2009 B Macroeconomics FRQ #2

2009 B Macroeconomics FRQ #2

These questions must be evaluated from their starting places.  The FED's actions must be thought of as outside the system.

(A) Calculate each of the following:

(i) The total change in reserves in the banking system.

This is a contractionary policy as the money supply is being decreased.

If the FED sells government securities (bonds) on the open market. Then the supply of money will be reduced by $50 million in reserves. Individuals will exchange $50m for FED bonds.

Understand that Required reserves and excess reserves will be reduced.

(ii) The maximum possible change in the money supply.

So this withdrawal of $50 million out of the system would reduce the money supply by $500m.

Why?

The multiplier works in reverse for this question: Its a contractionary policy...

But first let us think about the expansionary policy, if the FED had bought bonds instead of sold them.

So if the FED had bought bonds there would normally be an increase in the money supply of $450m 

$50 million bonds bought by the FED and 10% must be held in reserves, 50 x 10% = 5 mil

So we are down to $50 - 5 = $45 million able to be loaned out and multiplied.

With a 10% RRR the $45 million would be multiplied by a factor of 10m which would increase the money supply by $450m but don't forget the original 50m which would need to be added into the multiplied amount. So, 450m + original 50m = 500m expansion of the money supply.

The FED withdrawals the whole $50m out of the money supply reducing the amount of money that the banks have in reserves or could have loaned out, thus decreasing the money supply by the entire $500m.

(B) Using a CLG of the money market, show the impact of the Central Bank's bond sale on the nominal interest rate.

If the money supply is reduced then the nominal interest rate will rise. 

(C) What is the impact of the Central Bank's bond sale on the equilibrium price level in the short-run?

If a contractionary policy is enacted (selling of bonds) then the nominal interest rate will rise. A rising interest rate will cause investment and consumption to fall. If consumption (C) and investment (I) fall then AD will fall and therefore the PL will fall.

Graph - 

(D) As a result of the price level change in (C), are people with fixed incomes better off, worse off, or unaffected. Explain.

Recognise that even if you don't have a clue that by guessing you have a 331/3% chance of getting a point. 

If the price level falls, then people with a fixed income will be better off. They can buy more stuff as prices have fallen. Their purchasing power has increased.