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135
8 LEVEL, AND
INFLATION**
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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.
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W H AT I S E C O N O M I C S ? 137
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.
3. What are the Feds three policy tools?
The Federal Reserve has three policy tools: required reserve ratio, last resort loans,
and open market operations.
4. 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 nations monetary policy as
conducted through open market operations. The FOMC meets approximately once
every six weeks.
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5. 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.
2. 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.
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.
4. 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.
5. 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.
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.
5. 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
banks 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 5 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
5 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.
6. China Cuts Banks Reserve Ratios
The Peoples 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.)
7. The spreadsheet provides data about the
demand for money in Minland. Columns A and A B C
B show the demand for money schedule when 1 r Y0 Y1
real GDP (Y0) is $10 billion and Columns A and 2 7 1.0 1.5
C show the demand for money schedule when 3 6 1.5 2.0
real GDP (Y1) is $20 billion. The quantity of 4 5 2.0 2.5
money is $3 billion. What is the interest rate 5 4 2.5 3.0
when real GDP is $10 billion? Explain what 6 3 3.0 3.5
happens in the money market in the short run 7 2 3.5 4.0
if real GDP increases to $20 billion. 8 1 4.0 4.5
When real GDP is $10 billion, the equilibrium
nominal interest rate is 6 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 5 percent.
8. 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 2.
The quantity of money in year 1 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 2 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
9. 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.
17. 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 banks 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 Feds assets and liabilities. What is the monetary base and does
it relate to the Feds 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 Feds 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 do 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 do 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.
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.
23. Use the data in Problem 7 to work this problem. The interest rate is 4 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 4 percent, the quantity of money people are holding exceeds the quantity
of 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 3 percent a year, people are
holding exactly the quantity of money that they want to hold so 3 percent is the
new equilibrium interest rate.
24. The table provides some data for
the United States in the first 1869 1879
decade following the Civil War. Quantity of $1.3 $1.7
money billion billion
Source of data: Milton Real GDP (1929 $7.4 Z
Friedman and Anna J. dollars ) billion
Schwartz, A Monetary History Price level (1929 = X 54
of the United States 1867 100)
1960 Velocity of 4.50 4.61
a. Calculate the value of X in circulation
1869.
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.
c. By how much would the quantity of M2 demand decrease if the interest rate
rose to 2 percent, 3 percent, and 4 percent? (Express your answer as a
percentage of GDP.)
If the interest rate rises to 2 percent, the quantity of money demanded is
approximately 50 percent of GDP; if the interest rate rises to 3 percent, the
quantity of money demanded is approximately 48 percent of GDP; and, if the
interest rate rises to 4 percent, the quantity of money demanded is approximately
47 percent of GDP.
d. What could the banks do to prevent deposits from decreasing by as much as
predicted by the demand for M2 curve in Fig. 3 on p. 203 (page 611 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.
Mathematical Note
27. In the United Kingdom, the currency drain ratio is 38 percent of deposits and
the reserve ratio is 2 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 8 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 = 2 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 8 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.