Review and Assignment Questions 2

Economics 2154b

This will be graded, but will not be returned before the end of the term.

You are to submit written hard-copy answers to all questions by the class of March 24; due to the timing of the year, no late assignment will be accepted.

Items with (*) are more time-consuming, and will not be necessarily covered in the midterm test.

1. (Definition and Scope of Money and Money Supply Multiplier)

1) (*)What are included in each category of money supply measures given below?

(Hint: Bank of Canada or Statistics Canada websites).

What are the most recent Canadian statistics for the following variables? Timesaving Hint: Refer to the Data Table on the Course Webpage.

High Powered Money ( $ billion)

M1 ($ billion) and its composition

M2($ billion) and its composition

M2+(S billion) and its composition

2) What are the most recent U.S. statistics for the following variables? Timesaving Hint: Refer to the Data Table on the Course Webpage. http://www.federalreserve.gov/econresdata/releases/statisticsdata.htm High Powered Money or Monetary Base ( $ billion)

M1 ($ billion) and its composition

M2($ billion) and its composition

3) (*)Compare the different components for M1, M2, and so forth across countries in the world. (Hint: You may look into the EMU and 15 non-EMU countries as shown in http://instruct.uwo.ca/economics/154-570/MoneySupplyScopesInternationalComparison.pdf, and make it a table.)

4) (*)Show different scopes of money supply in Canada.

(Hint: See page 21 of http://instruct.uwo.ca/economics/154- 570/MoneySupplyScopesInternationalComparison.pdf.)

5) In the above Canadian case of different scopes of money supply, the real money demand of which scope of money is elastic with respect to interest rate, and the real money demand of which scope of money is inelastic with respect to interest rate?

6) Explain in your own words why the above interest (rate) elasticity of real money demand is important, particularly in relation to the effectiveness of monetary policy. You may also illustrate your answer.

7) (*) Find some empirical works/results on the studies of interest elasticity of real money demand and summarize them (about one page of answer will be sufficient) (Hint: You may google this. The following pages are a few example of starting points of your search:

http://en.wikipedia.org/wiki/Demand_for_money ;

http://www.questia.com/googleScholar.qst?docId=5000127448 , and so forth)

2. (Interest rate and Money Supply: Liquidity Theory versus Irving Fisher Equation)

What is the impact on interest rates of an increasing real money supply (M/P) as a result of an expansionary monetary policy?

1) Explain the liquidity effect.

2) Explain the expected inflation effect. Explain it with Irving Fisher’s equation in the financial market. What determines the (ex-ante) real interest rate?- what is the real interest equal to?

3) Discuss the time frame, long- or short-run, for the above two effects in the real world.

4) In the perfect world, expected inflation is the same as the actual inflation. The real interest is always constant, and thus there is only one real interest rate.

However, in an imperfect world, expectations may be different from the reality. Suppose that this is an imperfect world, and actual inflation rate keeps going up while the expectations about inflation by the general public are lagging behind. Things become more complicated.

In this case, what is the ex-post real interest rate as opposed to the ex-ante real interest rate? How do you define it mathematically? Show it.

What will happen to the post-real interest rate, which matters most for physical investors for I (in C+I+G+X-M)? 3. (Money Supply, and y and P in general) By using the quantity equation of exchange MV = Py, answer the following questions:

Suppose that the monetary authority is applying expansionary monetary policy.

What will happen to real national income or y? Discuss all possibilities under all possible circumstances.

1) When would y or P not change at all?

2) When would y change/increase while P does not change at all?

3) When would P change/increase while y does not change at all?

Even in this case, is real income y always constant, in the short- and long-run?

4) In most cases, the reality would be at some point in the continuum between ii and iii.

Illustrate it with IS-LM, and AS-AD curves.

4. (Money Supply and P)

In order to focus on P, suppose that for now y or real national income is constant.

