Norman

1. Assume that the U.S economy is in long-run equilibrium with an expected inflation rate of 6% and an unemployment rate of 5%. The nominal interest rate is 8%. (a) Using a correctly labeled graph with both the short-run and long-run Phillips curves and the relevant numbers from above, show the current long-run equilibrium as point A. (b) Calculate the real interest rate in the long-run equilibrium. SRPC Inflation 6%6% Unemployment 5% LRPC A Answer to 1. (b) The real interest rate = the nominal interest rate – anticipated (expected) The real interest rate = the nominal interest rate – anticipated (expected) inflation. inflation. NIR [8%] - expected inflation [6%] = RIR [2%] NIR [8%] - expected inflation [6%] = RIR [2%]

(c) Assume now that the Federal Reserve decides to target an inflation rate of 3%. What open-market operation should the Federal Reserve undertake? (d) Using a correctly labeled graph of the money market, show how the Federal Reserve’s action you identified in part c will affect the nominal interest rate. Answer to 1. (c) The open market operation to decrease inflation from 6% to 3% The open market operation to decrease inflation from 6% to 3% would be for the Fed to sell bonds to the banks. would be for the Fed to sell bonds to the banks. Answer to 1. (d) The Fed’s selling of bonds would decrease MS from MS1 to MS2 The Fed’s selling of bonds would decrease MS from MS1 to MS2 and increase nominal interest rates. and increase nominal interest rates. Money Market ir1 0 DmDmDmDm MS 2 MS 1 Nominal Interest Rate ir2 [Sell bonds]

Y * Y * Investment Demand ir1 ir1 0 Money Market QID 2 AS ir1 0 MS 2 AD 2 PL 2 QID 1 YIYIYIYI AD 1 DIDI DmDmDmDm PL 3 MS 1 QIDQIDQIDQID RGDP ir2 NIR (e) How will the interest rate change you identified in part d affect aggregate demand in the short run? Answer to 1. (d) The Fed’s selling of bonds would decrease MS from MS1 to MS2 and The Fed’s selling of bonds would decrease MS from MS1 to MS2 and increase nominal interest rates, decreasing quantity of investment increase nominal interest rates, decreasing quantity of investment demanded, which decreases AD in the short run. demanded, which decreases AD in the short run.

SRPC 1 Inflation 6%6% Unemployment 5% LRPC A (f) Assume that the Federal Reserve action is successful. What will happen to each of the following as the economy approaches a new long-run equilibrium. (i) The short-run Phillips Curve. Explain (ii) The natural rate of unemployment Answer to 1. (f) (ii) The natural rate of unemployment would not increase Answer to 1. (f) (ii) The natural rate of unemployment would not increase in the long run, but stay the same. in the long run, but stay the same. SRPC 2 3%3% B Answer to 1. (f) (i) Answer to 1. (f) (i) As can be seen on the graph, the decrease in AD would result in a As can be seen on the graph, the decrease in AD would result in a movement down and to the right on the SRPC, but as the economy movement down and to the right on the SRPC, but as the economy approaches long-run equilibrium, the decrease in expected inflation approaches long-run equilibrium, the decrease in expected inflation would result in the SRPC shifting left. would result in the SRPC shifting left.

2. Assume that as a result of increased political instability, investors move their funds out of the country of Tara. (a) How will this decision by investors affect the international value of Tara’s currency on the foreign exchange market? Explain. (b) Using a correctly labeled graph of the loanable funds market in Tara, show the impact of this decision by investors on the real interest rates in Tara. (c) Given your answer in part b, what will happen to Tara’s rate of economic growth? Explain. Answer to 2. (a) As foreign investors pull their money out of Tara, there would be a decrease As foreign investors pull their money out of Tara, there would be a decrease in demand for their currency, which would depreciate their currency. in demand for their currency, which would depreciate their currency. S1S1 D r1 F1F1F1F1 Real Interest Rate, (%) Quantity of Loanable Funds E1 r2r2r2r2 F2F2F2F2 E2E2E2E2 S2S2S2S2 LFM Answer to 2. (b) As can be seen on the graph, as As can be seen on the graph, as investors pull their money out of Tara, investors pull their money out of Tara, there is a decrease in supply in their LF there is a decrease in supply in their LF market which increases the RIR. market which increases the RIR. Answer to 2. (c) As the RIR increases, it becomes less profitable for firms to invest in capital equipment, As the RIR increases, it becomes less profitable for firms to invest in capital equipment, which decreases economic growth. which decreases economic growth.

3. Assume that the reserve requirement is 20% and banks hold no excess reserves. (a) Assume that Kim deposits $100 of cash from her pocket into her checking account. Calculate each of the following. (i) The maximum dollar amount the commercial bank can initially lend (ii) The maximum total change in demand deposits in the banking system (iii) The maximum change in the money supply. (b) Assume that the Federal Reserve buys $5 million in government bonds on the open market. As a result of the open market purchase, calculate the maximum increase in the money supply in the banking system. (c) Given the increase in the money supply in part b, what happens to real wages in the short run? Explain. Answer to 3. (a) (i) The $100 in DD will result in $80 new ER that the banks can initially lend. (i) The $100 in DD will result in $80 new ER that the banks can initially lend. (ii) Maximum total DD could be as high as $500. This includes $100 DD in the (ii) Maximum total DD could be as high as $500. This includes $100 DD in the first bank and a PMC of $400. M M [5] x ER [$80] = PMC of $400. Total DD of $500. first bank and a PMC of $400. M M [5] x ER [$80] = PMC of $400. Total DD of $500. (iii) The MS was already $100 as the $100 in cash was part of MS, so this results (iii) The MS was already $100 as the $100 in cash was part of MS, so this results in an increase in money supply of $400. in an increase in money supply of $400. Answer to 3. (b) Once this $5 million is deposited by the public, $1 million has to be kept in RR Once this $5 million is deposited by the public, $1 million has to be kept in RR and $4 million becomes ER. M M [5] x ER [$4 M] = $20 million increase in the MS and $4 million becomes ER. M M [5] x ER [$4 M] = $20 million increase in the MS in the banking system. The Total MS is now $25 million [DD of $5 & PMC of $20] in the banking system. The Total MS is now $25 million [DD of $5 & PMC of $20] Answer to 3. (c) The increase in MS results in a decrease in the NIR, resulting in a increase in The increase in MS results in a decrease in the NIR, resulting in a increase in QID, and an increase in AD, which pushes prices up, therefore a decrease in QID, and an increase in AD, which pushes prices up, therefore a decrease in real wages. real wages.

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