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Unit 5 Review Problems
1. Explain the difference between saving and investment as defined by a macroeconomist. Which of the
following situations represent investment? Saving? Explain
a. Your family takes out a mortgage and buys a new house.
b. You use your $200 paycheck to buy stock in AT&T.
c. Your roommate earns $100 and deposits it in her account at a bank.
d. You borrow $1,000 from a bank to buy a car to use in your pizza delivery business.
2. Economists in Funlandis, a closed economy, have collected the following information about the
economy for a particular year:
Y = 10,000
C = 6,000
T = 1,500
G = 1,700
The economists also estimate that the investment function is: I = 3,300 – 100 r
where r is the country’s real interest rate, expressed as a percentage. Calculate private saving, public
saving, national saving, investment, and the equilibrium real interest rate.
3. Suppose the government borrows $20 billion more next year than this year.
a. Use a supply-and-demand diagram to analyze this policy. Does the interest rate rise or fall?
b. What happens to investment? To private saving? To national saving? Compare the size of the
changes to the $20 billion of extra government borrowing.
c. How does the elasticity of supply of loanable funds affect the size of these changes?
d. How does the elasticity of demand of loanable funds affect the size of these changes?
e. Suppose households believe that greater government borrowing today implies higher taxes to
pay off the government debt in the future. What does this belief do to private saving and the
supply of loanable funds today? Does it increase or decrease the effects you discussed in parts
(a) and (b)?
4. Your bank account pays an interest rate of 8%. You are considering buying a share of stock in XYZ
Corporation for $110. After 1, 2, and 3 years, it will pay a dividend of $5. You expect to sell the
stock after 3 years for $120. Is XYZ a good investment? Support your answer with calculations.
5. Beleaguered State Bank (BSB) holds $250 million in deposits and maintains a reserve ratio of 10%.
a. Show a T-account for BSB.
b. Now suppose that BSB’s largest depositor withdraws $10 million in cash from her account. If
BSB decides to restore its reserve ratio by reducing the amount of loans outstanding, show its
new T-account.
c. Explain what effect BSB’s action will have on other banks.
d. Why might it be difficult for BSB to take the action described in part (b)? Discuss another
way for BSB to return to its original reserve ratio.
6. Assume that the reserve requirement is 20%. Also assume that banks do not hold excess reserves and
there is no cash held by the public. The Federal Reserve decides that it wants to expand the money
supply by $40 million dollars.
a. If the FED is using open-market operations, will it buy or sell bonds?
b. What quantity of bonds does the FED need to buy or sell to accomplish the goal? Explain
your reasoning.
7. Suppose that this year’s money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is
$5 trillion.
a. What is the price level? What is the velocity of money?
b. Suppose that velocity is constant and the economy’s output of goods and services rises by 5%
each year. What will happen to nominal GDP and the price level the next year if the FED
keeps the money supply constant?
c. What money supply should the FED set next year if it wants to keep the price level stable?
d. What money supply should the FED set next year if it wants inflation of 10%?
8. Suppose that changes in bank regulations expand the availability of credit cards so that people need
to hold less cash.
a. How does this event affect the demand for money?
b. If the FED does not respond to this event, what will happen to the price level?
c. If the FED wants to keep price level stable, what should it do?
9. Recall that money serves three functions in the economy. What are those functions? How does
inflation affect the ability of money to serve each of these functions?
10. Suppose that people expect inflation to equal 3%, but in fact, prices rise by 5%. Describe how this
unexpectedly high inflation rate would help or hurt the following:
a. The government
b. A homeowner with a fixed-rate mortgage
c. A union worker in the second year of a labor contract
d. A college that has invested some of its endowment in government bonds
11. The Federal Reserve expands the money supply by 5 percent.
a. Use the theory of liquidity preference to illustrate in a graph the impact of this policy on the
interest rate.
b. Use the model of aggregate demand and supply to illustrate the impact of this change in the
interest rate on output and the price level in the short run.
c. When the economy makes the transition from its short run equilibrium to its long run
equilibrium interest rate?
d. How will this change in the price level affect the demand for money and the equilibrium
interest rate?
e. Is this analysis consistent with the proposition that money has real affect in the short run but is
neutral in the long run?
12. The economy is in a recession with high unemployment and low output.
a. Draw a graph of aggregate demand and aggregate supply to illustrate the current situation. Be
sure to include the aggregate demand curve, the short run aggregate supply curve, and the
long run aggregate supply curve.
b. Identify an open market operation that would restore the economy to its natural rate.
c. Draw a graph of the money market to illustrate the effect of this open-market operation. Show
the resulting change in the interest rate.
d. Draw a graph similar to the one in part (a) to show the effect of the open market operation on
output and the price level. Explain in words why the policy has the effect that you have shown
in the graph.