Question

i. suppose national saving is $100b, the government deficit is $15b, and the gross investment is $130b. foreign financing is:

a. $30b or less

b. more than $30b but not more than $40b

c. more than $40b but not more than $50b

d. more than $50b

ii. the bank of Canada can pay for its bond purchase simply by crediting the amount of its purchase to the account of the bank involved in the transaction. as a result:

a. bank reserve ultimately increases by this amount times the money multiplier

b. bank reserve ultimately decreases by this amount times the money multiplier

c. the money supplies ultimately increase by this amount times the money multiplier

a. the money supplies ultimately decrease by this amount times the money multiplier

iii. monetarists were convinced that business cycle could be smoothed away simply by requiring the federal reserve to:

a. keep the money supply constant.

b. increase money supply growth in recessions and decrease it in booms.

c. increase money supply growth in booms and decrease it during recessions.

d. increases the money supply at the same rate during booms and recessions.

Answer 1

i. While for a closed economy, saving is necessarily equal to investment, in an open economy, the equations change as per the foreign inflows/outflows and balance of payment equilibria. The equation then equates supply of financial capital to demand of financial capital. Supply of financial capital is taken as equal to , where S is national saving while M minus X is excess of import by exports, ie trade deficit to be filled with foreign financial investment; while demand of financial capital is equal to where I is investment and G minus T is excess of government expenditure by tax revenues, ie the government deficit. Thus, we have the identity as . We have the values, and hence in billion dollars, and solving, we have , and hence, the foreign financing is $45 billion.

Hence, the correct answer is option (c).

ii) The bank of Canada is assumed to be the central bank in Canada. If it credits an amount in the commercial bank involved in the transaction, it increases the deposit of the commercial bank. It basically comes under the method of central bank's open market operation to increase/decrease the money supply. In case, the central bank is purchasing a bond, the money supply is planned to be increased, as the deposit/credit by the central bank in the money market will work as an injection of money in the market. The reserve deposit ratio then increases the money supply by the amount deposited by multiplier effect.

Hence, correct answer is option (c).

iii. Monetarists assume that the business cycles are caused by the central bank's policies of expansion and contraction of money. According to Milton Friedman, a major contributor to the monetarist economics, "Inflation is everywhere and always a monetary phenomenon". They suggested that it is the change in money supply that directly affects the aggregate demand. To them, a steady continuous increase in the money supply at the same rate (during boom and recessions) is what is needed to smooth the business cycle fluctuation. Even if money supply is contracted during inflation with/without recession, the result according to them will be that there will be more unemployment without any significant decrease in price level, since they assume that prices and wages are sticky and the don't move downward. Yet they are found to be true to some extent, they are still considered as quite inefficient in planning long term policies, as according to them, the free market is quite stable in itself and only government intervention causes market failure, which is founded to be empirically false by many later economists.

Hence, the correct answer is option (d).