Review for Final Exam
· measures (M1, M2, etc.)
· motives for holding money
The Federal Reserve System
· purpose and functions
· the process of money creation
· the money multiplier
· interest rates and the price of bonds
· expansionary and contractionary
· tools, including the required reserve ratio, the discount rate, and open market operations
Deficits and Debts
· Definition of each
· structural and cyclical deficits and surpluses
· differences between individual and government debt
· the debt burden, including debt service and debt compared to GDP
· functional finance and pro-cyclical fiscal policy
· positive and negative consequences of debt, including the Ricardian equivalence theorem, crowding out
· Sound Finance
· Functional Finance
· bubbles, herding, and extrapolative expectations
· derivatives and mortgage-backed securities
· government responses to financial crises
Problems You Should Be Able to Solve
Determining the value of the money multiplier
Calculating the amount of potential money creation in the banking system
Determine the exact amount of monetary policy action required to close a recessionary or inflationary gap
Compare the exact amount of monetary policy to the exact amount of fiscal policy needed to close gaps (notice that you’ll be asked to remember how to use the Keynesian multiplier and determine fiscal policy actions—so you can’t forget all the ideas and problems from fiscal policy)
Some Sample Problems
1. Assume the following information for questions 1 and 2:
the economy has an inflationary gap of $250 billion
the required reserve ratio is 10%
the MPC is 0.8
for every 1% change in the interest rate, investment changes by $30 billion
a) If the Federal Reserve decides to decrease the money supply by $150 billion to solve the inflationary problem, what dollar amount of bonds should it sell in open market operations?
b) If the decrease in the money supply described above leads to an increase in the interest rate of 2%, by what dollar amount will Aggregate Demand change?
2. Suppose bank reserves are $100 billion, the required reserve ratio is 0.2, and excess reserves are zero. Now suppose that the required reserve ratio is lowered to 0.1. What is the new level of demand deposits that can be created if banks fully utilize their new lending capacity? (Hint: first figure out the original level of deposits, then figure out the new lending capacity.)
3. The banking system has Excess Reserves of $60 billion, Required Reserves of $40 billion, and $500 billion in deposits. Currently, the system has $400 billion in outstanding loans.
- What is the required reserve ratio?
- If a person deposits an additional $200 in the bank, what is the potential deposit creation if the banking system fully uses its lending capacity?
4. Assume that the following data describe the condition of the banking system (all $s are in billions):
Total Reserves $200
Transactions Deposits $800
Required Reserve Ratio 0.20
If the Federal Reserve wanted to stop further lending activity in the banking system, what required reserve ratio should be imposed?
5. Assume the following economic conditions:
C = $800 million + 0.8YD
I = $900million
G = $1000 million
(X-M) = -$10
Required reserve ratio = 0.10
Potential output = 20,000 million
a) What is the Keynesian multiplier for this economy?
b) What is the money multiplier for this economy?
c) What is the equilibrium rate of output in this economy?
d) What kind of gap currently exists in the economy (recessionary or inflationary) and how big is it?
e) If the government increases spending by $200, how much will aggregate spending change (assuming taxes do not change)?
f) If the government cuts taxes by $200, how much will aggregate spending change (assuming no change in government spending)?
g) Which of the above actions (#5 or #6) would be better in this situation? Why?
h) If the Federal Reserve wants to help ease the current economic situation, should it buy government bonds or sell government bonds?
i) If the Fed wants to change the money supply by the amount of the gap, what dollar amount of bonds should the Fed buy or sell?
j) Overall, which would be better at solving the current economic situation—fiscal or monetary policy? Why?