Answers to review quizzes marcroeconomics 12e parkin chapter 8

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W H AT I S E C O N O M I C S ? 135 MONEY, THE PRICE LEVEL, AND INFLATION** Answers to the Review Quizzes Page 222 (page 630 in Economics) What makes something money? What functions does money perform? Why you think packs of chewing gum don’t serve as money? Money is anything that is generally acceptable as a means of payment Money has three functions: medium of exchange (money is accepted in exchange for goods and services), unit of account (prices are quoted in terms of money), and store of value (money can be held and exchanged for goods and services later) Packs of chewing gum not function as money because they are not particularly good as a store of value—gum deteriorates Additionally, packs of gum are not generally accepted in exchange for goods and services, so packs of gum are not a medium of exchange What are the problems that arise when a commodity is used as money? Commodities are not used as money because of several problems Many commodities are bulky And many commodities change in value over time Using as money a commodity that changes in value would be awkward Prices would change simply because the commodity’s value changed Additionally, using a commodity as money has a higher opportunity cost than currency and bank deposits because the commodity has alternative uses that must be foregone What are the main components of money in the United States today? The main components of money in the United States today are currency and deposits at banks and other depository institutions What are the official measures of money? Are all the measures really money? The official measures of money are M1 (the sum of currency, traveler’s checks, and checking deposits owned by individuals and businesses) and M2 (the sum of M1, savings deposits, time deposits, and money market mutual funds and other deposits) All of the components of M1 are truly money because all the components serve as a means of payment Some of the components of M2 are not truly money because they are not a means of payment (For instance, funds at money market mutual funds cannot be used as a means of payment for small purchases.) But all of these “non-money” assets are highly liquid so they are operationally similar to money 135 136 Why are checks and credit cards not money? Checks and credit cards are not money because they are not a means of payment A check is an order to transfer a deposit from one person to another The deposits are money but the checks are not A credit card is an ID card that lets a person take out a loan at the instant he or she buys something The loan still needs to be repaid with money so the credit card is not a means of payment, that is, it is not money Page 226 (page 634 in Economics) What are depository institutions? Depository institutions are financial firms that take deposits from households and firms They then make loans available to other households and firms What are the functions of depository institutions? Depository institutions have four major economic functions: They create liquidity, pool risk, lower the cost of borrowing, and lower the cost of monitoring borrowers How depository institutions balance risk and return? Banks earn a higher return by using the funds they acquire from their deposits to buy higher-yielding, riskier assets such as loans But these assets are risky If the loans fail, then the bank might not have sufficient funds to repay their depositors If the bank undertakes too much risk, then its depositors might rush to withdraw their deposits, which would cause the bank to fail But if the bank forgoes all risky assets its profit will be much lower So the bank must balance its search for higher return against the risk earning the return entails How depository institutions create liquidity, pool risks, and lower the cost of borrowing? Liquidity is the property of being easily convertible into a means of payment without loss in value Depository institutions create liquidity when they offer deposits that can be withdrawn as money at short (or no) notice and then use these deposits to make long-term loans Depository institutions pool risk because they use funds obtained from many depositors to make loans to many borrowers As a result, if a borrower defaults, no one depositor bears the entire loss because the loss is spread over all depositors By spreading the risk, depository institutions are pooling risk Depository institutions lower the cost of borrowing because they specialize in borrowing For instance, a firm that wants to borrow a large sum of money need only visit one depository institution to arrange such a loan In the absence of depository institutions, the firm would need to undertake many transactions with many lenders, which would be a costly process How have depository institutions made innovations that have influenced the composition of money? Checking deposits at thrift institutions such as S&L’s savings banks, and credit unions are examples of deposits that were created by innovations in the 1980s and 1990s These deposits have become an increasingly large percentage of M1 Savings deposits have decreased as a percentage of M2, while time deposits and money market mutual funds have increased, and checking deposits at commercial banks have become a decreasing percentage of M1 Page 230 (page 638 in Economics) 136 What is the central bank of the United States and what functions does it perform? W H AT I S E C O N O M I C S ? 