Question

In: Economics

U.S. Economy Data Category Value Total Reserves (private banks) $100 Billion Currency (firms, households) $50 Billion...

U.S. Economy Data

Category

Value

Total Reserves (private banks)

$100 Billion

Currency (firms, households)

$50 Billion

Value of Euros in the U.S. (private banks, firms, households)

$1 Billion

Gov’t bonds (private banks, firms, households)

$30 Billion

Demand deposits (private banks)

$1 Trillion

Certificates of Deposit, CDs (private banks)

$10 Billion

Reserve requirement on demand deposits

.10


  1. Let’s say the Federal Reserve buys $20 Billion in bonds from private banks
    1. What is the total amount (in $) of reserves that banks now have on hand to lend?
    2. Using the simple deposit multiplier, how much additional money (M1) is created by this process?
    3. What will happen to the Federal Funds Rate, the prime rate, and other nominal interest rates in the economy? (Go up, down, stay the same?) Why?
    4. What effect will this policy have on investment? Why?
    5. What effect will this policy have on consumption? Why?
    6. Is this monetary policy or fiscal policy? Contractionary or expansionary? Explain.
    7. Thinking about the relationship between aggregate demand, short-run aggregate supply, and long-run aggregate supply:
      1. When would this policy be appropriate? Explain.
      2. When would this policy be inappropriate? Explain.

Solutions

Expert Solution

The total amount (in $) of reserves that banks now have on hand to lend is $(100+20) billion = $120 billion

The additional money (M1) creation can be found using the simple deposit multiplier given as

dD=1/r*dR

where dD is the change in bank deposits, r is the Reserve requirement on demand deposits, and dR is the change in the total reserve.

Here, dD =1/0.1*20= 200

Thus, there will be an additional $200 billion in money creation through this process.

With rise in the money supply, there will be an excess supply situation in the money market with no significant change in the demand for the money. This will lower the interest rate in the money market to maintain equilibrium. Thus,  Federal Funds Rate, the prime rate, and other nominal interest rates in the economy will go down.

Because of all in the interest rate, there is will rise in investment in the economy. As the interest rate represents the cost of capital, a fall in the variable means the cost of capital going down. This will encourage firms to undertake more and new investments. That is why investments in the economy will go up due to the fall in the interest rate.

A fall in the interest rate means less return on savings. Thus, the household will tend to save less and spend that amount on consumption. Thus, a fall in interest rate consumption is likely to increase the level of consumption.

This is monetary policy as the government is making an attempt to intervene in the economy through a monetary tool, which is the interest rate. A fiscal policy mainly deals with maneuvering with taxes and government expenditure. Again, this policy is expansionary as it is likely to result in a growth in GDP and employment level.  It can be seen that the rise in the money supply will lower the market rate of interest and thereby boost investment. More investment means an increase in production and generation of more employment and a subsequent rise in disposable income in the economy. With rising disposable income and less incentive to save due to lower return offered by falling rate of interest there will be a rise in consumption demand. This will again strengthen the aggregate demand of the economy and set it on the path of growth.

The expansionary monetary policy is appropriate when the economy is far away from the full-employment GDP. It is under such a condition, the economy has space to grow and generate more employment and be less inflationary.   However, if the economy is close to the full-employment GDP, an expansionary monetary policy will raise the inflation rate more than ensuring growth in the GDP. Thus, it will be inappropaite to apply an expansionary monetray policy under such a condition.       

  


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