Econ 1, Fall 2005
Problem Set 8 with solutions

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Econ 1, Fall 2005
Problem Set 8 with solutions

Attribution Non-Commercial (BY-NC)

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Hard copies of your answers are due at the beginning of your section, either on

Thursday, November 17, or Friday, November 18. For example, if your section

starts at 10:00am on Friday, you should submit your answers to your TA in your

section classroom at 10:00am on Friday, November 18. Late problems earn zero

points.

Note: you can work on these problems or your own, or in a small group with

other current Econ 1 students. If you choose to work in a group, each student

needs to hand in a separate, individual copy to his/her TA.

that keeps the money supply fixed. The population is concerned with the effect

of a possible war on the value of the domestic currency. Could this expectation

have an effect on prices? Why or why not? Make sure your explanation is based

on one or more of the economic models we studied.

increases sharply but the unemployment rate does not fall. Why might this

occur?1

be counted as employed because they perform important services. How do you

think this change would affect our measure of the labor force, the participation

rate, and the unemployment rate?2

4. Ellen is downloading labor market data for the most recent month, but her

internet connection is interrupted and this is all she is able to get.

Unemployment rate = 5.0%

Participation rate = 62.%

Not in the labor force = 60 million

Find the labor force, the working-age population, the number of employed

workers, and the number of unemployed workers.3

5. Explain why the money multiplier is generally greater than 1. In what special

case would it equal 1?4

1

O’Sullivan and Sheffrin, third edition, page 450.

2

O’Sullivan and Sheffrin, third edition, page 450.

3

Frank and Bernanke, first edition, page 480.

4

Frank and Bernanke, first edition, page 633.

6. The money supply is $1,000 and the velocity of money is five. What is

nominal income? Real income? What happens to nominal income if the money

supply is doubled? What happens to real income?5

mouth and mad cow diseases and all other countries block its meat exports,

how would it affect the consumption and investment shares of GDP of the

European Union in the long run? Analyze verbally and graphically.

2. (a) If the Federal Reserve increases the money supply in the U.S. by 10% in

2001, while real GDP increases by only 2%, what will be the long run effect on

prices? Explain.

(b) Would your answer change if the increase in the money supply was

simultaneous with an increased consumer desire to hold cash? Why?

3. Given the economic definition of money, which of the following goods would

qualify as money? Why or why not? Explain briefly.

(a) Cigarettes in POW (prisoner of war) camps during the Second World War.

(b) Argentine pesos during the hyperinflation of the late 1980’s.

(c) Deutsche marks in the United States.

(d) U.S. dollars in Argentina now.

Note: if you do not know the historical details surrounding any of these

scenarios, please write any reasonable assumptions that you need to make in

order to answer this question.

4. In trying to rescue the economy from a possible recession, the Fed gradually

decreased the interest rate this year from 6% in January to 4% at the end of

May. Suppose the demand for money is as follows:

Nominal Interest 2% 4% 6% 8%

Rate

Quantity of Money 936 918 900 882

(Billions of Dollars)

a) Draw to scale a graph of the money demand and money supply before and

after the interest rate cut (you may interpolate between points).

5

Case and Fair, seventh edition, page 663.

b) Suppose that in January the total amount of currency and reserves were

$400 billion and $50 billion, respectively. Calculate the monetary base and

the money multiplier. How much has the money supply changed from

January to May of this year?

c) Assume that the Fed made open market operations to achieve such interest

rate reduction. Calculate the exact total amount of the transactions

executed by the Fed, and explain how they were implemented. You may

assume that the reserve ratio and currency to deposit ratio are constant.

d) Suppose that real GDP grows only 1% this year, and that the money supply

stays constant for the rest of the year. What would be the inflation rate for

this year?

e) Assume that the energy crisis forces banks to suspend ATM service several

hours a day starting in June. Are there any changes to your answer to part

(d)? Explain why.

ECONOMICS 1 – FALL 2005

PROBLEM SET 8 SOLUTIONS

Question 1

The best way to approach this problem is by using the quantity equation of money:

If people are concerned about a war changing the value of the domestic currency, they are

concerned that their money will be worth less in the future (they are concerned that there

will be inflation). If their dollars will be worth less in the future, then they will want to

get rid of their cash and spend more now, to get more value out of their dollars. If

everyone is spending more now, then there are more transactions now. This means that a

dollar bill is changing hands more times which implies that V goes up.

Since the money supply (M) and real GDP (Y) are constant in this problem, an increase

in velocity (V) will be matched by an increase in the price level (or GDP deflator) (P).

Question 2

The unemployment rate is defined as U/LF, where LF is the labor force and U is the

number of unemployed workers. Note that LF=E+U where E is the number of employed

workers. To be classified as an unemployed worker, however, a worker must be actively

looking for a job. During economic downturns, many workers exit the labor force

completely, meaning that they stop actively searching for work. These people are often

referred to as “discouraged workers”. By not including these types of workers in our

unemployment estimates, in some sense, unemployment rates are biased downwards

during economic recessions. Once the economy improves these discouraged workers

reenter the labor force and begin actively searching for work, thus being counted as

unemployed. So even though E rises, U also rises, and thus the unemployment rate does

not fall.

Question 3

Labor Force = E+U

Participation Rate = (E+U)/WAP

Unemployment Rate = U/(E+U)

where E is the number of persons employed, U is the number unemployed, and WAP is

the working-age population (persons above 16 years of age).

employed persons will rise. Using the above definitions we have that the labor force will

rise, the participation rate will rise, and the unemployment rate will fall.

