2004 Macro FRQ #3 (FED Buys Bonds/ Reserve Requirements)

FED Buys Bonds (Money Supply)

So, lately I was stumped in class.

The 2004 Macro FRQ #3

A) As a result of the FED's action, what is the change in the money supply if the required reserve ratio is 100%??

Answer - If the RRR is 100%, the amount held by the bank in Required Reserves is all $5000 dollars. But  the thing is,, the FED dropped $5,000 into the market initially by buying the bonds. That is where the increase comes from (the initial purchase of bonds from the FED)

B) If the Required reserve ration is reduced to 10%, calculate the following.

(i) The maximum amount this bank could lend from this deposit.

If the required reserve is reduced to 10%, then that means the bank is required to keep in reserve 10% of the $5,000 dollars deposited. So .10 x 5,000 = $500 in Reserve

This means that $4,500 of the amount deposited is put in excess reserves that can be loaned out. 

Answer (i) - So, the maximum amount that can be loaned out from the initial deposit of $5,000 is $4,500.

The part below is where I had a bit of a brain-fart.

(ii) The maximum increase in the total money supply from the FED's purchase of bonds.

The maximum increase in the money supply is happening from two different actions.

1) The bank is able to loan out the $4,500 and that amount is multiplied throughout the economy. We calculate this as 1/RRR = 1/.1 = 10,, so the $4,500 x 10 = $45,000 increase in the money supply. This is the amount of money that the banks can increase the money supply by the deposit. BUT,, there is someone we forgot about.

2) The FED had increased the money supply by buying bonds from our friends at the Clark Consulting Service of $5,000. 

Answer - the maximum amount the money supply can be increased is $50,000,, $45,000 from the actions of the bank and $5,000 from the initial buying of bonds from Clarks.

C) If the bank keeps some of its excess reserves how will this influence the change in the money supply? 

Answer - if the banks don't use all of there excess reserves to loan out,, then the money supply will not be increased by as much as it could. It would be less than the $50,000 of maximum increase.

D) If the public decides to not put the cash into the banks how will this effect the money supply?

Answer - this is the same as question (C),, if people don't put their deposits in the bank,, then the money supply cannot be increased. If Clark had just kept the $5,000 in cash,, then the money supply would only have increased by $5,000,, no more.

College Board, I salute you.

Thanks, Jung-Sub

2004 AP Micro FRQ#1

This was a tough one. College Board, "You bastards"

watch me answer it here

https://youtu.be/yA4bYaeKhqA

2004 AP Micro FRQ#1 

My Understanding:

Answer from the college board 

As MSC > than MPC, the externality is a negative production externality.

At a quantity of Q2, MSB = MSC at a price of $12.

The government can incentivise the monopolist to produce more by providing a subsidy. A subsidy should be provided to the point where the monopolists MC (MPC) curve will be reduced until it intersects with the MR (MPB) curve at Q2 (social optimal quantity)

A Perfectly competitive firm would produce an overproduction of a negative production externality. Its market price is where MPC = MPB and this is at the price of $7 and at a quantity of Q3. To get the perfectly competitive firm to produce less a per-unit tax must be levied against the (industry). As the firm has no control over price (price-takers) the industry must have the tax imposed upon it. At a tax of $5 the price would rise to $12 and the quantity would be reduced to Q2. Or what I believe to be the socially optimal quantity and price.

Students were asking why the government would subsidise a monopoly to create more negative goods,,, I believe the answer is to recognise that even a negative production externality has a benefit to society. Pollution might be the problem,, but no pollution means no production and this would be much worse than the externality. So government recognises that there is a benefit in the production of the good. 

Understand that the marginal benefit should equal the marginal cost. (MB = MC) or the MSC = MSB.

We could spend trillions of dollars to clean all of the rivers and lakes but then the MSC > MSB. Society would have pristinely clean rivers but not much of anything else.

Thank you Michelle for bringing this to my attention,,

Such fun I've had today,, trying to figure this out.