## Wednesday, December 7, 2016

### 2009 B Microeconomics FRQ #2

2009 B Microeconomics FRQ #2

(A) Assume the last unit of peanuts consumed increased Sasha's total utility from 40 utils to 48 utils and that the last unit of bananas consumed increase her total utility from 52 to 56 utils.

(i) If the price of a unit of peanuts is \$1 and Sasha is maximizing utility, calculate the price of a unit of bananas.

Anytime, you see a utility question use the formula:

(ii) If the price of a unit of peanuts increases and the price of a unit of bananas remains unchanged from the price you determined in (a)(i), how will Sasha's purchase of peanuts change?

Understand that if the price of peanuts increases, then the value of MU (marginal utility) to price will decrease. If the price of peanuts increase then for every dollar spent on peanuts I will be able to buy fewer and fewer peanuts.

(B) Assume that the cross price elasticity (XED) of demand between peanuts and bananas is positive. A widespread disease has destroyed the banana crop. What will happen to the equilibrium price and quantity of peanuts in the short-run? Explain.

Understand what a positive XED means, from the elasticity cheat sheet here.

Since peanuts and bananas are substitutes, when the crop of bananas are destroyed (banana's supply curve shifts leftward) the price of bananas will rise and consumers will demand more peanuts as they are a substitute for bananas they (peanuts) are relatively cheaper. You must understand that if the price of bananas rises and the price of peanuts stays the same, then, per dollar spent, peanuts have now become cheaper.

(C) Assume the price of bananas increase.

(i) Will the substitution effect increase, decrease, or have no effect on the quantity of bananas demanded?

The substitution effect will decrease the quantity of bananas demanded. Price goes up the quantity demanded goes down. The substitution effect is one of the very reasons that the demand curve slopes down....

(ii) What happens to Sasha's real income?

If prices rise/Inflation increases then real incomes/wages fall.

From an earlier post on nominal and real wages here.

### 2009 Macroeconomics FRQ #2

2009 Macroeconomics FRQ #2

(A) How will this decision by investors affect the international value of the Tara's currency on the foreign exchange market? Explain.

So, If I have my money in Tara, and all hell breaks loose. I will want to get my money out of the country super quick. I have to exchange my Tara currency for some other more stable currency to preserve the value of my money. So the FOREX will have many people trying to do this and therefore the supply of Taras' will increase in the FOREX, meaning that the value of the Tara will fall.

(B) Using a CLG of the loanable funds market in Tara, show the impact of the decision by investors on the real interest rate in Tara.

Understand that the loanable funds market is the graph of the amount of money in the commercial banks in Tara. If investors pull their money out of Tara then the supply of cash in Tara's banks must decrease.

The real rate will increase as the supply of loanable funds decrease.

(C) Given your answer in part (b), what will happen to Tara's rate of economic growth.

A rising interest rate will deter people from borrowing money. This will deter investment and consumption and therefore Tara's economic growth will suffer.

### 2009 Macroeconomics FRQ #3

2009 Macroeconomics FRQ #3

(A) Assume that Kim deposits \$100 of cash from her pocket into her checking account. Calculate each of the following.

Refer to the Reserve Requirement Cheat Sheet here.

(i) The maximum dollar amount the commercial bank can initially lend.

So, Kim deposits her \$100 into the bank. The bank has to hold in reserves 20% of the \$100. So, \$20 is kept in reserve (it cannot be loaned out), which leaves \$80 that can be loaned by this commercial bank.

(ii) The maximum total change in demand deposits in the banking system.

This one confused me today,,, That tends to happen if you don't go over these questions regularly.

So, the change in demand deposits in the banking system. Demand deposit is the amount deposited into a bank and payable back to the customer upon demand. The whole \$100 is owed to Kim.

Excess reserves x money multiplier = max. change in loans
\$80 x 5 - \$400
Max. change in loans + original deposit = max. change in demand deposits
\$400 + \$100 = \$500

So, \$100 is deposited which makes demand deposits increase by \$100 and then money creation happens within the banking system.

How does that look????

This question is asking you how much money creation can happen throughout the banking system due to the deposit of \$100 by Kim, in the banking system. The 1st bank takes in Kim's \$100, keeps \$20 (20%) of it in required reserves, and loans out the remaining \$80. That money is then used and deposited into bank #2. Bank #2 takes the \$80 and keeps \$16 (20%) of it in required reserves and loans out the other \$64 dollars. That \$64 loan is spent and ends up in Bank #3 of which \$12.8 (20%) is required to be kept in reserve and the remaining \$51.2 is loaned out. Rinse, Repeat.

(iii) The maximum change in the money supply.

We can understand that the multiplier is 5.
How do we know this?
Check out the MPC/MPS Cheat Sheet here.

You can also use the formula 1/RRR and 1/.2 is 5. (the .2 is the 20%, required to be held in reserve)

So, Kim, deposits \$100 and 20% is held in reserve which means that \$80 can be loaned out and so on.

\$80 x 5 = \$400 ,,,,,,,

Understand that Kim's \$100 is not counted because it was already considered part of the money supply. So we just look at change in the money supply or just the new money created by the banks loaning out money.

(B) Assume that the Federal Reserve buys 5 million in government bonds on the open market. As a result of the open market purchase, calculate the maximum increase in the money supply in the banking system.

First, the FED has created \$5m and injected it into the money supply increasing the supply of money by \$5m immediately. Then the banks create money by loaning out the excess reserves.  The banks have \$5m deposited and their required reserves are \$5m x 20% or \$1m. Now banks have \$4m in excess reserves able to be loaned out by the banks. If they loan it all out, the \$4m is multiplied by 5 (just like above) which will give us \$20m.... oops!, don't forget to add to the \$20m the original \$5m that the FED invested into the money supply to get a total money supply increase of \$25m

(C) Given the increase in the money supply in part (b), what happens to real wages in the short-run. Explain.

If the money supply increases real wages fall as the value of every individual dollar someone holds will decline. We could also say that the prices of all goods will rise as more money chases the same amount of goods, pushing prices higher. If there are no wage increases to keep up with rising prices (inflation) then real wages have fallen.