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Drexel University Econ 202: Principle of Macroeconomics Winter 2012 - Midterm 2, February 27th SOLUTION
Professor: Marco Airaudo Name Instructions: you have 1h and 30 minutes to complete the exam. You do not have to motivate your answers for the multiple choice part. Show your work for the short answer part in order to get full credit. MULTIPLE CHOICE SECTION (40 points total, 4 each) The correct answer is marked with a "**"
- During a contractionary monetary policy
(a) government spending increases (b) the supply of reserves shifts leftward** (c) the supply of reserves shifts rightward (d) taxes are cut
- Suppose that a commercial bank has $800 million worth of checking deposits and that the reserve requirement is 25%. What is the maximum amount of loans that the bank can issue to, say, Örms and business?
(a) $25 million (b) $600 million** (c) none (d) $200 million
- A contractionary Öscal policy is likely to determine
(a) a leftward shift of the supply curve of reserves (b) an increase in the interest rate (c) a leftward shift of the AD curve** (d) a rightward shift of the AS curve
- The Fed can induce lower interest rates
(a) by imposing lower interest rates on checking deposits (b) by selling T-bills and taking reserves from the banking system, via open market operations (c) by buying T-bills and giving more reserves to the banking system via open market operations** (d) by none of the above alternatives
- Through a contractionary monetary policy, the Fed manages to
(a) lower interest rates, which will shift the AD curve to the right (b) increase interest rates, which will shift the AD curve to the left** (c) keep interest rate unchanged, and hence determine higher investments (d) increase interest rates without any impact on AD and the economy
- Suppose the reserve requirement was 25%. Then the money multiplier would be
(a) about 25% (b) 4** (c) 10 (d) zero
- A larger reserve ratio makes
(a) banks safer and the money multiplier larger (b) banks less safe and the money multiplier larger (c) banks less safe and the money multiplier smaller (d) banks safer but the money multiplier smaller**
- An increase in the price of oil is likely to determine an increase in the price level in the economy because
(a) it detemines a rightward shift in AD (b) it determines a move along the AS curve (c) it determines a leftward shift of the AS curve** (d) it make the AS curve áatter
- Suppose the Fed injects more reserves into the banking system. The implied change in the interest rate is going to be larger
(a) the áatter the demand curve for reserves (b) the steeper the demand curve for reserves** (c) the more sensitive consumption and investments are to interest rates (d) none of the above: the change in the interest rate does not depend on the demand curve
- The supply-side Öscal policy pursued by the government during the í80s was not very successful because
(a) consumers did not respond to the tax cut (b) government spending was not increased enough (c) the corporate sector did not signiÖcantly respond to the tax cut** (d) none of the above
OPEN QUESTIONS SECTION Please answer to the following questions. You have to show your work to get full credit. Ex: if you are asked to compute the multiplier, you have to write down its formula, not just the Önal result.
- (20 Points) Consider an economy where total checking accounts are equal to $10 trillion, and where total required reserves are $2 trillion.
(a) What is the reserve ratio, m? What is the value of money multiplier? Answer Reserve ratio: m = 102 = 0: 2 Money multiplier: (^) m^1 = 5 (b) Suppose the demand of reserves by the banking system is given by
QRD^ = 1000 100 i
while the supply of reserves by the Fed is given by QRS^ = 990: Notation: QR stands for excess reserves, i is the interest rate. Compute the equilibrium interest rate i. Answer You had to equate demand and supply of reserves:
1000 100 i = 990
Then solve for i : 10 = 100i! i = 0: 1
(b) What are the two components of total spending that are going to be mostly a§ected by this policy? Brieáy explain how. component 1: Consumption A contractionary monetary policy generates a higher interest rate, which makes people save more and consume less component 2: Investments The higher interest rate makes it harder for investors to obtain liquidity from banks. This implies a reduction of investments in the economy. (c) Show how your answer to b. a§ects the AD-AS equilibrium (use a graph). Answer The contractionary monetary policy makes AD shift leftward, since both investments and con- sumption decrease. As a result, both the equilibrium level of output and the price level drop.
Extra Credit Suppose that the economy is at its potential level and suddenly the stock market crashes, implying a substantial decrease of Önancial wealth in the economy (similar to the 2007-8 crisis). What type of monetary policy by the Fed could help keeping real GDP close to potential? Explain using the appropriate graphs. Answer Letís think about it in bullet points
A stock market crash makes people loose Önancial wealth
This implies a drop in consumption: hence AD shifts to the left
The equilibrium level of output (assuming that AS does not move), goes below the potential level
To restore full employment (that is, to make actual output equal to potential) the Fed should pursue an expansionary monetary policy: this would lower the interest rate, induce an increase in consumption and investments, which will bring the AD curve to the right.
