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Chapter 16: Q.3 - Problems (page 373)

Assume that the following conditions exist :

a. All banks are fully loaned up - there are no excess reserves, and desired excess reserves are always zero.

b. The money multiplier is 3.

c. The planned investment schedule is such that at a 6percent rate of interest, the investment is \(1200billion; at 5 percent, investment is \)1225billion

d. The investment multiplier is 3.

e. The initial equilibrium level of real GDP is \(18trillion.

f. The equilibrium rate of interest is 6percent.

Now the Fed engages in expansionary monetary policy. It buys \)1billion worth of bonds, which increases the money supply, which in turn lowers the market rate of interest by 1percentage point. Determine how much money supply must have increased, and then trace out the numerical consequences of the associated reduction in interest rates on all the other variables mentioned.

Short Answer

Expert verified

Bonds bought of $1 billion Increase inmoney supply by $3billion, decrease interest rate by 1% & increases investmentby $25billion, and raisesincome by $75 billion

Step by step solution

01

Investment Multiplier 

Change in investment due to change in interest rates can be calculated by =

(1225-1200)/(6-5). So, 1%change in interest rates leads to $25billion change in investment.

Investment multiplier shows multiple times increase in income due to change in income.

Formula = Change in Income/ Change in Investment

So, change in Income =3x25=$75 billion

02

Money Multiplier Concept 

Money multiplier shows the multiple times increase in money supply due to change in government monetary policy (FOMC bonds buying here).

Money Multiplier = Money supply change / Monetary policy change (bonds' purchase)

As money multiplier = 3, bonds purchase value = $1billion

So, 3= Money supply change /1

Money supply change = 3x1=$3billion dollars

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Most popular questions from this chapter

What do you suppose might be gained-and by whom-if the Fed were to follow an easily understood rule as a guide for conducting monetary policy? Explain.

Take a look at Figure 16-6. Suppose that a multiple reduction in GDP is the final outcome that the Fed desires in the last box in the figure. Explain the required directions of efforts - that increases or decreases - that most occur in the preceding boxes in the figure in order to yield in this desired decrease in real GDP

Consider figure 16-7. Discuss a specific monetary policy action that Fed's Trading Desk could implement in order to induce the effects traced out by this figure.

You learned in an earlier chapter that if a recessionary gap occurs in the short run, then in the long run a new equilibrium arises when input prices and expectations adjust downward, causing the short-run aggregate supply curve to shift downward and to the right and pushing equilibrium real GDP per year back to its long-run value. In this chapter, you learned that the Federal Reserve can eliminate a recessionary gap in the short run by undertaking a policy action that increases aggregate demand.

a. Propose one monetary policy action that could eliminate the recessionary gap in the short run.

b. In what way might society gain if the Fed implements the policy you have proposed instead of simply permitting long-run adjustments to take place?

If the FOMC were to aim to attain targets for M1 or M2 instead of the federal funds rate, would people be as concerned with trying to anticipate future federal funds rate changes? Explain.
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