Problem Set Jan 14

Question 1  Money Definition (3 Pts ) – a current medium of exchange that is accepted for payment for a good/service  Example (2pts) – Federal Reserve Notes (dollars, coins)  Bond (3pts) – a certificate issued by a government or a public company promising to repay borrowed money at a fixed rate of interest at a specified time.  Example (2pts) – Federal bond

Question 1  Stock (3pts) – private ownership in a company or business.  Example (2pts) – Share of Apple or Starbucks

B. Time Value of Money  Present Value (3pts) – less than or equal to future value, amount of money  Some example (2pts) using the formula $ / (1+r) ^ years  Future value (3pts) – value or worth of a sum of money in the future that assumes an interest rate  Example (2pts) using the above formula or a calculation of a money plus an interest rate.

C. Measures of Money Supply  Total amount of money assets in the economy at a certain time  M1 – highest liquidity – in current circulation - ex. Coins, dollars, checkable deposits  M2 – medium liquidity – ex. bank reserves  M3 – lowest liquidity – M2 plus long term deposits ex. Deposit of $1 million dollars

D. How banks create money  Banks create money through loans ( 3pts)  Reserve Ratio (2pts) 1/r

E. Money Demand  Definition: At any given time, people demand a certain amount of money for every day purchases.  Inverse relationship between nominal interest rates and the amount of money demanded  Graph on board

Money Market  Definition: Money is a commodity (something to be bought and sold). Money market is short term part of the financial market including the lending, borrowing, buying and selling of financial assets.  Example – deposit, treasury notes  Graph on board

Loanable funds market  Definition: Amount of money from banks and lending institutions available for firms and households to finance expenditures (investment, consumption)  Graph on board

#2 – Tools of Central Bank  Open Market Operations – activity by the central bank to buy or sell bonds on the open market  Discount Rate – minimum interest rate set by the Fed Reserve for lending to other banks  Reserve Requirement – central bank regulation that sets minimum fraction banks must keep in their reserves from deposits  3 pts for definition  2pts for each example

B. Quantity Theory of Money  Definition: Money supply has a direct relationship with price level  Money * Transaction Velocity = Price * Monetary value of output  M * V = P * Y  3pts for definition  2pts for just writing or explaining the equation (numerical example not needed)

Real V. Nominal Interest Rates  Real – percentage increase of purchasing power the borrower pays(adjusted for inflation)  Real = nominal – expected inflation  Nominal – percentage increase in the money supply the borrower pays (not adjusted for inflation)  Nominal = real interest rate + expected inflation  3pts for definition  2pts for an example

FRQ 1  A. Draw correctly labeled AD/AS graph showing the economy operating below full employment (2pts)  B. Fed should purchase bonds (increases money supply)  Correctly labeled money market graph ( 1pt)  C. Rightward shift of the money supply curve, and lowering of interest rates (1pt)

FRQ 1  D. Decrease Interest rates  interest sensitive expenditures to decrease. (1pt)  E. AD would increase  increase in output and PL. (1pt)  F. If no action was taken, wages and other production costs would eventually fall, AS would shift to the right, PL would fall and output would rise ( 1pt)

FRQ #3 – 8pts – 2pts each  A. Reserve ratio = 100% = $5000 increase in the money supply, because gov purchased that much In bonds  B..9 * $5000 = $4500  Money supply multiplier = 10, max increase = $5,000 *10 = $50,000  C. Increase would be > $50,000. Can’t lend out full amount in reserve  D. > $50,000. Banks will not get the maximum amount. More cash held in the hands of the public reduces bank deposits, so there is less money in the reserves.