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Transcript
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