HW08 LM a Foundations of Economic Analysis Stratton

0819e9c2b24ad7e60ad4e5cfddea7502.doc Foundations of Economic Analysis Stratton

Homework #8 Name ______Key______Objective: to provide practice and assessment of your understanding of the role of money and “money markets” in the U.S. Your ability to demonstrate understanding, insight and/or the ability to use the material is the primary purpose of the assessment. Thus full credit will only be earned if you follow the directions carefully and provide the explanation, description, and thought process as directed. Each numbered question is worth 2 points – total 50 points. Instructions: In your own words compare and contrast or distinguish between the members of each pair of terms in the space provided or attach additional sheets if necessary. Terms: 1. Money as medium of exchange and Money as store of value – Money functions as a medium of exchange if it is “universally” accepted in trade for real goods and services. It functions as a store of value if its purchasing power is maintained over time. Thus, as a medium of exchange current income can be used to purchase goods and services out of current income. As a store of value, current income that is not consumed immediately can be stored to purchase goods and services in the future.

2. M1 and M2 – These are both definition of money used in the U.S. and both must be held by the “non-banking public.” M1 contains the most liquid assets (currency, demand deposits, travelers’ checks), while M2 contains all of the assets included in M1 plus some less liquid assets (money market funds, savings accounts, and small time deposits).

3. Commercial Banks and The Federal Reserve System – Both are financial intermediaries and are part of the U.S. financial markets. Commercial banks are financial intermediaries which accept deposits from individuals and organizations. They use these deposits to make commercial loans. They create accounts against which depositors can write on- demand withdrawals (checks). The Federal Reserve System is our central bank, which regulates commercial banks (among other intermediaries) and undertakes monetary policy.

4. The discount rate and the federal funds rate – Both are interest rates at which commercial banks can borrow reserves. The discount rate is the interest rate charged by the FED, while the federal funds rate is the interest rate charged in the competitive federal funds market.

5. Federal Open Market Committee and The Federal Reserve Board of Governors – The Board of Governors consists of seven members appointed by the President of the U.S. and is the main policy making body of the FED. The FMOC consists of the seven members of the Board of Governors and five of the twelve Federal Reserve Bank presidents. It is the monetary policymaking body of the FED.

6. Monetary base and M1 – The Monetary base consists of all currency and all reserves. It is controlled by the FED and thus influences the money stock (supply). M1 is one measure of the money stock (supply).

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7. Reserve requirement and the simple deposit multiplier – The reserve requirement is the percentage of demand deposits banks are required by the FED to hold in very liquid assets (cash in vault or accounts at the FED) called reserves. The simple deposit multiplier is the measures the potential impact of a change in demand deposit on the money stock. The simple deposit multiplier (d) is determined by the reserve requirement (rr): d = 1/rr.