137 The Federal Reserve System is the central bank of the United States The Federal Reserve conducts the nation’s monetary policy and regulates the nation’s depository institutions The Fed provides banking services to commercial banks What is the monetary base and how does it relate to the Fed’s balance sheet? The monetary base is the sum of Federal Reserve notes, coins, and depository institutions’ deposits at the Fed Aside from coins, the rest of the monetary base consists of Federal Reserve liabilities Federal Reserve notes and depository institutions’ deposits are liabilities of the Federal Reserve What are the Fed’s three policy tools? The Federal Reserve has three policy tools: required reserve ratio, last resort loans, and open market operations What is the Federal Open Market Committee and what are its main functions? The Federal Open market Committee (FOMC) is the main policy-making group within the Federal Reserve System It decides upon the nation’s monetary policy as conducted through open market operations The FOMC meets approximately once every six weeks 137 How does an open market operation change the monetary base? The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Federal Reserve, that is, banks’ reserves When the Federal Reserve conducts an open market operation, it either buys securities and pays for them with newly created reserves or it sells securities and is paid with reserves held by banks In both cases the monetary base changes In the first case, when the Fed buys securities, the monetary base increases In the second case, when the Fed sells securities, the monetary base decreases Page 232 (page 640 in Economics) How banks create money? Banks within the banking system create money by creating deposits, which are part of the nation’s money Banks create deposits by making loans because part or all of the loans they make will be deposited in another bank For instance, a student given a loan may purchase books at the local bookstore The bookstore will then deposit the proceeds into its bank as part of the bookstore’s checking account Thus the loan has created new deposits at the bookstore’s bank What limits the quantity of money that the banking system can create? The quantity of money that the banking system can create is limited by: the monetary base, desired reserves, and desired currency holdings A bank manager tells you that she doesn’t create money She just lends the money that people deposit Explain why she’s wrong Though the manager does not see the entire process, nonetheless the loans the manager makes create more deposits and more money Point out to the manager that when she makes a loan, the deposits at her bank initially increase And, when the loan is spent, the recipient selling the goods or services that have been purchased will deposit part or all of the proceeds in his or her bank When the recipient makes this deposit, the total amount of the nation’s deposits increase and, because deposits are part of the nation’s money, the quantity of money also increases However, actions of other economic agents also affect the creation of money For example, if people decide to hold less currency and more deposits, the immediate effect on the quantity of money is nil But over time the quantity of money increases because banks gain more (excess) reserves, which are then loaned and then deposited, thereby creating additional deposits and increasing the quantity of money Page 237 (page 645 in Economics) What are the main influences on the quantity of real money that people and businesses plan to hold? The quantity of real money demanded depends on four factors: the price level, the nominal interest rate, real GDP, and financial innovation An increase in the price level increases the nominal demand for money but the quantity of real money demanded is independent of the price level An increase in the nominal interest rate decreases the quantity of real money demanded, because the nominal interest rate is the opportunity cost of holding money An increase in real GDP increases the demand for real money, because more real GDP implies more transactions and an increase in the demand for money to finance the transactions And, financial innovations that make it less costly to get by with less money on hand decrease the demand for money M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N Show the effects of a change in the nominal interest rate and a change in real GDP using the demand for money curve An increase in the nominal interest rate decreases the quantity of real money demanded The slope of the demand for money curve shows how the quantity of real money demanded depends on the nominal interest rate As illustrated in Figure 8.1, a decrease in the nominal interest rate results in a movement