Change Effect on nominal money demand Effect on real money demand Decrease in aggregate price level Shift nominal money demand to left Has no effect

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1 AP Macroeconomics Unit 4 Review Session Money Market 1. Draw the money market, indicating the equilibrium interest rate and quantity. 2. Use the following table to answer this question. Change Effect on nominal money demand Effect on real money demand Decrease in aggregate price level Shift nominal money demand to left Has no effect Increase in interest rate Cause movement along the nominal money demand curve Causes movement along the real money demand curve Change in regulation so that interest is now allowed on checking accounts Shift nominal money demand to right Shift real money demand curve to the right a. In the table above, enter how each scenario will affect nominal money demand and real money demand. b. Explain why a change in the aggregate price level affects the nominal demand curve differently from the way it affects the real money demand curve. When the agg price level changes, the nominal money demand curve does not automatically take into account the effect of this change in prices on the nominal demand for money. For example, as the aggregate price level rises, people will find that, due to the increase in the aggregate price level, they need to hold greater amounts of money in order to make their transactions. This causes the nominal money demand curve to shift to the right; people demand a greater quantity of nominal money at every interest rate. In contrast, the real money demand curve automatically takes into account any change in the agg price level; a change in the agg price level requires a proportionately equal change in the nominal quantity of money in order that the real quantity of money is unchanged. 3. Use the following figure of the nominal demand and money supply curves to answer these questions. Assume this market is initially in equilibrium with the nominal quantity of money equal to M 1 and the interest rate equal to r 1. a. Suppose the Federal Reserve engages in an open-market purchase of Treasury bills. Holding everything else constant, what happens to the equilibrium quantity of money and the equilibrium interest rate? Sketch a graph illustrating these changes. Money supply increases, resulting in a decrease in equilibrium interest rate and increase in equilibrium quantity.

2 b. Suppose the Fed engages in an open-market sale of Treasury bills. Holding everything else constant, what happens to the equilibrium quantity of money and the equilibrium interest rate? Sketch a graph illustrating these changes. MS shifts left. Interest rates increase and quantity of money decreases. c. Suppose the aggregate price level increases. Holding everything else constant, what happens to the equilibrium quantity of money and the equilibrium interest rate? Sketch a graph illustrating these changes. Money demand curve shifts to the right, causing interest rates to decrease while equilibrium quantity of money is unchanged. Loanable Funds Market 4. Draw the loanable funds market, indicating the equilibrium interest rate and quantity.

3 5. For each of the following situations, state the effect on the equilibrium interest rate and the equilibrium quantity of loanable funds. In your answer, make reference to how the demand and supply curves in the loanable funds market are affected. Hold everything else constant. a. Capital inflows into a country increase. Shift supply of loanable funds to the right. b. The government reduces the government deficit. Demand for LF from the government has diminished. This will cause Dlf curve to shift to the left, resulting in a decrease in both interest rate and quantity. But because interest rate is now lower, the quantity of LF for private investment spending will increase. c. There is an increase in the expected inflation rate. (Comment on both real and nominal interest rate in your answer.) Both demand and supply curves for LF will shift due to changes in expected inflation. D shifts right, reflecting fact that borrowers are willing to borrow just as much as they did at the original nominal interest rate as they are now willing to borrow at the higher nominal interest rate. (Remember that the real interest rate is the nom interest rate minus inflation rate). S shifts left because lenders now are willing to lend the same amount of funds only if the nominal interest rate they receive reflects the new higher expected inflation rate. Both curves shift, resulting in the nom interest rate rising by the amount of the change in expected inflation. No change in Qlf. d. Private savings increase. S shifts right e. Perceived business opportunities decrease. D shifts left Monetary Policy 6. The economy of Macroland is initially in long-run equilibrium. Then the central bank of Macroland decides to reduce interest rates through an open-market operation. a. Draw an AD-AS graph representing the initial situation in Macroland. On your graph, be sure to include the SRAS, LRAS, and AD. Mark the equilibrium aggregate price level and the aggregate output level as well as potential output. b. Draw a graph of the money market depicting Macroland s initial situation before the central bank engages in monetary policy, as well as the effect of the monetary policy actions. Be sure to indicate the initial equilibrium, as well as the equilibrium after the monetary policy. c. How does this monetary policy action affect the aggregate economy in the short run? Explain, including a graph of the AD-AS model to illustrate your answer. Agg demand increases and causes the AD curve to shift to the right. In the short run, this causes output and price level to increase. d. How does this monetary policy action affect the aggregate economy in the long run? The economy must return to producing its potential output. This occurs as SRAS shifts to the left, eliminating the inflationary gap, restoring economy back to potential output. 7. The economy of Macroland is initially in long-run equilibrium. Then the central bank of Macroland decides to sell Treasury bills on the open market.