Short Answer Questions: Answer each question, indicating any assumptions you make, explaining your thinking, and showing all work where appropriate. 8. Briefly describe how commercial banks create money. Money is created when new loans are made. By loaning their excess reserves, a commercial bank is able to create demand deposits (counted as part of M1 money). Since we operate in a fractional reserve system, the value of the demand deposits can be more that the value of the reserves. In making the loan, the bank is converting non-money assets (reserves) into money assets (demand deposits). 9. Explain the impact an increase in the reserve requirement on the money multiplier (mm). mm = Ms / MB = (c+1) / (c + rr + e), where rr is the reserve requirement. An increase in rr will increase the size of the denominator and thus reduce the value of mm. An increase in rr will reduce the size of excess reserves (other things constant) and reduce the ability of the bank to create money, thus reducing the money multiplier. 10. Cheryl decides to keep $1000 in her checking account at National City Bank rather than buy a $1000 government bond paying 7 percent per year. If the inflation rate is 4 percent per year, calculate Cheryl’s opportunity cost of holding the $1000 as money. The opportunity cost of holding money is the forgone interest. If Cheryl purchased the $1000 government bond she would $70 in interest at the end of one year. The appropriate comparison is between the purchasing power at the end of the year: $1070 and $1000. With an inflation rate of 4%, the $1000 could purchase $960 worth of goods; the $1070 could purchase $1030 worth of goods. Therefore, Cheryl’s cost is $70 per year (the nominal interest). 11. Consider a money market in which a recent increase in the demand for money has caused the real current interest rate to be below the equilibrium real interest rate. Explain how this market will move toward equilibrium. [Hint: First determine if there is currently a shortage or surplus in this market, than use that information to explain the adjustment process.) The recent increase in the demand for money means the Md has shifted to the right and individuals desire to hold more of their assets in money. Thus there is a shortage of money. Some individuals will sell interest earning assets (converting them into money). The increased sale of interest earning assets will tend to drive their price down and the effective yield on these assets up. The increased real interest rate (yield) will increase the opportunity cost of holding money and reducing the quantity of money demanded. The real interest rate will continue to increase until it reaches the new equilibrium real interest rate. 12. The concept of elasticity measures how responsive one variable is to changes in another. We can define the interest rate elasticity of the demand for money as the ratio of the % change in Md caused by the % change in interest rates [% Md / % r]. How does the interest rate elasticity of the demand for money affect the responsiveness of changes in the real income (Y) to changes in the real interest rate along the LM curve? The LM curve is derived from the equilibrium between RLMS and RLMD as changes in Y shift RLMD. The more responsive the quantity of money demanded is to changes in the interest rate, the smaller the change in r resulting from a given increase in RLMD. Therefore, the more responsive Y is to changes in r along the LM curve.

Scenario 1: Use the following information for the all of the questions in this scenario. Answer each question, indicating any assumptions you make, explaining your thinking, and showing all work where appropriate. For simplicity, assume that Akropolis has only 12 commercial banks and each bank begins with identical balance sheets. The non-banking public holds $100 million of currency and Federal Reserve requirement is 10%. First National Bank is one of the 12 banks; it has the following simplified balance sheet.

First National Bank

Sheet #1

ASSETS LIABILITIES

Cash in vault $2 million Checkable Deposits $50 million

Reserves at Cleveland Fed $3 million

TOTAL Reserves

Loans $25 million

Gov’t. Securities $20 million Owner’s Equity $25 million

Property & Equipment $25 million

Total $75 million Total $75 million

13. Calculate the value of total reserves held by your bank. Total reserves equal cash in vault plus account at the FED: $2 million + $3 million = $5 million 14. Calculate the value of the bank’s required reserves. Required reserves equal the reserve requirement (10 %) times the value of demand deposits: 0.10 * $50 million = $5 million 15. Remembering that there 12 banks and the public holds $100 million in currency, what is the total money supply in Akropolis? $100 million in publics hand + $50 million of demand deposits in each bank = 100+12*50 = $700 million 16. Calculate the simple deposit multiplier (d). d = 1/ rr = 1 / 0.10 = 10. 17. Calculate the actual money multiplier (mm) to 3 decimal places. mm = Ms / MB = 700 million / $160 million = 4.375 mm = (c+1) / (c + rr + e) c = currency / deposit ratio: $100 million / $600 million = 0.167 rr = reserve ratio: 0.10 e = excess reserve ratio = excess reserve / demand deposits; excess reserves = total reserves – required reserves: $0 million / $50 million = 0 mm = ( c+ 1) / ( c + rr + e ) = (1.167) / (0.167 + 0.10 + 0) = 1.167 / 0.267 = 4.371

A customer deposits $1 million in First National Bank. Assume this is some of the currency originally held by the non-banking public. 18. What is the maximum dollar amount First National Bank can loan? The bank can safely loan its excess reserves (total reserves – required reserves). Total reserves are now $6 million ($5 million + $1 million). Required reserves are now 10% of $51 million: Excess reserves = ($6 million - $5.1 million) = $900,000 19. What is the maximum change in the money stock (supply) caused by the $1 million deposit? [Hint: use the simple money [deposit] multiplier (d)] d = 1/ rr = 1 / 0.10 = 10; thus the maximum change in Ms is 10 * $900,000 or $9 million. 20. What is your best estimate of the actual change in the money stock (supply) caused by the $1 million deposit? [Hint: use the money multiplier (mm)] mm = Ms / MB = 700 million / $160 million = 4.375 ; thus the change in Ms is 4.375 * $900,000 or $3,937,500 or $3.94 million.

