International Monetary Policy: Problem Sets
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1 International Monetary Policy: Problem Sets Michele Piffer 1 Problem Set 1: Money Supply 1.1 Operations on the Monetary Base Suppose that the central bank owns 100 in treasury securities, zero direct loans to depository institutions and 100 in international reserves. 3/4 of its balance sheet are issued in currency. Show what happens in the central bank balance sheet if it purchases foreign assets for 100 and if at the same time a commercial bank comes at the discount window to demand a loan for 10. What kind of open market operation should the central bank run if he wanted to keep the monetary base constant? 1.2 Deposit Creation Suppose that the outstanding monetary base is equal to 100, that c=1, r=0.1 and e=0.1. By how much should the central bank increase the monetary base if he wanted to double the money supply? Could he achieve the same result by changing the regulatory requirement? 1.3 Money Multiplier Suppose that there is no reserve requirement but banks spontaneously accumulate excess reserves equal to 50 % of their deposits. Assume currency to deposit ratio is equal to 1, which means that families allocate half of their wealth in cash, half in deposits. What happens in this economy if the central bank buys securities for 100 and pays in cash? Course prepared for the Shanghai Normal University, College of Finance, April
2 2 Problem Set 2: Interest Rate 2.1 Determination of Equilibrium Interest Rate Assume the following demand for reserves: i ff = R Assume that the outstanding non-borrowed reserves are equal to 5, the discount interest rate is 0.8 and the excess reserves earn 0.2. Compute the equilibrium interest rate. What happens if the central bank runs OMO decreasing the monetary base by 3? What happens if it increases it up to 7? Draw a graph and do the necessary computation 2.2 Monetary Policy and the Equilibrium Interest Rate Answer true or false and explain: 1. An increase in the discount rate i d will always increase the equilibrium interest rate. (true or false) 2. Under certain conditions, an expansionary monetary policy through OMOs can increase the interest rate. (true or false) 3. Under certain conditions, an expansionary monetary policy through OMOs can leave the equilibrium interest rate unchanged. (true or false) 4. An increase in the reserve requirement r increases the equilibrium interest rate unless it has already hit the maximum, which is the rate of remuneration of excess reserves. (true or false) 3 Problem Set 3: IS-LM Model Derivation 3.1 Government Multiplier Derive the IS curve abandoning the assumption of balanced budget. Assume a lump-sum tax (constant T, not proportional to income). What is the fiscal multiplier? Interpret 2
3 and compare it to the case of balanced budget. Assume now that investments are decreasing in the interest rate (continue assuming balanced budget). Interpret now the fiscal multiplier from the IS curve only. Is it bigger or smaller than in the case with no movement in the interest rate? 3.2 Government Multiplier under Proportional Taxes Assume now that taxes are not lump-sum but proportional to income. Assume for simplicity that investments are exogenous. What is the fiscal multiplier? Compute the tax rate τ that guarantees balanced budget. Is it increasing or decreasing in I 0? Interpret. 3.3 LM curve Assume that the money demand curve is given by M d = Y 2 r Compute and draw the LM curve as a function of money supply M s and price level P. Assume then that M s = 2 and that the price level is equal to one. Draw the LM curve. Compute and interpret the amount of money demand for the following combinations of interest rate and output: (r, Y ) = (10, 3); (24, 10); (24, 3); (10, 10). 4 Problem Set 4: IS-LM Model and Economic Policies 4.1 Balanced/Unbalanced Gov t Budget in the IS-LM Model Consider a fiscal expansion in the IS-LM model. Show what changes if the extra expenditure is financed with extra taxes or with extra debt. Show the fiscal multipliers on the graph. 4.2 Negative Shock to Consumption in the IS-LM Model Using the IS-LM framework, show and explain what happens as a result of a shock preferences that decreases the exogenous component of consumption. What can the government 3
4 do to stabilize output? What can the central bank do to stabilize output? Show and explain the differences. 4.3 Inflationary Pressures in the IS-LM Model What happens in the IS-LM model as a result of inflationary pressures? Explain. 5 Problem Set 5: IS-LM Model and Policy Effectiveness 5.1 LM curve Explain the shape of the LM curve when money demand is very interest elastic. How does this differ from the case of a money demand that is very inelastic in variations of output? Which economic policy will be more effective in this/these scenario(s)? 5.2 Fiscal Policy in the Long Run Assume that the economy is in equilibrium at the natural level of output. Discuss the effects of a contractionary fiscal policy both in the short run and in the long run. Explain how investments and consumption behave during the transition from the original to the new equilibrium. 5.3 Monetary Neutrality Assume that the economy is in equilibrium at the natural level of output. Discuss the effects of a contractionary monetary policy both in the short run and in the long run. Explain how investments and consumption behave during the transition from the original to the new equilibrium. 4
5 6 Problem Set 6: Balance of Payments and National Accounting 6.1 Exchange Rates Say that the market is trading 2 euros for a pound. If the market moves to requiring one third of a pound to buy a euro, does this mean that the pound has appreciated or depreciated? Have British goods become more or less competitive? 6.2 Balance of Payments In any country, the current account must be equal to the difference between capital inflows and capital outflows. This is in order to match demand of domestic currency with supply of foreign currency. Comment. 6.3 Current Account Explain the Current Account and its informative content. Use explicit notation when necessary. 7 Problem Set 7: Economic Policies in Open Economy 7.1 Monetary Interventions under Fixed Exchange Rates Suppose we are under fixed exchange rates and there is a tendency of domestic appreciation resulting from a positive balance of payments. The central bank will intervene selling its international reserves, but in this way it will increase the monetary base. To sterilize this undesired effect the central bank intervenes with open market operations. Comment. 7.2 Monetary Policy under Fixed Exchange Rates A monetary expansion is not compatible with the commitment to keep a fixed exchange rate, but a monetary contraction is. Comment. 5
6 7.3 Monetary Policy under Flexible Exchange Rates Analyze the effects of a monetary contraction on: domestic interest rate, equilibrium output, exchange rate, investments, consumption, current account, capital account. 6
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