(a) Using an MPC of.5, the impact of $100 spent the government will be as follows:

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1 S5 Solutions 24 points Chapter 2: Fiscal policy. If the marginal propensity to save is.5, how large is the multiplier? If the marginal propensity to save doubles to., what happens to the multiplier? With an MS of.5, the MC is.95. Since the multiplier is /(-MC) = /MS = /.5 = 2 pt. If the MS doubles to., the multiplier decreases to pt. 3. a. The multiplier process depicted in Table 2. is based on an MC of.75. Recompute the first five cycles using an MC of.5. b. What is the value of the multiplier in this case? c. What is the multiplier when the MC is ().8 and (2).9? (a) Using an MC of.5, the impact of $ spent the government will be as follows: pt (b) (c) Cycle Change in Spending Cumulative Change This cycle When the MC =.5, the Multiplier is 2. = /(-.5) pt When the MC =.8, the Multiplier is 5. = /(-.8) pt When the MC =.9, the Multiplier is. = /(-.9) pt

2 6. If taxes were cut by $ trillion and the MC were.95, by how much would total spending: a. increase in the first year with two spending cycles? b. increase over five year, with two spending cycles per year? c. increase over an infinite time period? Spending Cycle Total Spending Change in Spending $95 billion $95 billion One year 2,852.5 billion 92.5 billion 3 2,79.88 billion billion Two years 4 3, billion 84.5 billion 5 4,298.7 billion billion Three years 6 5,33.27 billion 735. billion 7 5,73.6 billion billion Four years 8 6,395.3 billion billion billion billion Five years 7,624 billion billion Using the table above, a) is $.86 trillion pt and b) is $7.62 trillion pt c. Over an infinite time period, the economy would expand by $9 trillion when the full multiplier effect takes place. This is calculated as: Tax Multiplier x $ trillion = MC/(-MC) x $ trillion =.95/(-.95) x $ trillion = 9 x $ trillion = $9 trillion pt

3 Chapter 3: Money and banking 4. What volume of loans can the banking system in Figure 3.2 support? If the reserve requirement were 5 percent, what would the system s lending capacity be? With a reserve ratio of.75, the money multiplier is /rr = /.75 =.33. With an initial injection of $ into the system, a total of $33 in new loans can be made. pt. If the rr =.5, then the money multiplier is 2 and $ of new loans can be supported in the banking system. pt 5. Suppose that an Irish Sweepstakes winner deposits $ million in cash into her transactions account at the Bank of America. Assume a reserve requirement of 25 percent and no excess reserves in the banking system prior to this deposit. Show the changes on the Bank of America balance sheet when the $ million is initially deposited. Changes in the balance sheet when the initial deposit is made are as follows: Assets Reserves $,, Required 2,5, Excess 7,5, Liabilities Demand Deposits +$,, pt.

4 Chapter 4: Monetary policy. Suppose the following data apply: Total Bank Reserves Total Bank Deposits Cash Held by the ublic Bonds Held by the ublic $5 billion Stocks held by public $4 billion $ billion Gross Domestic $5 trillion roduct $ billion Interest rate 6 percent $22 billion Required reserve ratio.4 a. How large is the money supply as measured by M? b. How much excess reserves are there? c. What is the money multiplier? d. What is the available lending capacity? a. The basic money supply (M) is transaction account balances and cash. Assuming that the total bank deposits are in transactions accounts the money supply is $ billion. pt b. If the required reserve ratio is.4, then banks are required to keep $4 billion in reserve ($ billion X.4). Since banks have total reserves of $5 billion, there is $ billion in excess reserves. pt c. The money multiplier is calculates as /(required reserve ratio). Thus, the money multiplier is /.4 = 25. pt d. Since there are $ billion in excess reserves and the money multiplier is 25, there is $25 billion in available lending capacity. pt

5 3. Suppose the Federal Reserve decided to purchase $ billion worth of government securities in the open market. a. How will M be affected initially? b. How will the lending capacity of the banking system be affected if the reserve requirement is 25 percent? c. How will banks induce investors to utilize this expanded lending capacity? When the Fed purchases $ billion of securities on the open market: a. M will increase by $ billion, assuming that the sellers of the securities hold the proceeds as cash or deposit them in a transactions account, e.g., checking account. pt b. Lending capacity will increase by $3 billion. (A money multiplier of 4 x excess reserves of $7.5 billion.) pt c. As the money supply increases, interest rates go down and investors will want to borrow more funds. pt

6 4. Suppose the economy is initially in equilibrium at an output level of and price level of. The Fed then manages to shift aggregate demand rightward by 2. a. Illustrate the initial equilibrium (E ) and the shift of. b. Show what happens to output and prices if the aggregate supply curve is () horizontal pt., (2) vertical pt., and (3) upward sloping pt.. When the economy is at an equilibrium output of and a price level is, the impact of a shift in rightward by 2 is illustrated below: (a) Initial equilibrium is E. (b) Output and price changes vary according to the shape of the AS curve. Aggregate supply Aggregate supply F E Q RATE OF OUTUT E RATE OF OUTUT 5 Aggregate supply E Q 7 RATE OF OUTUT 6

7 5. Illustrate the effects on bank reserve of an open-market sale (See Figure 4.5) An open market sale of government securities by the Federal Reserve would have exactly the opposite effect of the change illustrated in Figure 4.5: Step, FMOC sells government bond to the public, who pays by check. Step 2, Funds are withdrawn from buyer s private bank. Step 3, rivate bank s account at Regional Federal Reserve Bank is debited. pt. (okay to just explain that selling bonds decreases lending power) 6. How did the money multiplier change when China increased its reserve requirement? (see Headline p. 32) pt. When the reserve requirement increased from 6 percent to 7 percent, the money multiplier decreased from 6.7% to 4.3%.