Question 1: Consider the relationship between monetary policy and the financing of the deficit.
a) Suppose that the reserve ratio r is =0.1, and the currency ratio c =0.2. Assume that G - T +F = $200billion. By how much would the money supply, the monetary base, currency and bank reserves have to change if the Fed were to finance the entire budget deficit?
b) Suppose now that the money supply is initially equal to 600billion with output equal to potential. Suppose further that potential output is increasing by 2 % per year, prices are expected to grow by 3%, and the monetary velocity (V=PY/M) is expected to remain constant. If Fed wishes to keep output at potential, what percentage of the deficit does it have to finance?
Question 2: Suppose that the required reserve ratio is 0.12 for the deposits and there are no excess reserves. Suppose also that the total demand for currency is equal to 0.3 times deposits
a) If the total reserves are $40 billion , what is the level of the money supply?
b) By how much does the money supply change if the Fed increases the required reserve ratio to 0.20? Assume the total reserves are unchanged at 40 billion
c) By how much does the money supply change if the Fed buys $1 billion of the government bonds in the open market? (Keep the required reserve ratio at 0.12)
Question 3: There is a reason to believe that money demand may be more closely related to consumption than to total output. Suppose this is indeed the case. The money-demand function takes the form
M= (sC - hR)P , >0,
Where the rest of the economy is described by the usual spending equations
C = a +b(Y - T)
I= e - dR
X = g -mY- nR
a) What is the slope of the LM curve for this model?
b) Suppose Taxes T are lump-sum rather than proportional to income. Show the short-run effect of a tax cut in this modified model using an IS- LM diagram. Comment on the qualitative effect on interest rates and income in relation to the model in which money demand depends on income rather than on consumption.
Suppose that the required reserve ratio is 0.12 for the deposits and there are no excess.