAS1
•b
AD1
AD0
P1
P0
P2
•a
•b
•b
/
AD1
AD0
Yp
Figure 4
Y0
Y1
Y0 Yp
Real GDP
Figure 5
Real GDP