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ECO5POE S1 2013

Tutorial 9 Answers
Chapter 22: Money, The Price Level, and Inflation
Question 1 In Australia today, money includes which of the following items? a. Reserve Bank bank notes in CBAs ATMs Money includes currency outside the banks. Currency inside ATMs is not money. b. Your Visa card The Visa card is not money. c. Coins inside a vending machine The coins inside a vending machine are money. d. A Reserve Bank $20 note in your wallet The dollar bills inside your wallet are money. e. The cheque you have just written to pay for your rent The cheque is not money. f. The student loan you took out last August The loan is not money.

ECO5POE S1 2013

Question 10 The commercial banks in Zap have: Reserves Loans Deposits Total assets $250 million $1,000 million $2,000 million $2,500 million

If the banks hold no excess reserves, calculate their desired reserve ratio. The banks desired reserves equal their reserves, $250 million, divided by their deposits, $2,000 million, which is 12.5%.

Use the following information to work Problems 11 and 12. In the economy of Nocoin, banks have deposits of $300 billion. Their reserves are $15 billion, two thirds of which is in deposits with the central bank. Households and firms hold $30 billion in bank notes. There are no coins! Question 11 Calculate the monetary base and the quantity of money. 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. Therefore, 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. Question 12 Calculate the banks desired reserve ratio and the currency drain ratio (as percentages). The banks reserve ratio is 5%. 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 = ($15 billion/$300 billion)100 = 5%.

ECO5POE S1 2013

The currency drain ratio is 10%. The currency drain ratio is the percent of deposits that is held as currency. In Nocoin, deposits are $300 billion and currency is $30 billion, so the currency drain ratio = ($30 billion/$300 billion)100 = 10%. Question 15 The spreadsheet provides information about the demand for money in Minland. Column A is the nominal interest rate, r. Columns B and C show the quantity of money demanded at two values of real GDP: Y0 is $10 billion and Y1 is $20 billion. The quantity of money supplied is $3 billion. Initially, real GDP is $20 billion. What happens in Minland if the interest rate (i) exceeds 4 percent a year and (ii) is less than 4 percent a year?

A 1 2 3 4 5 6 7 8 r 7 6 5 4 3 2 1

B Y0 1.0 1.5 2.0 2.5 3.0 3.5 4.0

C Y1 1.5 2.0 2.5 3.0 3.5 4.0 4.5

(i) The equilibrium nominal interest rate is 4 percent. If the interest rate exceeds 4 percent a year, people want to hold less money than is available. So they try to reduce the amount of money held by buying bonds. The prices of bonds rise, and the interest rate falls. (ii) The equilibrium nominal interest rate is 4 percent. If the interest rate is less than 4 percent a year, people want to hold more money than is available. So they try to increase the amount of money held by selling bonds. The prices of bonds fall, and the interest rate rises. Question 17 Quantecon is a country in which the quantity theory of money operates. In year 1, the economy is at full employment and real GDP is $400 million, the price level is 200, and the velocity of circulation is 20. In year 2, the quantity of 3

ECO5POE S1 2013

money increases by 20 percent. Calculate the quantity of money, the price level, 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 = 200, Y = $400 million, and V = 20, therefore:

PY V 200 400 million 20 $40 million

Then in year 2: 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. The quantity of money grows by 20% hence M = $48 million. Because the quantity theory of money holds and the factors that influence real GDP have not changed, the price level therefore rises by the same percentage as the increase in the quantity of money, which is 20 percent, i.e.,

MV PY MV P Y 480 20 P 400 P 240