Answers to Questions #1 & #2

Assets Liabilities

First Generation Bank

$5,000 Demand Deposits

$5,000RequiredReserves

$5,000 $5,000Total

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Assets Liabilities

First Generation Bank

$5,000 Demand Deposits

$500RequiredReserves

$5,000 $5,000Total

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$4,500

a) 100% r.r. b) 10% r.r.

ExcessReserves

i) MS ↑ $5,000 (Fed has “new” money) ii) $5,000iii) $5,000

i) $4,500 ii) MS ↑ $50,000 ($4,500 X 10 + 5K)iii) $5,000iv) $50,000

(c) If banks keep some of the deposit as excess reserves, how will this influence the change in the money supply that was determined in part (b)(ii)? Explain.

If the banks hold some of the excess reserves => increase in the money supply would be less than $50,000 => banks lend less money => less money creation

The price of bonds would rise. When bond prices ↑ => interest rate ↓ (inverse relationship)

========================================d) When the Federal Reserve purchases bonds in the open marketwhat happens to the price of bonds?

a) One point for a correctly labeled graph of the short-run Phillips curve (SRPC). • One point for showing a vertical long-run Phillips curve (LRPC) and the point A to the right of the LRPC on the SRPC.

B) U.S. economy in a recessionC) Gov’t raises taxes => AD shifts left => real GDP falls => bigger recession

i) Buying Bonds in Open Market Operations injects money into the banking system increasing money supply and lowering nominal interest rates

(federal funds rate)

iii) Lower interest rates => more Investment (I) & Consumption (C) => AD will shift right => real GDP ↑ & Price Level ↑

MD

MS2NominalInterestRate

Qty of $

MS1

---------i1

---------------i2

Q1

ii)

Question d

iv) Monetarists believe money is neutral => an increase in MS Will have no effect on real GDP. Only nominal GDP would rise

i) SRAS shifts right as the expected price level falls

ii) The natural rate of unemployment is unchanged.

Question e