4 a. Draw a graph representing the initial situation in Macroland. In your graph, be sure to include the SRAS, LRAS, and AD. On your graph, mark the equilibrium aggregate price level and aggregate output level, as well as potential output. AD decreases due to consumer and investment spending decreases. b. Draw a graph of the money market depicting Macroland s initial situation before the purchase of Treasury bills, as well as the effect of the purchase. Be sure to indicate the initial equilibrium as well as the final equilibrium. MS increases, interest rates increase. c. How does the purchase of Treasury bills affect the aggregate economy in the short run? AD shifts to the left d. How does the purchase of Treasury bills affect the aggregate economy in the long run? Economy must return to producing its potential output. This occurs as SRAS shifts to the right, eliminating the recessionary gap. 8. Suppose that when the central bank reduces the interest rate by 1%, it increases the level of investment spending by $500 million in Macroland. If the marginal propensity to save equals 0.25, what will be the total rise in real GDP, assuming the aggregate price level is held constant? Explain your answer. The action of the Fed effectively creates a change in autonomous investment spending of $500 million. This change in autonomous investment spending will cause real GDP to increase by a larger, multiplied amount due to the multiplier process. Since the multiplier equals 1/(1-MPC) or, in this case, 4, we can compute the total change in real GDP as 4 x $500 million, or $2 billion 9. For each of the following situations, determine the appropriate central bank monetary policy. a. The central bank adopts an interest target of 5%. Currently the interest rate in the economy is at 8%. Central bank wants to decrease interest rates. It can accomplish this goal by engaging in open-market purchases of T-bills. b. The central bank adopts an inflation target of 3%. Currently the inflation rate is 4%. Central bank wants to reduce inflation rate. It can do this by increasing the interest rate because this will slow the economy and result in a smaller output gap, which will help to pull the interest rate, and therefore, the rate of inflation down. The central bank should engage in open-market sales of T-bills. c. The central bank adopts an inflation target of 4%. Current inflation is 4%. However, this quarter the central bank expects data to reveal that the economy is entering a recession and has a projected negative output gap. Because central bank anticipates a slowdown, it also anticipates downward pressure on the agg PL as the level of spending in the economy falls. Central bank can stabilize the agg PL by engaging in expansionary monetary policy; central bank should engage in open-market purchases of T-bills. d. Current unemployment is greater than the natural rate of unemployment. Because the current rate of unemployment is greater than the potential rate of unemployment, economy is in recession. The central bank will want to engage in expansionary monetary policy unless it is actively seeking to reduce the targeted rate of inflation and the actual rate of inflation of the economy. Time Value of Money 10. You have won the lottery and can receive your winnings as a single payment of $2 million in cash now or you can receive a payment of $500,000 a year for five years starting now. The interest rate is constant at 10% per year. Which payment plan do you prefer? Compare the present value of the future payments to the single payment now. The present value is $500,000 + ($500,000)/(1.1) + ($500,000)/(1.1)² + ($500,000)/(1.1)³ + ($500,000)/(1.1)⁴ = $2,086,164, which is greater than $2 million. Banking and Money Creation 11. Suppose Fantasia has a single bank that initially has $10,000 of deposits, reserves of $2,000, and loans of $8,000. To simplify our example, we will assume that bank capital is zero. Furthermore, Fantasia s central bank has a required reserve of 10% of deposits. All monetary transactions are made by check; no one in Fantasia uses currency. a. Construct a T-account depicting the initial situation in Fantasia. In your T-account, make sure you differentiate between required and excess reserves and that your T-account s assets equal its liabilities.

