a. use a loanable fund diagram to analyse the impact of the decrease in government expenditure...

a. use a loanable fund diagram to analyse the impact of the decrease in government expenditure on the interest rate investment and national saving

b. the bank syste, has 50 million in deposit and 10 million in reserve and there are no excess reserves. the public hold 5 million in cash. assume that the centrl bank sells 5 million government bonds in open market peration. calculate the change in money supply resulted from above policy and show its effects on interest rates and money quantity in the money market diagram

Solutions

Expert Solution

(a)

The decrease in government spending decreases government budget deficit, so government borrowing for deficit financing decreases, which decreases the demand for loanable funds. Demand curve shifts leftward, decreasing interest rate and decreasing quantity of lanable funds (national saving and investment).

In following graph, D0 and S0 are initial demand and supply curves for loanable funds, intersecting at point A with initial interest rate r0 and quantity of loanable funds Q0. A decrease in demand shifts D0 leftward to D1, intersecting S0 at point B with lower interest rate r1 and lower quantity of loanable funds Q1.

(b)

Required reserve ratio (rr) = Reserve / Deposit = 10/50 = 0.2

Currency-deposit ratio (cr) = Currency / Deposit = 5/50 = 0.1

Money multiplier (MM) = (1 + cr) / (cr + rr) = (1 + 0.1) / (0.1 + 0.2) = 1.1 / 0.3 = 3.67

When central bank sells bonds worth 5 million,

Decrease in money supply = 5 million x 3.67 = 18.35 million

In the money market, a decrease in money supply will shift money supply curve leftward, increasing interest rate and decreasing quantity of money.

In following graph, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0. When money supply falls, MS0 shifts left to MS1, it intersects MD0 at point B with higherr interest rate r1 and lower quantity of money M1.

Rahul Sunny answered 1 year ago

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