downward along the demand for money curve A change in real GDP changes the demand for money An increase in real GDP increases the demand for money and shifts the demand for curve for real money rightward from MD0 to MD1, as shown in Figure 8.2 How is money market equilibrium determined in the short run? 101 102 CHAPTER In the short run, the nominal interest rate adjusts to restore equilibrium to the money market When the quantity of money demanded equals the quantity supplied, the nominal interest rate is at its equilibrium level How does a change in the quantity of money change the interest rate in the short run? In the short run an increase in the quantity of money lowers the interest rate and a decrease in the quantity of money raises the interest rate Suppose the Federal Reserve increases the quantity of money At the initial interest rate people hold more money than the quantity they demand To restore the amount of money they hold to equality with the quantity demanded, people use the surplus in the loanable funds market to buy bonds The price of a bond rises which means that the interest rate on the bond falls When the Federal Reserve decreases the quantity of money, the reverse occurs: At the initial interest rate people have less money than the quantity they demand so they sell bonds in the loanable funds market to acquire more money Selling bonds lowers their price which raises the interest rate M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N How does a change in the quantity of money change the interest rate in the long run? In the long run a change in the quantity of money does not change the interest rate For example, suppose the Federal Reserve increases the quantity of money (the effects from a decrease in the quantity of money are the reverse of an increase) In the short run the nominal interest rate and the real interest rate fall Both households and firms increase their demand for goods The resulting shortages force prices higher and therefore the price level rises As the price level rises, the quantity of real money decreases, which raises the nominal interest rate and real interest rate The rise in the interest rate decreases the demand for goods Eventually the price level rises so that the quantity of real money equals the initial amount At this point, the nominal interest rate and real interest rate have risen to equal their initial values so there is no long-run effect on the interest rate from a change in the quantity of money Page 239 (page 647 in Economics) What is the quantity theory of money? The quantity theory of money is the proposition that in the long run an increase in the quantity of money creates an equal percentage increase in the price level How is the velocity of circulation calculated? The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP The velocity of circulation equals (nominal) GDP divided by the quantity of money What is the equation of exchange? The equation of exchange is the formula that MV = PY, where M is the quantity of money, V is the velocity of circulation, P is the price level, and Y is real GDP The equation of exchange is always true by definition because the velocity of circulation is defined as PY/M Does the quantity theory correctly predict the effects of money growth on inflation? The long-run historical and international evidence on the relationship between money growth and the inflation rate support the quantity theory The data suggest a marked tendency for nations with high money growth rates to have high inflation rates 103 104 CHAPTER Answers to the Study Plan Problems and Applications Money in the United States today includes which of the following items? • Cash in Citibank’s cash machines Money includes currency outside the banks Currency inside cash machines is not money • U.S dollar bills in your wallet The dollar bills inside your wallet are money • Your Visa card The Visa card is not money • Your loan to pay for school fees The loan is not money In June 2013, currency held by individuals and businesses was $1,124 billion; traveler’s checks were $4 billion; checkable deposits owned by individuals and businesses were $1,042 billion; savings deposits were $6,884 billion; time deposits were $583 billion; and money market funds and other deposits were $647 billion Calculate M1 and M2 in June 2011 M1 consists of currency and traveler’s checks plus checking deposits owned by individuals and businesses In June, 2011 M1 equaled $1,124 billion + $4 billion + $1,042, or $2,170 billion M2 consists of M1 plus time deposits, savings deposits, and money market mutual funds and other deposits In June, 2011 M2 equaled $2,170 + $583 billion + $6,884 billion + $647 billion, or $10,284 billion Europe’s Banks Must Be Forced to Recapitalize E.U banks must hold more capital Where private funding is not forthcoming, recapitalization must be imposed by E.U governments Source: Financial Times, November 24, 2011 What is the “capital” referred to in the news clip? How might the requirement to hold more capital make banks safer? The “capital” means owners’ capital; that is, funds the owners have invested in the bank When loans or