Chapter 4

Q5. What are the various ways in which the Federal Reserve can influence the money
supply?
Monetary tools that central bank can use to influence the money supply are:
(a) Open market operations – central bank’s buying and selling of government securities in the
open market to manipulate money supply
(b) Reserve requirement – the proportion of public’s deposits to be set aside as reserve, not for
loan
(c) Discount rate – interest rate charged on loans to banks

P2. Explain how each of the following events affects the monetary base, the money
multiplier, and the money supply.
a) The Federal Reserve buys bonds in an open-market operation.
When Federal Reserve buy bonds in an open-market operation, it also means that the public
who bought bonds earlier are now selling them back to Federal Reserve. As a result, money
is now transferred back to the bond holders’ bank account (in commercial banks) from
Federal Reserve’s account. Since the monetary base increases, the money supply also
increases. Also, since there is no change in currency-deposit ratio and reserve-deposit ratio,
money multiplier does not change.

b) The Fed increases the interest rate it pays banks for holding reserves.
When Fed increases the interest rate that it pays banks for holding reserves, banks have more
incentive to hold reserve, which also means giving out less loans as loans are riskier
compared to reserve which is almost risk-free. When interest rate increases, banks’ reserve
increases. An increase in reserve will lead to an increase in the reserve-deposit ratio. As a
result, the money supply decreases as the money multiplier decreases. Since reserve
increases, loans will decrease and monetary base will increase (more reserve and possibly
currency not lent out).

P5. In the economy of Panicia, the monetary base is $1,000. People hold a third of
their money in the form of currency (and thus two-thirds as bank deposits). Banks hold a
third of their deposits in reserve.
a) What are the reserve-deposit ratio, the currency–deposit ratio, the money multiplier,
and the money supply?
Reserve-deposit ratio, rr = 1/3
Currency-deposit ratio, cr = currency / deposit = (1/3) / (2/3) = 1/2
1
+1
cr +1 2
Money multiplier, m = = = 1.8
cr +rr 1 1
+
2 3
Money supply = money multiplier x monetary base = 1.8 x $1,000 = 1,800
b) One day, fear about the banking system strikes the population, and people now want to
hold half their money in the form of currency. If the central bank does nothing, what is
the new money supply?
Reserve-deposit ratio, rr = 1/3
Currency-deposit ratio, cr = currency / deposit = (1/2) / (1/2) = 1
1+1
cr +1
Money multiplier, m = = 1 = 1.5
cr +rr 1+
3
Money supply = money multiplier x monetary base = 1.5 x $1,000 = 1,500

Conclusion:
The amount of money that people want to hold as currency will influence over the money
supply.

Chapter 5
Q4. If inflation rises from 6 to 8 percent, what happens to real and nominal interest
rates according to the Fisher effect?
Nominal interest rate (i) = real interest rate (r) + inflation rate (π)
If π increases by 2%, nominal interest rate (i) increases by 2%. Real interest rate (r) is not
affected by inflation.

P1. In the country of Wiknam, the velocity of money is constant. Real GDP grows by 3
percent per year, the money stock grows by 8 percent per year, and the nominal
interest rate is 9 percent.
a) What is the growth rate of nominal GDP?
Given Y = 3%, M = 8%, i = 9%,
Nominal GDP = PY
MV = PY
M + V = PY
Since V = 0, M = PY
Therefore, PY = 8%

b) What is the inflation rate?

Inflation rate is the change in price (P)
M + V = P + Y
8% + 0 = P + 3%
5% = P = inflation rate

c) What is the real interest rate?

Real interest rate (r) = i – π
r = 9% – 5% = 4%