1. Investment

2. Aggregate demand

3. Output

4. The price level

Sample answer:

1. In order to pay for the bonds people will have to reduce their holding of cash and withdraw some of their bank deposits. Since the total amount of reserves banks keep to meet the requirements of the Fed is equal to the amount of deposits times the reserve ratio (given that there are no excess reserves), the decrease in the former will lead to a reduction in reserves.

The interest rate will go up for several reasons: on the one hand, to make bonds attractive to investors the Fed will have to cut their price thereby increasing the interest rate they yield, and, on the other hand, to restore deteriorated deposits banks will be offering a higher interest rate as well.

2. As we have already pointed out, this action of the Federal Reserve will reduce both the amount of cash people hold in their pockets and the amount of money they keep in bank accounts, which means that the quantity of liquid assets in the economy will be decreased. Graphically it corresponds to a leftward shift in the real money supply, which, as the following graph explains, will cause the interest rate to rise:

i (M/P)₂^S (M/P)₁^S

(M/P)^D

M/P

3. Since investment is inversely related to the interest rate, the increase in the latter (as a result of the reduction in the supply of real balances) will entail a decline in investment. Hence, aggregate demand will be decreased which can be represented graphically as a leftward shift in the AD curve (see the diagram below). The result of this change will be a contraction of the real output (in the short run at least) and a drop in prices.

P AS

P₁

P₂

AD₁

AD₂

Y

Problem 6 (APT'2000, P3)

Assume an economy with no international sector.

1. Using a correctly labeled money-market graph, show how a decrease in the money supply will affect interest rates.

2. Explain how the change in the interest rate you identified in part (a) will directly affect each of the three components of aggregate demand for this closed economy.

3. Using a correctly labeled aggregate demand and aggregate supply graph, show how the change in the interest rate you identified in part (a) will affect each of the following in the short run.

1. Output

2. Price level

Sample answer:

i (M/P)^S₂ (M/P)^S₁

i₂ - reduction in the money supply results in an increase in interest rates.

i1

M^D

(M/P)

2. In the closed economy aggregate demand consists of 3 components: consumption demand C, government expenditure G, and investment demand I. In the simple model we use consumption is a function of income only, so that the increase in interest rates will have no direct effect on this component of aggregate demand. However, it is reasonable to presume that in the real life higher interest rates might curb consumption, as most of the big purchases are financed by borrowing from the bank, which becomes more expensive and fewer people will therefore go for it. In addition to that, an increase in interest rates reduces the wealth of the population, as the price of assets bearing constant returns goes down incurring a loss on their holders, which may also decrease consumption. Another component of aggregate demand, government purchases, is exogenous to this model and depends only on the government policy. Consequently, changes in interest rates will have no impact on the size of public expenditure whatsoever. The only component of aggregate demand that will significantly change in response to the increase in interest rates is investment: being an inverse function of real interest rates, investment will decline pushing the economy into recession.

1. As we have identified, higher interest rates will produce a decrease in aggregate demand, which, as the following graph illustrates, will bring about a fall in prices and contraction of output.

P

AS

P₁

P₂

AD₁

AD₂

Y₂ Y₁ Y

Problem 7 (APT, 2001,P3)

Janet Smith deposits $1,000 of her cash holdings in her checking account at First Federal Bank. The reserve requirement is 20 percent and the bank has no excess reserves.

1. What is the immediate effect of her deposit on the money supply? Explain why.

2. What is the maximum amount of money First Federal Bank can initially loan out? Explain how you determined this amount.

3. What is the maximum amount of money the entire banking system can create? Explain how you determined this amount.

4. Give one reason why the money supply may not increase by the amount you identified in (c).

Sample answer:

1. Straight away there will be absolutely no effect on the amount of money in the economy. The money supply consists of cash outside banks and checking accounts. Hence, the act of depositing $1,000 in a bank account simply transforms one form of money into another but it does not change the total quantity of money in circulation.

2. When a bank receives a deposit it is legally bound to create reserves against it, i.e. it must keep a certain part of the money (in our case 20%) in its vault or in a special account at the CB. Thus, of the $1,000 initially deposited by Janet Smith the bank can lend no more than $800.

3. Suppose the bank loans out $800 of the $1,000 it has received from Janet Smith. The effect of this action will be an increase in the money supply by $800: Janet Smith still has $1,000 in her checking account but in addition to this there is a borrower who now has extra $800 of liquidity he or she did not previously have. However, it is not the end of the story. The borrower will use the funds to buy goods or pay off his debts so that ultimately all the money will return to the banking system in the form of new deposits. Banks will retain 20% of the receipts to meet their minimum reserve requirements and lend the rest of the sum to start a new round of depositing. The process will continue until all the hard cash ($1,000) is already kept in the form of reserves against the deposits and there is nothing left to loan out. With the required reserve rate fixed at 20% the $1,000 initially placed at the First Federal Bank can support a maximum of $1,000/0.2=$5,000 of deposits. The banking system will thus be able to create $4,000 of additional liquidity (instead of $1,000 of cash Janet Smith originally held there will be $5,000 of various deposits).

4. There are two main reasons why the money supply may increase by less than $4,000. The fist one is that rather than putting all their money in the bank people prefer to have some amount of cash in case they need it immediately. The second reason is that banks tend to be cautious and hold more reserves than is required.

Efficiency of Fiscal and Monetary Policies. Policy Mix.