Discuss and illustrate the three different kinds of changes in Money Supply:

1) A once-and-for-all increase in money supply

2) Continuous but constant –rate increases in money supply

3) Continuous and accelerated increases in money supply

4) Continuous and decelerated increases in money supply 5. The Money Multiplier (Textbook pp.383-395 of Chapter 16; Instructor’s Note on Money Multiplier)

1) Deriving the (M2) Money Supply Multiplier as a function of Deposits(DD+TD), C(Cashes in Circulation), R(Reserves of banks; = ER + DR), and MB(=H; high powered money or Monetary Base) in the first place or R/D and C/D ratios and MB in the second place.

2) Discuss the impact of an increasing C/D ratio, an increasing R/D ratio on M2.

3) Analyze the impact of ‘financial instability and ‘liquidity crisis’: The general public feels doubt about the safety of its deposits with banks, and the bank executives feel more need for reserves as buffer against increased cash withdrawals and possible bank runs.

4) In the current financial crisis since 2008, how did Canadian government successfully deal with the situation where R/D ratio rose, C/D ratio also rose, and the money multiplier dropped sharply? Use the money multiplier to explain what happened during the crisis and what the Canadian monetary authority did to counter the problem?

(Hint: Refer to the paper by Han and Ibbott(2009) on the course webpage, which discusses the Insure Mortgage Purchase Plan).

6. Open Market Operation (Textbook pp.415-417, Chapter 17; Instructor’s Note on OMO)

Analyze the impact of the following operations on the Money Supply: Draw the graph with the government (of Canada) and the general public (of Canada) with flows of money and securities between the two. 1) The Ministry of Finance of the Canadian Government issues government bonds. It sells them to the Canadian general public, and uses the acquired fund to spend on made-in- Canada products as part of expansionary fiscal policy.

2) The Ministry of Finance of Canada sells government bonds to the Bank of Canada. The Ministry spends the acquired funds on Canadian goods as part of fiscal activities.

3) The Canadian Ministry of Finance sells bonds though bond dealers to the Chinese government, and uses the acquired funds on made-in-U.S.A. military equipments for war operation in Afganistan.

4) In light of the above analyses, evaluate the following comment:

“Bond-financed fiscal expenditures are inflationary”.

Hint 1: “Evaluating” means determining i)whether a given statement is ‘unconditionally’ or ‘at- all-times’ true; ii) true only under a certain condition and you specify the condition under which the statement is true or the condition under which the statement is false; or iii) false at all times, and explaining your answer.

Hint 2: There are two actions by the government: Bond-financing means that the government sells bonds (to whom it does not specify; and thus you have to think about the two cases) and gets proceeds. Fiscal expenditures mean that the government spends the proceeds (on domestic or foreign goods, it does not specify; and thus you have to discuss both cases of expenditures on domestic goods and on foreign goods).

5) What are the instruments for the Open Market Operation? What are SPRAs or repos(very important terminologies), and SRAs? - Note that only with one letter difference ‘P’ in the middle SPRAs and SRAs are completely different. 7. (*) Answer the following questions by reading Chapters 17 and 18.

1) What is the Large Value Transfer System(LVTS) in Canada? How many participants are there in LVTS? What are the participants of LVTS? How large is the daily transaction of LVTS?

2) How does the Bank of Canada affect the availability of liquidity through the Open Market Operation? What is the arrangement/instrument called, in which the Bank of Canada buys the government securities to the participants of LVTS in order to increase liquidity among the private sector with the understanding that the Bank will sell them back to the participants of LVTS? What is the financial arrangement/instrument for the opposite operation called? Draw graphs with the Bank of Canada and the Private Sector with flows of money and securities between them.

3) In the Bank of Canada’s Open Market Operation, the bank targets the overnight interest rate. Read pp. 403-412.

What is the band? Where is the target rate?

4) What are the Nonconventional Monetary Policies? (read pp.424-428).

i)What is QE?

ii)Where is the target (overnight interest rate)?: Is it in the middle of the band?(P. 426, Figure 17-10)

iii)What is Credit Easing?