Question

. How would a tax on bond held by individuals affect the demand for money, interest rate, investment, aggregate demand, price and real GDP?

2. Trace the impact of buying more bonds by government on bond prices, interest rates, investment, aggregate demand, real GDP, unemployment, and the price level.

3. True or false, explain you answers.

1. Lenders sell bonds, and borrowers buy them.
2. An increase in reserve requirements raises the reserve ratio and decreases the money supply.
3. When the government runs a budget deficit, interest rates rise, and investment falls.
4. Joan uses some of her income to buy mutual fund shares. A macroeconomist would refer to Joan’s purchase as investment.
   

4) Jeremiah deposits in a bank an amount of $1000 that he had been holding at home in a jar for a long time.
a. If the banking system is 100 percent reserve, how does the money supply change?
b. If the reserve requirement is 10 percent and the bank holds no excess reserves, how does the money supply change?
c. If the reserve requirement is 10 percent and the bank holds an excess reserve of 2 percent, how does the money supply change?

Answer 1

1. Tax on bonds held by individuals will increase the demand for money as people tend to hold money rather than buying bonds.

Again, with increase in demand for money, interest rates must rise.

At higher interest rates, investments will fall.

With fall in investments, aggregate demand, price level and real GDP will fall as well.

2. If government buys more bonds, supply of money in the economy rises. As a result, people tend to buy more bonds. This will lead to rise in bond prices.

With rise in bond prices, interest rates will fall.

At lower interest rates, investments will rise.

With rise in investments, aggregate demand, price level and real GDP will rise as well.

With rise in real GDP, unemployment will decrease.

3.a. The given statement is incorrect as lenders buy bonds and borrowers sell bonds.

b. The given statement is true. The higher the reserve requirement, the lower the money supply becomes.

c. The given statement is correct. When government runs budget deficit by borrrowing money, interest rates must rise. This will lead to fall in investments.

d. The given statement is correct. Here, mutual funds shares are considered as investments.

4. a. If banking system is 100 percent reserve, money supply will not change (i.e, $1,000).

b. If reserve requirement is 10% i.e, 0.1, then money multiplier = 1/0.1 = 10

As a result, bank will keep $100 as reserves and money supply ($1000-$100 = $900) will increase by 10 times i.e, $900*10 = $9,000

c. If reserve requirement is 10% i.e, 0.1, then money multiplier = 1/0.1 = 10

With reserve requirement of 10%, banks can lend $900.

Again, if banks hold excess reserves of 2 percent i.e, it can now lend (900*98/100) = $882 as loans

As a result, money supply will increase by $882*10 = $8,820