5 b. Explain how you calculated the level of excess reserves in Fantasia. Excess reserves are equal to total reserves minus required reserves, or $1,000. To find required reserves, multiply deposits by the required reserve ratio ($10,000)(0.1) = $1000 c. Suppose the bank in Fantasia lends the excess reserves you calculated in part (b) until it reaches the point at which its excess reserves equal zero. How does this change the T-account? d. Did the money supply in Fantasia change when the bank loaned out the excess reserves? Yes, because the money supply is defined as bank deposits plus currency in circulation. Explain your answer. Because Fantasia has no currency in circulation, we need to consider only what happens to bank deposits. Initially, deposits equaled $10,000, and after the lending out of all the excess reserves, bank deposits equaled $20,000. Thus, the money supply increased by $10,000. e. What is the value of the money multiplier in Fantasia? Using the money multiplier, compute the change in deposits. Money multiplier is 1/rr, or 10. The change in deposits equals the money multiplier times the change in reserves or, in this case, the change in deposits equal (1/0.1)($1,000) = $10, You are provided the following T-accounts for the central bank of Economia and the only commercial bank in Economia. In Economia, all financial transactions occur within the banking system; no one holds currency. The required reserve ratio imposed by the central bank is 20% of deposits.

6 a. Suppose the central bank in Economia purchases $2,000 of treasury bills from the commercial bank. Provide a T- account for both the central bank and the commercial bank showing the immediate effect of this transaction. Be sure to differentiate between required and excess reserves for the commercial bank. b. Provide a T-account for the commercial bank once the commercial bank lends out tis reserves and all adjustments have been made through the money multiplier process. c. What happens to the money supply when the central bank purchases $2,000 of Treasury bills from the commercial bank? The money supply increases from $100,000 to $110,000. Recall that the money supply equals checkable deposits plus currency in circulation; because Economia has no currency in circulation, the money supply equals the level of deposits. d. How does the change in money supply relate to the money multiplier? The change in the money supply equals the money multiplier times the change in the monetary base. In this problem, the money multiplier is 5, and the change in the monetary base is the $2,000 increase in reserves that occurs when the central bank purchases the T- bills. e. What was the monetary base initially? The monetary base equals reserves plus currency in circulation. In Economia, currency in circulation is zero, so the monetary base is equivalent to reserves. Initially, the monetary base was $20,000. f. What is the monetary base after all adjustments to the central bank s monetary policy have taken effect? Increases to $22, Use the following information about Macroland to answer these questions. Bank deposits at the central bank $100 million Currency in bank vaults 50 million Currency held by the public 75 million Checkable deposits 600 million Traveler s checks 5 million a. What are the total bank reserves in Macroland? Bank reserves = currency in bank vaults plus bank deposits at the central bank, or $150 million. b. Suppose banks hold no excess reserves in Macroland. Given the information in this table, what is the required reserve ratio? rr= ration of required reserves to checkable deposits. Because there are no excess reserves in Macroland, the bank reserves calculated in part (a) equal the required reserves: thus, $150 million/$600 million equals a required reserve ratio of 0.25.

7 c. If the public does not change its currency holdings, what will happen to the level of checkable deposits in Macroland, relative to their initial level, if the central bank of Macroland purchases $10 million worth of Treasury bills in the open market? Provide the numerical answer and explain. When central bank of Macroland purchases $10 million in T-bills, the level of reserves in the banking system increases by $10 million. This increase in reserves starts the multiplier process; the change in the money supply is calculated as the increase in reserves times the money multiplier, or ($10 million)(4) = $40 million. Thus, the money supply increases by $40 million when the Central Bank purchases T bills on the open market. d. If the public does not change its currency holdings, what will happen to the level of checkable deposits in Macroland, relative to their initial level, if the central bank of Macroland sells $5 million in Treasury bills on the open market? Explain your answer. Using the concept explained in part (c), this sale of T bills by the central bank will decrease the money supply by $20 million. We can see this by recalling that the change in the money supply equals the changes in reserves times the money multiplier or (-$5 million)(4), or -$20 million. Adapted from Strive for a 5: Preparing for the Macroeconomics AP Examination (Margaret Ray and David Mayer)

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