other assets go bad, the bank incurs a loss and the bank’s capital decreases If enough losses are incurred, the bank’s capital might be totally dissipated, in which case the bank fails because the bank has no further cushion to absorb more losses The requirement to hold more capital makes the possibility of failure less likely The FOMC sells $20 million securities to Wells Fargo Enter the transactions that take place to show the changes in the following balance sheets The first balance sheet to the right Federal Reserve Bank of New York shows the balance sheet of the Assets Liabilities Federal Reserve Bank of New York (millions) (millions) The Fed’s assets decrease by $20 Securities Wells Fargo reserve million because the Fed now has $20 −$20 deposit −$20 million less securities The Fed’s liabilities also decrease by $20 million because Wells Fargo pays for its purchases Wells Fargo using the reserves that it has on deposit at the Fed Assets Liabilities (millions) (millions) The second balance sheet to the right shows Securities +$20 Reserve deposit −$20 M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N the balance sheet of Wells Fargo Bank Wells Fargo gains assets in the form of securities of $20 million Simultaneously it also losses reserve deposit assets of $20 million because it pays for the government securities using its reserve deposits at the Fed 105 106 CHAPTER In the economy of Nocoin, bank deposits are $300 billion, bank reserves are $15 billion of which two thirds are deposits with the central bank Households and firms hold $30 billion in bank notes There are no coins Calculate a The monetary base and the quantity of money The monetary base is $45 billion The monetary base is the sum of the central bank’s notes, banks’ deposits at the central bank, and coins held by households, firms, and banks There are $30 billion in notes held by households and firms, banks’ deposits at the central bank are $10 billion (2/3 of $15 billion), the banks hold other reserves of $5 billion (which are notes), and there are no coins The monetary base is $45 billion The quantity of money is $330 billion In Nocoin, deposits are $300 billion and currency is $30 billion, so the quantity of money is $330 billion b The banks’ desired reserve ratio and the currency drain ratio (as percentages) The banks’ reserve ratio is percent The banks’ reserve ratio is the percent of deposits that is held as reserves In Nocoin, deposits are $300 billion and reserves are $15 billion, so the reserve ratio equals ($15 billion/$300 billion) × 100, which is percent The currency drain is 10 percent The currency drain is the ratio of currency to deposits In Nocoin, currency is $30 billion and deposits are $300 billion, so the currency drain equals ($30 billion/$300 billion)  100, which is 10 percent China Cuts Banks’ Reserve Ratios The People’s Bank of China announces it will cut the required reserve ratio Source: Financial Times, February 19, 2012 Explain how lowering the required reserve ratio will impact banks’ money creation process Lowering the required reserve ratio decreases banks’ desired reserves When banks’ desired reserves decrease they will make more loans so the quantity of money in China increases (The Mathematical Note shows that an decrease in the desired reserve ratio increases the money multiplier.) The spreadsheet provides data about the demand for money in Minland Columns A and B show the demand for money schedule when real GDP (Y0) is $10 billion and Columns A and C show the demand for money schedule when real GDP (Y1) is $20 billion The quantity of money is $3 billion What is the interest rate when real GDP is $10 billion? Explain what happens in the money market in the short run if real GDP increases to $20 billion A r B Y0 C Y1 1.0 1.5 2.0 2.5 3.0 3.5 4.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 When real GDP is $10 billion, the equilibrium nominal interest rate is percent because that is the interest rate that sets the quantity of money demanded equal to $3 billion If real GDP increases to $20, the quantity of money demanded exceeds the quantity supplied, so people want to hold more money than is available They try to increase the amount of money held by selling bonds The prices of bonds fall, and the interest rate rises to its new equilibrium of percent M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N In year 1, the economy is at full employment and real GDP is $400 million, the GDP deflator is 200 (a price level is 2), and the velocity of circulation is 20 In year 2, the quantity of money increases by 20 percent If the quantity theory of money holds, calculate the quantity of money, the GDP deflator, real GDP, and the velocity of circulation in year The quantity of money in year is $40 million Because the equation of exchange tells us that MV = PY, we know that M = PY/V Then, with P = 2.0, Y = $400 million, and V = 20, M = $40 million Then in year the quantity of money is $48 million because money grows by 20 percent, which is $8 million The GDP deflator is 240 Because the quantity theory of money holds and because the factors that influence real GDP have not changed, the GDP