Assignment 2

Total Marks: 50

1. Suppose that this year’s money supply is $500 billion, nominal GDP is $10trillion, and
real GDP is $5 trillion. (10 marks)
a. What is the price level? What is the velocity of money?
b. Suppose that velocity is constant and the economy’s output of goods and services
rises by 5 percent each year. What will happen to nominal GDP and the price level
next year if the Fed keeps the money supply constant?
c. What money supply should the Fed set next year if it wants to keep the price level
stable?
d. What money supply should the Fed set next year if it wants inflation of 10 percent?

2. What is happening to the US real exchange rate in each of the following situations?
Explain. (10 marks)
a. The U.S. nominal exchange rate is unchanged, but price rise faster in the United
States than abroad.

b. The U.S. nominal exchange rate is unchanged, but price rise faster abroad than in
the United States.

c. The U.S. nominal exchange rate declines, and prices are unchanged in the United
States and abroad.

d. The U.S. nominal exchange rate declines, and prices rise faster abroad than in the
United States.

3. A senator renounces her past support for protectionism: “The US trade deficit must be
reduced, but import quotas only annoy our trading partners. If we subsidize U.S. exports
instead, we can reduce the deficit by increasing our competitiveness.” Using a three-panel
diagram, show the effect of an export subsidy on net exports and the real exchange rate.
Do you agree with the senator? (10 marks)
On the graph, MS represents the money supply and MD represents money demand. The usual
quantities are measured along the axes. (10 marks)

MS
1.125

0.875

0.75

0.625

0.5
MD
0.375 2
0.25 MD1
0.125

5,000

4. Refer to the above Figure. If the relevant money-demand curve is the one labeled MD2,
a. What is the equilibrium value of money?

b. What is the equilibrium price?

c. Suppose the relevant money-demand curve is the one labeled MD2; also suppose the velocity
of money is 2. If the money market is in equilibrium, then what was the economy’s
nominal GDP?

d. At the end of 2007 the relevant money-demand curve was the one labeled MD2. At the end
of 2008 the relevant money-demand curve was the one labeled MD1. Assuming the
economy is always in equilibrium, what was the economy’s approximate inflation rate for
2008?

Q5. Beleaguered State Bank (BSB) holds $250 million in deposits and maintains a reserve
ratio of 10 percent. (10 marks)
a. Show a T-account for BSB.
b. Now suppose that BSB’s largest depositor withdraws $10 million in cash from her account.
If BSB decides to restore its reserve ratio by reducing the amount of loans outstanding, show
its new T-account.
c. Explain what effect BSB’s action will have on other banks.
d. Why might it be difficult for BSB to take the action described in part (b)? Discuss another
way for BSB to return to its original reserve ratio.