ECO-202-H3575 Macroeconomics quiz mod 4

5. The money creation process

Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 10%. Alex, a client of First Main Street Bank, deposits $500,000 into his checking account at First Main Street Bank.

Complete the following table to reflect any changes in First Main Street Bank's T-account (before the bank makes any new loans).

Assets	Liabilities
Reserves	$500,000	Deposits	$500,000

Complete the following table to show the effect of a new deposit on excess and required reserves when the required reserve ratio is 10%.

Hint: If the change is negative, be sure to enter the value as negative number.

Amount Deposited	Change in Excess Reserves	Change in Required Reserves
(Dollars)	(Dollars)	(Dollars)
500,000

Now, suppose First Main Street Bank loans out all of its new excess reserves to Susan, who immediately uses the funds to write a check to Raphael. Raphael deposits the funds immediately into his checking account at Second Republic Bank. Then Second Republic Bank lends out all of its new excess reserves to Clancy, who writes a check to Becky, who deposits the money into her account at Third Fidelity Bank. Third Fidelity lends out all of its new excess reserves to Eileen in turn.

Fill in the following table to show the effect of this ongoing chain of events at each bank. Enter each answer to the nearest dollar.

	Increase in Deposits	Increase in Required Reserves	Increase in Loans
	(Dollars)	(Dollars)	(Dollars)
First Main Street Bank
Second Republic Bank
Third Fidelity Bank

Assume this process continues, with each successive loan deposited into a checking account and no banks keeping any excess reserves. Under these assumptions, the $500,000 injection into the money supply results in an overall increase of 500,000, 4,500,000, 5,000,000 in demand deposits.

6. The reserve requirement, open market operations, and the money supply

Assume that banks do not hold excess reserves and that households do not hold currency, so the only form of money is demand deposits. To simplify the analysis, suppose the banking system has total reserves of $500. Determine the money multiplier and the money supply for each reserve requirement listed in the following table.

Reserve Requirement	Simple Money Multiplier	Money Supply
(Percent)		(Dollars)
25	(1, 2.5, 4, 10, 25)	(500, 1250, 2000, 5000, 12500)
10	( , 2.5, 4, 10, 25)	(500, 1250, 2000, 5000, 12500)

A lower reserve requirement is associated with a (LARGER, SMALLER)  money supply.

Suppose the Federal Reserve wants to increase the money supply by $200. Again, you can assume that banks do not hold excess reserves and that households do not hold currency. If the reserve requirement is 10%, the Fed will use open-market operations to (BUY, SELL)     

worth of U.S. government bonds.

Now, suppose that, rather than immediately lending out all excess reserves, banks begin holding some excess reserves due to uncertain economic conditions. Specifically, banks increase the percentage of deposits held as reserves from 10% to 25%. This increase in the reserve ratio causes the money multiplier to (RISE, FALL) to ( 1, 2.5, 4, 10). Under these conditions, the Fed would need to (BUY, SELL) worth of U.S. government bonds in order to increase the money supply by $200.

Which of the following statements help to explain why, in the real world, the Fed cannot precisely control the money supply?  Check all that apply.

The Fed cannot prevent banks from lending out required reserves.

The Fed cannot control the amount of money that households choose to hold as currency.

The Fed cannot control whether and to what extent banks hold excess reserves.

8. Problems and Applications Q8

Suppose that people expect inflation to equal 5 percent, but in fact, prices rise by 7 percent.

Which of the following groups or individuals are hurt by this unexpectedly high inflation rate?  Check all that apply.

The government

A college that has invested some of its endowment in government bonds that are not indexed Treasury bonds

A homeowner with a fixed-rate mortgage

A union worker in the second year of a labor contract

9. The level of prices and the value of money

Suppose the price level reflects the number of dollars needed to buy a basket of goods containing one cup of coffee, one donut, and one newspaper. In year one, the basket costs $9.00.

In year two, the price of the same basket is $8.00. From year one to year two, there is INFLATION, DEFLATION at an annual rate of 1.00% 1.11% 1.25%, 11.11% 12.50%.

In year one, $72.00 will buy 0.11, 0.13, 4.5, 8, 9 baskets, and in year two, $72.00 will buy 0.11, 0.13, 4.5, 8, 9 baskets.

This example illustrates that, as the price level falls, the value of money RISE, FALL, REMAIN the SAME.

10. Using money creation to pay for government spending

Consider Tralfamadore, a hypothetical country that produces only cakes. In 2016, a cake is priced at $4.00.

Complete the first row of the table with the quantity of cakes that can be bought with $900.

Hint: In this problem, assume it is not possible to buy a fraction of a cake, and always  round down to the nearest whole cake. For example, if your calculations result in 1.5 cakes, the answer should be 1 cake.

Year	Price of a Cake	Cakes Bought with $900
	(Dollars)	(Quantity)
2016	4.00
2017

Suppose the government of Tralfamadore cannot raise sufficient tax revenue to pay its debts. In order to meet its debt obligations, the government prints money. As a result, the money supply rises by 20% by 2017.

Assuming monetary neutrality holds, complete the second row of the table with the new price of a cake and the new quantity of cakes that can be bought with $900 in 2017.

The impact of the government's decision to raise revenue by printing money on the value of money is known as the CLASSICAL DICHOTOMY, FISHER EFFECT, INFLATION TAX, VELOCITY OF MONEY.

11. Identifying costs of inflation

Andrew manages a grocery store in a country experiencing a high rate of inflation. He is paid in cash twice per month. On payday, he immediately goes out and buys all the goods he will need over the next two weeks in order to prevent the money in his wallet from losing value. What he can't spend, he converts into a more stable foreign currency for a steep fee. This is an example of the MENU COST, SHOE-LEATHER COST, UNIT-OF-ACCOUNTS-COST of inflation.

12. Inflation-induced tax distortions

Musashi receives a portion of his income from his holdings of interest-bearing U.S. government bonds. The bonds offer a real interest rate of 2.5% per year. The nominal interest rate on the bonds adjusts automatically to account for the inflation rate.

The government taxes  nominal interest income at a rate of 10%. The following table shows two scenarios: a low-inflation scenario and a high-inflation scenario.

Given the real interest rate of 2.5% per year, find the nominal interest rate on Musashi's bonds, the after-tax nominal interest rate, and the after-tax real interest rate under each inflation scenario.

Inflation Rate	Real Interest Rate	Nominal Interest Rate	After-Tax Nominal Interest Rate	After-Tax Real Interest Rate
(Percent)	(Percent)	(Percent)	(Percent)	(Percent)
2.0	2.5
7.5	2.5

Compared with higher inflation rates, a  lower inflation rate will DECREASE, INCREASE the after-tax real interest rate when the government taxes  nominal interest income. This tends to ENCOURAGE, DICOURAGE saving, thereby INCREASING, DECREASING the quantity of investment in the economy and INCREASING, DECREASING the economy's long-run growth rate.

13. Problems and Applications Q5

You take $150 you had kept under your mattress and deposit it in your bank account. Suppose this $150 stays in the banking system as reserves and banks hold reserves equal to 12.5 percent of deposits.

The total amount of deposits in the banking system increases by

, and the money supply increases by