Chapter 4&5

Construct a bank balance sheet (t account) with the following items: reserves, deposits, and loans (to customers/public.) Choose values so that the reserve-deposit ratio is 10 percent.

On the asset side: reserves = $10, loans = $ 90. On the liabilities side: checking deposit = $100.

The real interest rate is equal to

the nominal interest rate minus the inflation rate.

People use money as a store of value when they

hold money to transfer purchasing power into the future.

The one-to-one relation between the inflation rate and the nominal interest rate, the Fisher effect, assumes that

real rate is constant

If you hear in the news that the federal reserve conducted open-market purchases, then you should expect_____ to increase.

the money supply.

In the classical model, and according to the quantity theory of money equation and the Fisher equation/effect, an increase in nominal money supply increases:

the nominal interest rate

Currency equals

the sum of coins and paper money.

What is the effect of the following on the money supply? a. the public decide to deposit more currency held by them to the bank, hold less currency. b.the bank decides to have a higher reserve to deposit ratio.

a. The bank's reserves go up. But then it can make loans (new money is created) based on the reserves. The amount of loans is a multiple of the reserves. Hence, money supply goes up. b. Money supply goes down. Higher reserve to deposit ratio means with the same amount of reserve, there is less checking deposit (part of money supply) which means money supply goes down.

The federal reserve's tools to control the money supply include: open-market operations and the discount rate. a. how should each instrument be changed if the Fed wishes to decrease the money supply? b. will the change affect the monetary base?

a. To decrease money supply, the Fed can sell bonds (which means take away some currency from public). Alternatively, it can raise the discount rate, which means the banks would borrow less from the Fed, which means a decrease in the reserves of the banks which in turn, means less loans by the banks. b. Both will decrease the monetary base (which is defined as currency held by the public + reserves of the banks)

Real money balances equal the

amount of money expressed in terms of the quantity of goods and services it can purchase.

The reserve-deposit ratio is determined by:

business policies of banks and the laws regulating banks.

The monetary base consists of

currency held by the public, plus reserves held by banks.

The money supply, M1 consist of

currency plus money market funds.

If the federal reserve wishes to increase the money supply, it should:

decrease the discount rate (decrease in discount leads to "less loans by the bank."

The opportunity cost of holding money is the

nominal interest tate

The rate of inflation is the

percentage change in the level of prices

The quantity theory of money assumes that

velocity is constant

Bank create money

when they make loans

To increase the money supply, the federal reserve

buys government bonds.

A classical economist wears a T-shirt printed with the slogan "Fast Money Raises My Interest!" Use the quantity theory of money and the Fisher equation to explain the slogan.

According to the classical model and quantity theory of money, since velocity and real output (Y) are constant/fixed, an increase in quantity of money, M, would, by the quantity theory of money equation, increase the price level by the same percentage. This means an increase in the inflation rate. By the Fisher equation/effect, an increase in inflation rate would increase the nominal interest rate by the same percentage (as real interest rate is determined already in the goods market equilibrium).

If the demand for money depends positively on real income and depends inversely on the nominal interest rate, what will happen to the price level today, if the central bank announces (and people believe) that it will decrease the money growth rate in the future, but it does not change the money supply today?

People will expect lower inflation rate in the future. A lower inflation means a lower nominal interest rate. This means the demand for (real) money will increase. Since the Fed does not immediately decrease the money supply, price (P) must fall so the real balances ( M/P ) would increase to match the increase demand for money [the money market equilibrium equation]. Thus, current price will fall as a result of expected future decrease in money growth.

In classical macroeconomic theory, the concept of monetary neutrality means that changes in the money supply do not influence real variables. Explain why changes in money growth affect the nominal interest rate, but not the real interest rate.

Recall that in the model in chapter 3 (the so-called classical model), the real interest rate, r, is already determined in the goods market equilibrium, and the real output, Y, is determined from the production function with fixed amounts of L (L-bar) and K (K-bar). Hence all these real variables are determined without reference to money. In the quantity theory of money (equation), the money supply, M, (with fixed Y and velocity, V) has a one-to-one positive relationship with price, P. An increase in money supply would result in the same percentage increase in P. Hence an increase in money supply would result in the same percentage increase in inflation. By the Fisher equation/effect, this would result in the same percentage increase in nominal interest rate. Hence money supply only affects nominal variables such as P, nominal GDP ( which is P*Y), inflation rate, and nominal interest rate. Note that by the relationship: nominal variable = P * the corresponding real variable, and since money supply affects P, which in turn would affect other nominal variables such as nominal consumption, nominal investment, and so on. nt:According to the Fisher equation, the nominal interest rate equals the real interest rate plus the expected rate of inflation. The expected rate of inflation depends on the rate of money growth, so the nominal interest rate depends on the rate of money growth. According to classical macroeconomic theory, the real interest rate adjusts to bring the level of saving and investment (both real variables) into equilibrium without reference to the rate of money growth.

Assume that the demand for real money balance (M/P) is M/P = 0.6Y - 100i, where Y is national income and i is the nominal interest rate. The real interest rate r is fixed at 3 percent by the investment and saving functions. The expected inflation rate equals the rate of nominal money growth. a. If Y is 1,000, M is 100, and the growth rate of nominal money is 1 percent, what must i and P be? b. If Y is 1,000, M is 100, and the growth rate of nominal money is 2 percent, what must i and P be?

a) Since the expected inflation rate = rate of growth of M = 1% (given), the nominal interest rate = i = real interest rate + inflation rate = 3 + 1 = 4%. Now the (demand for) real balance is M/P = 0.6*1000 - 100*4 = 200. Since M = 100, it means 100 / P = 200 or P = ½. Note that the equation, M/P = 0.6Y - 100i, can be interpreted as the money market equilibrium equation. And the above exercise shows that the value of price, P, can be determined from the money market equilibrium equation (when the values of Y, r and expected inflation rate are given) b) Repeat the same exercise as part a), we have P = 1 and i = 5%.

Economists occasionally speak of "helicopter money" as a short-hand approach to explaining increases in the money supply. Suppose Janet Yellen, the current Chair of the Federal Reserve, flies over the country in a helicopter dropping 10,000,000 in newly printed $100 bills (a total of $1 billion). By how much will the money supply increase if, holding everything else constant: a) all of the new bills are held by the public? b) all of the new bills are deposited in banks that choose to hold 10 percent of their deposits as reserves (and no one in the economy holds any currency)? c) all of the new bills are deposited in banks that practice 100-percent-reserve banking? d) people in the economy hold half of their money as currency and half as deposits, while banks choose to hold 10 percent of their deposits as reserves?

a. 1 billion, the original amount dropped from the sky (which is similar to purchase of bonds from public) b. 10 billion. If the public deposit all the currency in the banks, then by definition, the currency become the reserves of the bank. Now, use the ratio = reserves / total deposit = 1 billion / total deposit = 10 percent. Hence total deposit must be 10 billion. c. This is the same as saying the banks want to keep the (reserves/total deposit) ratio at 100 percent. So since reserves = 1 billion, total deposits = 1 billion. Hence the increase in the money supply is the same as in part a) when the public hold the money in currency. d. The currency outside the banks (held by public) = 0.5 billion. Now, the rest, another 0.5 billion becomes the reserves in the banks. Using the 10 percent ratio (see part b. above), it means the total demand deposits is 5 billion. By definition, M, the (increase in) money supply is the total of currency outside the banks and demand deposits which in this case is 5.5 billion.