deflator rises by the same percentage as the increase in the quantity of money, which is 20 percent Real GDP is $400 million because it remains equal to potential GDP (the quantity of GDP produced at full employment) The velocity of circulation is 20 Because the factors that influence velocity have not changed, velocity is unchanged Mathematical Note In Problem 5, the banks have no excess reserves Suppose that the central bank of Nocoin increases bank reserves by $0.5 billion a Explain what happens to the quantity of money and why the change in the quantity of money is not equal to the change in the monetary base The quantity of money increases by $3.67 billion The quantity of money increases by the change in the monetary base multiplied by the money multiplier The money multiplier is 7.33 (see part b), so when the monetary base increases by $0.5 billion, the quantity of money increases by $3.67 billion The change in the quantity of money is not equal to the change in the monetary base because of the multiplier effect The open market operation increases bank reserves and creates excess reserves, which banks use to make new loans New loans are used to make payments and some of these loans are placed on deposit in banks The increase in bank deposits increases banks’ reserves and increases desired reserves But the banks now have excess reserves which they loan out and the process repeats until excess reserves have been eliminated b Calculate the money multiplier The money multiplier is 7.33 The money multiplier is equal to (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the banks’ reserve ratio From the problem, C/D = 0.1 and R/D = 0.05, so the money multiplier equals (1 + 0.1)/(0.1 + 0.05), which equals 7.33 107 108 CHAPTER Answers to Additional Problems and Applications 10 Kristin deposits $5,000 cash into her savings account at the First National Bank What is the immediate change in M1 and M2? The deposit of $5,000 in the savings account will decrease M1 However, M2 will not change 11 Rapid inflation in Brazil in the early 1990s caused the cruzeiro to lose its ability to function as money Which of the following commodities would most likely have taken the place of the cruzeiro in the Brazilian economy? Explain why a Tractor parts It is unlikely that tractor parts would be used as money because tractor parts are heavy and unwieldy to carry around for use as a medium of exchange b Packs of cigarettes Packs of cigarettes would likely be used as a substitute for money because they are light to carry around, are durable, and can be easily divided into fractions of packs for making change c Loaves of bread Loaves of bread would be unlikely to be used as a substitute for money because they would spoil too rapidly d Impressionist paintings Impressionist paintings would be unlikely to be used as a substitute for money because they would be unwieldy to carry around and because their quality and value differs dramatically from one artist to another e Baseball trading cards Baseball cards would be unlikely to be used as a substitute for money because most Brazilians are unfamiliar with baseball (and unlikely to value the cards per se) and because the cards are not very durable 12 Are You Ready to Pay by smartphone? Starbucks customers can now pay for their coffee using their smartphone Does this mean the move to electronic payments is finally coming? Source: The Wall Street Journal, January 20, 2011 If people can use their smartphone to make payments, will currency disappear? How will the components of M1 change? People will probably carry less currency because their cell phone will substitute for currency, but currency won’t disappear because currency is used in the underground economy As a component of M1, currency and traveler’s checks will be smaller and most of M1 will be checkable deposits M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N Use the following news clip to work Problems 13 and 14 The World’s 29 Too Big to Fail Banks, JP Morgan at the Top The Financial Stability Board has released the latest list of the world’s too-big-tofail banks Each year, the board examines banks to decide which ones pose a threat to the global economy if they were to fail Those on the list of too-big-to-fail must hold more capital to absorb potential losses, and therefore protect taxpayers from bailouts In 2013, JPM and HSBC top the list This means they must each hold an extra 2.5% of capital on top of the additional 7% that will be required down the road Source: www.forbes.com, November 11, 2013 13 Explain how the failure of big banks would be disastrous for the economy? A commercial bank lends its excess reserves which are the actual reserves minus required (safe) reserves Hence, to maximize its profit, the bank minimizes these reserves to the maximum or lends all its excess reserves If there is a run on the bank from depositors and a large number of depositors request the return of their funds, the bank might fail if it does not have adequate reserves in hand to meet these withdrawals In this case, depositors will lose their savings and if the bank is too big and holds an important share of the