Scenario 2: Use the following information for the all of the questions in this scenario. Answer each question, indicating any assumptions you make, explaining your thinking, and showing all work where appropriate. For simplicity, assume that Akropolis has only 12 commercial banks and each bank begins with identical balance sheets. There are no excess reserves in the system. The non-banking public holds $120 million of currency and Federal Reserve requirement is 10%. Thus the current money stock (supply) is $720 million and the monetary base is $180 million. First National Bank is one of the 12 banks; it has the following simplified balance sheet.

First National Bank

Sheet #2

ASSETS LIABILITIES

Cash in vault $2 million Checkable Deposits $50 million

Reserves at Cleveland Fed $3 million

TOTAL Reserves $ 5 million

Loans $25 million

Gov’t. Securities $20 million Owner’s Equity $25 million

Property & Equipment $25 million

Total $75 million Total $75 million

21. Calculate the actual money multiplier (mm) to 3 decimal places. mm = Ms / MB = 720 million / $180 million = 4.000 c = currency / deposit ratio: $120 million / $600 million = 0.200 rr = reserve ratio: 0.10; e = 0 mm = ( c+ 1) / ( c + rr + e ) = (1.2) / (0.2 + 0.10 + 0) = 1.2 / 0.3 = 4.000

22. What is your best estimate of the potential change in the money stock (supply) caused by the federal open market committee purchase of $10 million of government securities? [Hint: remember that not all banks are fully loaned up and there is some currency drain.] When the FED (FOMC) buys bonds it pays for them by increasing the reserves in the system. Thus, with a money multiplier (mm) of 4, a $10 million increase in excess reserves would lead to a $40 million increase in Ms. ( mm *  excess reserves = 4*$10 million = $40 million) 23. Independent of the previous question, calculate the potential change in the money stock (supply) caused by the increase in the reserve requirement to 10.5%. Assume all banks adjust their assets by selling government securities. Since each bank has $50 million in demand deposits, each bank’s reserves will have to increase to (10.5% of $50 million) $5.25 million. Thus each bank must sell $250,000 worth of government securities. This would not change the money stock (supply), though the profit of each bank would decline. (They converted interest earning securities for non-interest earning reserves.) It may also tend to decrease the price of securities and increase real interest rates. Note that the monetary base will increase and the money multiplier (mm) will decrease.

Scenario 3: Explain impact of each of the following changes on real demand for money (RLMD), real money supply (RLMS) and real GDP suggested by the LM model. Be sure to answer the questions as completely as you can and to show your work!

24. “The Conference Board Consumer Confidence Index, which had rebounded in August, plummeted in September. The Index now stands at 86.6 (1985=100), down from 105.5 in August. The Expectations Index fell to 71.7 from 93.3 last month.” http://www.conference-board.org/economics/consumerconfidence.cfm (September 27, 2005) These indexes indicate a decline in the expectations of future economic activity, which impact on the real market more than the money market. I would expect planned consumption to decline; causing IS to shift to the left. This would reduce the quantity of money demanded for transaction purposes. This in turn will reduce the real interest rate. This would represent a movement along the LM curve down and to the left. 25. “After 11 straight quarter-percentage point steps, they [the federal funds rate] now stand at 3.75 percent and financial markets see them hitting 4.5 percent before the Fed calls off its rate-rise campaign.” http://news.yahoo.com/s/nm/20051019/bs_nm/economy_fed_beigebook_dc_3 (October 20, 2005) This news article indicates that the FED is tightening monetary policy (reducing RLMS), graphically depicted as a shift to the left of the RLMS. The increased interest rate is expected to reduce the quantity of money demanded (movement along RLMD).This monetary tightening is increasing the equilibrium interest rate. Since real output (Y) has not changed, this would be shown as an upward shift of the LM curve.

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