Economics 219

Solutions to Problem Set #8

 

  1. Recall that the formula for the money multiplier is:

 

    1. The multiplier will be 4. The purchase of securities represents a $100 million increase in the monetary base, so M1 increase by $400 million.
    2. If C/D falls to .05, the multiplier rises to 7. Therefore, the change in M1 would be $700 million.

 

2.    Two things happened during the great depression. First of all, remember that when a bank creates loans, they are not creating money – only "electronic" money. The only real money is the cash on reserve in the vaults. During the great depression, many banks went out of business, taking their "electronic" money with them. The second thing was a by-product of consumer behavior. With the banking industry in shambles, consumers lost their faith in banks and demanded holding onto their wealth in cash rather than deposits. This drastically increases the C/D ratio, which greatly lowered the money multiplier.

3.

    1. The Fed should do nothing in the short run, but would have to reduce the money supply in the long run if the negative shock persisted.
    2. The increase in consumer confidence would shift IS to the right. To maintain a constant interest rate, the fed would need to increase the money supply.
    3. A decrease in the C/D ratio would lower the money supply (not M0, but all other measures). The Fed would need to increase the money supply through an open market purchase or a lowering of the discount rate.

4.

    1. If the Fed targets the real interest rate, Then money demand shocks are offset by changes in money supply, so the LM curve does not move. Since the shock causes money supply to change, but does not affect real output, money supply is aclyclical. By following an interest rate rule, AD is unaffected by money demand shocks, and hence more stable than if the fed had no rule.
    2. When there are preference shocks (that shift the IS curve), the rule does not work very well. Suppose, for example, that a rise in consumer confidence shifts the IS curve to the right. The appropriate monetary response would be to increase the money supply (to shift LM to the right). While this maintains a constant interest rate, it amplifies the increase real output. This makes aggregate demand less stable. Note that this policy is not sustainable in the long run. Output will eventually return to the full employment level at the higher interest rate. If the fed were to try to maintain the lower interest rate, the result would be higher inflation.
    3. When there are supply shocks, this rule also doesn’t work very well. Suppose a technology shock shifts the FE curve to the right. There is no effect on output and the interest rate in the short run (short run eq. Is the intersection of IS and LM.). However, in the long run, prices and interest rates will fall. If the fed tries to target the interest rate at its initial level, it would have to reduce the money supply. As in part (b), this is not a sustainable long run policy.

5.

    1. As the unemployment rate approaches 5%, consumers expect the Fed’s policy to kick in and start to expect higher inflation rates. As this happens, money demand falls and the price level starts to go up. The rising lowers the real wage and offsets some of the rise in unemployment.
    2. Now the Fed is faced with a problem. If it raises money growth, it will have no affect on employment because now it will only be creating the inflation that consumers are already expecting. However, if it doesn’t increase money growth, once consumers realize that the inflationary expectations are unwarranted, prices will go back down and unemployment will increase.
    3. This policy is not is not time consistent. Even though it initially sounded like a good policy to raise money growth when unemployment is high, the fact that the policy affect consumers behavior reduces the desirability of the plan once high unemployment actually occurs.