total banking system assets this will affect the savings of a country A fall in the savings may lead to a recession 14 Should such banks receive financial support from their governments to avoid failure? The world’s largest financial institutions, at least most of them, are connected These connections would pose a systemic risk in the sense that the failure of one large bank could bring down others and threaten the stability of the financial system In order to prevent such a default, the government may use public funds to ensure payment of a large bank’s debt This would increase the stability of the banking system However, the financial support by the government will encourage the bank to take more risks and might lead to a greater chance of failure than it would without the government’s financial support Moreover, these funds could be alternatively allocated by the government to other sectors that are productive 15 Explain the distinction between a central bank and a commercial bank A central bank is basically a “bank for banks.” It will conduct business with commercial banks, such as making loans to them and holding their reserves A central bank does not accept deposits from private citizens A central bank also regulates the nation’s depository institutions and conducts the nation’s monetary policy A commercial bank conducts business with firms and households It accepts deposits from individuals and then makes loans to other people or firms Commercial banks are privately owned and have as their objective the maximization of their profit 16 If the Fed makes an open market sale of $1 million of securities to a bank, what initial changes occur in the economy? If the Fed sells $1 million of securities to a bank, both the Fed’s balance sheet and the bank’s balance sheet change The Fed’s holding of securities falls by $1 million and the bank’s holding of securities rises by $1 million The bank pays for the purchase with its reserves, so the reserves held by the Fed fall by $1 million and the bank’s reserves fall by $1 million The amount of the bank’s assets does not change, though the composition changes (more securities, fewer reserves) The Fed’s assets and liabilities both fall by an equal amount ($1 million in this case) 109 110 17 CHAPTER Set out the transactions that the Fed undertakes to increase the quantity of money The Fed has three procedures by which it can increase the quantity of money: • The Fed could use an open market purchase of securities from banks When the Fed buys securities, it pays for the purchase by increasing banks’ reserves The increase in banks’ reserves increases the monetary base and allows banks to make more loans, which then increase the quantity of money • The Fed could make a last resort loan to a bank When the Fed makes a loan to a bank, the bank’s reserves increase The increase in reserves increases the monetary base and allows the bank to make more loans, which then increase the quantity of money • The Fed could lower the required reserve ratio By lowering the required reserve ratio, the Fed lowers the reserves banks must hold and thereby lowers their desired reserve ratio Banks respond by increasing their loans, which then increase the quantity of money 18 Describe the Fed’s assets and liabilities What is the monetary base and does it relate to the Fed’s balance sheet? The Fed has two main assets: U.S government securities and loans to depository institutions The Fed also has two main liabilities, Federal Reserve notes and depository institution deposits (the reserves that depository institutions hold at the Fed) The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Fed Coins are only a small part of the monetary base The two largest components of the monetary base, Federal Reserve notes and depository institutions deposits at the Fed, are the Fed’s two liabilities 19 Fed Minutes Show Active Discussion of QE3 The FOMC discussed “a new large-scale asset purchase program” commonly called “QE3.” Some FOMC members said such a program could help the economy by lowering long-term interest rates and making financial conditions more broadly easier They discussed whether a new program should snap up more Treasury bonds or buying mortgage-backed securities issued by the likes of Fannie Mae and Freddie Mac Source: The Wall Street Journal, August 22, 2012 What would the Fed to implement QE3, how would the monetary base change, and how would bank reserves change? To implement QE3 the Fed would undertake massive (“quantitative”) purchases of assets These assets likely would be long-term securities and could include Treasury bonds and/or mortgage backed securities, such as those issued by Fannie Mae or Freddie Mac These purchases would increase both the monetary base and banks’ reserves 20 Banks in New Transylvania have a desired reserve ratio of 10 percent of deposits and no excess reserves The currency drain ratio is 50 percent of deposits Now suppose that the central bank increases the monetary base by $1,200 billion a How much the banks lend in the first round of the money creation process? Banks loan $1,200 billion because the entire increase in reserves is