Problem 2 (apt’94, p2)

Using the aggregate supply and aggregate demand model, explain how the use of monetary policy to promote long-run economic growth will affect each of the following.

1. Short-term interest rates

2. The composition (mix) of aggregate expenditures

3. Potential gross domestic product

Sample answer:

1. To promote long-run economic growth the government should try to encourage more investment. The way to do that is to lower interest rates on loanable funds by implementing expansionary monetary policy, such as a decrease in the discount rate. This will increase total money supply and bring interest rates down:

i (M/P)^S₁ (M/P)^S₂

i₁

i₂

M^D

(M/P)

2. As a result of the drop in the interest rates, investment demand will go up entailing an increase in output and prices:

P

SAS

P ₂

P ₁ AD₂

AD₁

Y₁ Y₂ Y

Compared to the initial situation, at the new point of equilibrium there will be more investment (due to lower interest rates) and higher consumption expenditure (due to a higher level of income). If the economy is open, there will also be an increase in imports, which, just like consumption, are a direct function of income and inversely related to domestic prices. Exports, by contrast, are expected to go down, as domestic goods are getting more expensive relative to the goods produced abroad. The only component of the aggregate expenditure which is to remain the same is government purchases (it is exogenous to the model and changes only when fiscal policy is implemented).

3. The increase in investment means that capital stock will grow faster than it did before. Growing stock of capital resources, in turn, implies a rise in potential gross domestic product.

Problem 3 (APT’96, P3)

A stranger arrives from outside a given economic system with $1000 of acceptable currency that has never been in the system before. The nation’s banking system is governed by a central bank that has set a reserve requirement of 10 percent.

1. Assume the stranger deposits the $1000 in a local bank. Explain the impact of this deposit on each of the following.

1. The change in the dollar value of the local bank’s reserves

2. The maximum possible change in the dollar value of the local bank’s loans

3. The maximum possible change in the dollar value of the total money supply

2. State TWO factors in the real world that might cause this change in the money supply to be less than the maximum possible change.

Sample answer:

1. i) The moment the stranger deposits $1000, the local bank’s liabilities increase by $1000. Simultaneously, the value of the bank’s assets must increase by just the same amount. Hence, unless the bank lends out the money or uses it to purchase some other assets, its reserves will also increase by $1000.

ii) Since the reserve requirement is set at 10 percent, the bank can not lend more than 90% of its deposits. Thus, the maximum possible change in the value of the local bank’s loans is $900.

iii) Provided that all the money that is lent ultimately returns to the banking system and that banks do not hold excess reserves, the maximum possible change in the total money supply will be $1000/0.1 = $10,000 (the amount initially deposited in the bank times one over the reserve requirement).

2. In the real world the increase in the money supply will be less than stated above, because, first, people do keep some money in cash and, second, banks hold some reserves in excess of the required minimum.

Problem 4 (APT’97, P1)

1. Explain the short-run effects of a 5 percent increase in the money supply on each of the following.

1. The real interest rate.

2. Output

3. The price level

In Country X investment is only slightly responsive to changes in the real interest rate, while money demand is quite responsive to changes in the real interest rate. In Country Y investment is very responsive to changes in the real interest rate, while money demand is only slightly responsive to changes in the real interest rate.

2. Using a single graph, draw a curve showing the relationship between the real interest rate and the demand for money for each of the following.

1. Country X

2. Country Y

Label the curve for Country X as M_X and the curve for Country Y as M_Y.

3. Using a single graph, draw a curve showing the relationship between the real interest rate and the demand for investment for each of the following.

1. Country X

2. Country Y

Label the curve for Country X as I_X and the curve for Country Y as I_Y.

4. Based on your answers to parts (a) through (c), in which country will the change in the real interest rate be greater? Explain why.

5. Based on your answers to parts (a) through (c), in which country will the change in output be greater? Explain why.

6. In which of these countries do conditions more closely reflect the monetarists’ view of the economy?

Sample answer:

1. (i) The following graph shows the short-run effect of an increase in the money supply on the money market:

i M^S₁ M^S₂

i₁

i₂ M^D

(M/P)

As one can see, the money supply curve shifts to the right indicating an increase in the amount of liquid assets and causing the nominal interest rate to fall. As we shall see later, another effect of the increase in the money supply will be rising prices, so that the real interest rate, which is the nominal interest rate minus inflation, will go down as well.

(ii) and (iii) The decrease in the real interest rate we pointed out above will produce an increase in investment demand, which, in turn, will lead to an increase in equilibrium output for any given level of prices:

A E 45°-line

AE₂=C+G+I₂

AE₁=C+G+I₁

Y

Y₁ Y₂

This corresponds to a rightward shift in the aggregate demand curve in the price-output space, so that the ultimate result of the increase in the nominal money supply will be a higher level of output and growing prices:

P

SAS

P ₂

P ₁ AD₂

AD₁

Y₁ Y₂ Y

2. As demand for money is very responsive to changes in the real interest rate in country X, the money demand curve in this country is rather flat. In country Y, by contrast, the demand for money is quite insensitive to changes in the real interest rate, so that the corresponding money demand curve is relatively steep:

r M_Y

M_X

(M/P)

3. In country X, investment is interest rate inelastic, hence, the investment demand curve must be rather steep. Conversely, Country Y’s demand for investment is very sensitive to changes in the real interest rate and must therefore have a much flatter slope:

r I_X

I_Y

I

4. As the following graph illustrates, in country Y, where the demand for money is much steeper than in country X, it will take a bigger decrease in the interest rate to offset the effects of the 5 percent increase in the money supply and restore equilibrium in the money market:

M^S₁ M^S₂

r M_Y

r₀

r_X M_X

r_Y

(M/P)

5. As the decrease in the interest rate is greater in country Y than in country X, so will be the increase in investment, the more so as investment demand in country Y is much more sensitive to changes in the real interest rate:

r I_X

r₀

r_X

r_Y I_Y

I₀ I_X I_Y I

As a result, the increase in output provoked by the increase in investment will also be greater in country Y than in country X, provided that other important characteristics of the economy, such as marginal propensity to consume, are same in both countries:

A E 45°-line

AE_Y=C+G+I_Y

AE_X=C+G+I_X

AE₀=C+G+I₀

Y

Y₀ Y_X Y_Y

P

SAS

P _Y

P _X

AD_Y

P ₀ AD_X

AD₀

Y₀ Y_X Y_Y Y

6. Monetarists argue that monetary policy is much more effective than fiscal policy and support this assertion by referring to specific features of the money and investment markets. In our case, the economy which best suits the monetarist point of view is that of country Y. Here, the demand for money is relatively insensitive to changes in the interest rate, while investment demand is, on the contrary, quite responsive to these changes. As a result, increasing or decreasing money supply has a substantial impact on the economy’s output rendering monetary policy extremely effective, at least in the short run.

Problem 5 (APT’98, P2)

Assume that the Federal Reserve System sells bonds in the open market, and that commercial banks hold no excess reserves.

1. Explain in detail how the Federal Reserve’s action affects the commercial banks’ reserves and the interest rates.

2. Show graphically what happens in the money market when the Federal Reserve sells bonds.

3. Explain the effects of the Federal Reserve’s action on each of the following.