2010 B Macro FRQ #2
Sells bonds = Contractionary = MS decreases
(A) Assume that banks in Sewell have no excess reserves. What is the effect of the central bank's action on the amount of customer loans that banks in Sewell can make?
Banks have no excess reserves, meaning they have no money to lend out. Then the FED sells bonds and bank customers take out even more cash to buy FED bonds. The bank is now having to borrow money from other banks to cover the checks written by its customers to buy those FED bonds. There is even less money in the system and no excess reserves to loan out. Loans decrease.
(B) Using a CLG of the money market, show they affects of the central banks actions on the nominal interest rate in Sewell.
(C) What is the effect of the Central bank's action on each of the following.
(ii) Real interest rate (RIR) Explain.
If the Central Bank uses a contractionary policy by selling bonds then the nominal interest rate will increase as the money supply shrinks. As the money supply decreases and the nominal interest rate increases then there will be less consumption and investment which will decrease AD. As AD (aggregate demand) decreases the Price Level will fall.
A quick way to know about the RIR is to know that nominal and real interest rates for the AP exam move in the same direction. So if the Nominal IR is increasing then the Real IR must also be increasing.
The central bank is contracting the money supply. The real interest rate is affected by the supply of money in the loanable funds market (commercial banks). If the FED is contracting the money supply then the supply of loanable funds is being extracted from the commercial banks. This lowers the supply of loanable funds and therefore the RIR will increase.
(D) Given your answer in part (C)(ii), how is the international value of the Sewell's currency, the Ono, affected. Explain.
Understand that when the AP College Board starts speaking about currency and RIR's together then we have to take the affects on the FOREX market.
So, if the RIR increases, foreigners will see the higher interest rates in the country of Ono, and want to invest in the country to get the higher interest rates. Profits attract investors. So if the RIR in Ono, increases and foreigners demand more currency from Ono in the FOREX. Then we will see the value of Ono's currency increasing. As demand for the Ono increases in the FOREX the value of the Ono will increase.