excess reserves M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N b How much of the initial amount lent flows back to the banking system as new deposits? $800 billion flows back to the banks as new deposits The currency drain, which is the percentage ratio of currency to deposits, is 50 percent Of the $1,200 billion that has been loaned, $800 billion is deposited back in banks and 50 percent of the deposits, $400 billion, is kept as currency c How much of the initial amount lent does not return to the banks but is held as currency? Currency increases by $400 billion The currency drain, which is the percentage of currency to deposits, is 50 percent Of the $1,200 billion that has been loaned, $800 billion is deposited and 50 percent of the deposits, $400 billion, is kept as currency 111 112 CHAPTER d Why does a second round of lending occur? A second round of lending takes place because the $800 billion flowing back to the banks as new deposits means that banks have excess reserves Of the $800 billion flowing back to the banks, 10 percent, or $80 billion, is kept as reserves leaving $720 billion that will be loaned in a second round of lending 21 Explain the change in the nominal interest rate in the short run if a Real GDP increases The nominal interest rate rises When real GDP increases, the demand for money increases At the initial interest rate people are holding less money than the quantity they demand People sell bonds to increase the money they hold The price of a bond falls and the nominal interest rate rises b The money supply increases The nominal interest rate falls When the supply of money increases, the quantity of real money increases At the initial interest rate people are holding more money than the quantity they demand People buy bonds to decrease the money they hold The price of a bond rises and the nominal interest rate falls c The price level rises The nominal interest rate rises When the price level rises, the quantity of real money decreases The supply of money decreases The demand for money does not change At the initial interest rate people are holding less money than the quantity they demand People sell bonds to increase the money they hold The price of a bond falls and the nominal interest rate rises 22 Figure 8.3 shows the demand for money curve If the Fed decreases the quantity of real money supplied from $4 trillion to $3.9 trillion, explain how the price of a bond will change If the Fed decreases the quantity of money to $3.9 trillion, the price of a bond falls The decrease in the quantity of money means that at the initial interest rate, percent, people are holding less money than the quantity they demand In response people sell bonds to try to increase the quantity of money they hold As people sell bonds, the price of a bond falls and the interest rate rises, in the figure from percent to percent 23 Use the data in Problem to work this problem The interest rate is percent a year Suppose that real GDP decreases from $20 billion to $10 billion and the quantity of money remains unchanged Do people buy bonds or sell bonds? Explain how the interest rate changes When real GDP decreases, the demand for money decreases At the initial interest rate of percent, the quantity of money people are holding exceeds the quantity of M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N money they want to hold People buy bonds to decrease the quantity of money they are holding When people demand bonds, the price of a bond rises, and the interest rate falls When the interest rate equals percent a year, people are holding exactly the quantity of money that they want to hold so percent is the new equilibrium interest rate 24 The table provides some data for the United States in the first decade following the Civil War Source of data: Milton Friedman and Anna J Schwartz, A Monetary History of the United States 1867– 1960 a Calculate the value of X in 1869 Quantity of money Real GDP (1929 dollars) Price level (1929 = 100 ) Velocity of circulation 1869 $1.3 billion $7.4 billion X 1879 $1.7 billion Z 4.50 4.61 54 Using the formula MV = PY gives ($1.3 billion × 4.5) = (P × $7.4 billion) so that P equals 0.79, or, transformed to an index number, P = 79 b Calculate the value of Z in 1879 Using the formula MV = PY gives ($1.7 billion × 4.61) = (0.54 × Y) so that Y equals $14.5 billion c Are the data consistent with the quantity theory of money? Explain your answer The quantity theory holds The quantity theory predicts that the inflation rate equals the growth rate of the quantity of money plus the growth rate of velocity minus the growth rate of real GDP The growth rate of velocity is approximately zero, so the inflation rate equals the growth rate of the quantity of money minus the growth rate of real GDP The quantity of money grew by approximately 27 percent, real GDP grew by approximately 65 percent and the price level fell by approximately 38 percent (These percentages are calculated using the average of the quantity of money, the price level, and real GDP as the base for the percentage.) The inflation rate, −38 percent (deflation) equals the growth rate of the quantity of money, 27 percent, minus the growth rate of real GDP, 65 percent Economics in the News 25 After you have studied Reading Economics in the News on pp 240–241 (648– 649 in Economics,) answer the following questions a What changes in the interest rate and the quantity of M2 occurred between 2007 and 2014? The interest rate plummeted from almost percent per year to near percent per year Meanwhile the quantity of M2 soared from about $7 trillion to $10 trillion b Why is the outcome feared by bankers optimistic? Bankers are concerned that the quantity of money demanded will decrease by $1 trillion if the Fed raises the interest rate to percent Because most of the decrease will be a decrease in deposits, bankers expect a $1 trillion decrease in deposits But the demand curve for M2 shows that if the interest rate rises to percent, the quantity of money demanded will decrease by $1.8 trillion Bankers expect a decrease of only $1 trillion, so the predicted decrease is much larger than the outcome they expect 113 114 CHAPTER c By how much would the quantity of M2 demand decrease if the interest rate rose to percent, percent, and percent? (Express your answer as a percentage of GDP.) If the interest rate rises to percent, the quantity of money demanded is approximately 50 percent of GDP; if the interest rate rises to percent, the quantity of money demanded is approximately 48 percent of GDP; and, if the interest rate rises to percent, the quantity of money demanded is approximately 47 percent of GDP d What could the banks to prevent deposits from decreasing by as much as predicted by the demand for M2 curve in Fig on p 241 (page 649 in Economics)? Banks can raise the interest rate they pay on deposits in order to prevent the deposits from decreasing as much as the demand for M2 curve shows e What would you expect to happen to the monetary base if interest rates rise? Why? The monetary base will decrease If interest rates rise, banks will have a greater incentive to loan the funds they are keeping as reserves at the Fed Decreasing the quantity of reserves decreases the monetary base M O N E Y , T H E P R I C E L E V E L , A N D I N F L AT I O N 26 The Truth is Out: Money is Just an IOU, and the Banks Are Rolling In It The central bank can print as much money as it wants to, but it doesn’t as it was created to regulate money supply If governments could print money, and not independent central banks, they would surely put out too much of it, and the resulting inflation would throw the economy into chaos Source: The Guardian, March 18, 2014 a Explain how the money market will be affected if too much money is printed by the central bank Printing money will increase money supply The excess money supply will lower the interest rate A change in the interest rate will bring a movement along the demand for money curve b Explain using the quantity theory of money how printing money increases inflation in the long run Printing money by the central bank increases money supply (M) In the long run, with the economy at full employment, real GDP equals potential GDP, so the real GDP growth rate equals the potential GDP growth rate If we assume a constant velocity in the long run, the inflation rate will be the money growth rate minus the real GDP growth rate The increase in M will increase the price level proportionally if the growth rate of real GDP is assumed to be zero in the long run Mathematical Note 27 In the United Kingdom, the currency drain ratio is 38 percent of deposits and the reserve ratio is percent of deposits In Australia, the quantity of money is $150 billion, the currency drain ratio is 33 percent of deposits, and the reserve ratio is percent of deposits a Calculate the U.K money multiplier The money multiplier equals 3.45 The money multiplier is equal to (1 + C/D)/(R/D + C/D), where C/D is the currency drain ratio and R/D is the banks’ reserve ratio From the problem, C/D = 38 percent and R/D = percent, so the money multiplier equals (1 + 0.38)/(0.38 + 0.02), which equals 3.45 b Calculate the monetary base in Australia The monetary base equals $46.2 billion The monetary base equals the sum of currency and depository institution deposits at the central bank The currency drain is 33 percent, so with the quantity of money equal to $150 billion, currency is $37.2 billion and deposits are $112.8 billion The banks’ reserve ratio is percent, so reserves are ($112.8 × 0.08), which is $9 billion The monetary base equals $37.2 billion + $9.0 billion, or $46.2 billion 115 ... have sufficient funds to repay their depositors If the bank undertakes too much risk, then its depositors might rush to withdraw their deposits, which would cause the bank to fail But if the bank... MD0 to MD1, as shown in Figure 8. 2 How is money market equilibrium determined in the short run? 101 102 CHAPTER In the short run, the nominal interest rate adjusts to restore equilibrium to the... following news clip to work Problems 13 and 14 The World’s 29 Too Big to Fail Banks, JP Morgan at the Top The Financial Stability Board has released the latest list of the world’s too-big-tofail banks
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