1

Question 4

U/(E+U) = 0.05 Æ 0.05E = 0.95U Æ E = 19U

(E+U)/WAP = 0.62 Æ (E+U) = 0.62*WAP

E + U + N = WAP and N = 60 million Æ 0.62*WAP + 60m = WAP Æ

60m=0.38WAPÆ WAP=157.9 million

LF = E+U = 0.62*WAP = 97.9 million

U = LF/20 = 4.9 million

E =19U = 93.0 million

Question 5

MM = Money Supply = C + D = k + 1

Monetary Base C+R k+r

The money multiplier (MM) is generally greater than one in because deposits (D) are

generally greater than reserves (R). This is equivalent to saying that the reserve ratio (r)

is generally less than one. The money multiplier would equal one in the special case

where reserves are exactly equal to deposits, that is, if banks were not permitted to lend

out any portion of deposits placed under their control.

Question 6

We know that MV=PY, so nominal income (PY) must equal $5,000. Real income (Y) is

just nominal income divided by the GDP deflator (P). If the money supply is doubled

and we assume that velocity is constant, nominal income should also double. The effects

on real income will depend on what happens to the price level. The prediction of the

quantity theory of money is that if:

(a) the economy is on a long-run growth path where real GDP growth equals potential

GDP growth, and

(b) the growth rate of the velocity of money is constant

then an increase in money growth will be matched by an increase in inflation.

Consequently, if (a) and (b) apply and there is a sudden doubling of the money supply,

then we would expect this to be matched by a doubling of the price level so that there are

no effects on real income.

2

EXTRA PRACTICE PROBLEMS

Question 1

Since the question asks about shares of GDP, we should use the Spending Allocation

Model. If the meat exports from the European Union are blocked by the rest of the

world, then net exports = exports – imports will decrease, shifting the X/Y line

downwards. This, in turn, shifts the NG/Y line downward as well, and the equilibrium

interest rate will fall. Hence, we will observe a movement along the C/Y and I/Y curves,

increasing their respective shares of European GDP.

NG/Y

R R R R

R1

R2

C/Y1 C/Y2 C/Y I/Y1 I/Y2 I/Y X/Y2 X/Y1 X/Y NG/Y

Question 2

In this case, Money Growth = 10%, Real GDP Growth = 2%, and we can assume

the Velocity Growth = 0 in the short-run. (Remember, velocity tends to change

very little from year to year). Plugging these values into the equation yields:

10% + 0% = 2% + Inflation

Hence, we may conclude that Inflation = 8%, e.g. in the long-run, there

will be positive pressure on prices.

b) An increased consumer desire to hold cash will lead to lower inflation in the

long run than we saw in part (a). Why? The change in behavior corresponds to a

decrease in the velocity of money (say by v%). As a result, we have from the

original equation:

10% - v% = 2% + Inflation

3

Inflation = 8% - v%, e.g. it is lower than it was in part (a).

to hold cash will decrease the money multiplier, so money supply will

increase by less than 10%. The result is the same: lower inflation.

Question 3

First, remember that money serves three functions, acting as: a medium of exchange, a

store of value, and a unit of account. In each of these situations, you need to either argue

why all three functions hold (and hence the example fits the economic definition of

money) or why at least one does not (hence the example does not fit the economic

definition of money).

exchange and a unit of account. But since cigarettes have a limited

shelf-life, you could argue that they are not a store of value (e.g. Would you value a year-

old cigarette the same as a new one?).

b) No. Because of the hyperinflation, the Argentine peso was not a store of value (e.g. a

peso today would lose its purchasing power if held until tomorrow).

c) No. A Deutsche mark in the US is not a unit of account (e.g. the prices of textbooks at

the Stanford Bookstore are not quoted in marks), nor is it a medium of exchange (for the

most part, people in the US are not willing to accept as payment Deutsche marks).

d) At one point when Argentina pegged its currency one-for-one to the U.S. dollar by

law, it could be argued that the US dollar did qualify as money since it was accepted as a

medium of exchange, a store of value, and a unit of account. Now the system is more

complex, so it depends on your assumptions about current conditions in Argentina.

4

Question 4

a)

i Money

Supply

8%

6%

4%

Money

Demand

2%

MB = Currency + Bank Reserves

= $400b + $50b

= $450b

Money Supply = MB * Multiplier

$900 = $450 * Multiplier

2 = Multiplier

Finally, to get the interest rate to move from 6% to 4%, we know that the Fed must

have increased the money supply by $18 billion ($918b – $ 900b).

c) In order to increase the money supply via open market operations, the Fed must buy

treasury bonds and expand the monetary base. Since the currency to deposit ratio and

the reserve ratio are constant, we know that the money multiplier is constant at 2, the

same as we found in part (b). Recall that the Money Supply = MB * Multiplier. So,

5

to increase the money supply by $18 billion, the Fed must increase the monetary base

by $9 billion.

(918-900)/900 + 0 = Inflation + .01

.02 + 0 = Inflation + .01

Inflation = .01 or 1%

Note that, barring a shock, velocity tends to change very little from year to year. Thus,

velocity growth should be assumed to be zero unless you are given a reason to think

otherwise.

E) This will create negative velocity growth, and, thus, will lower the inflation rate. The

reasoning is identical to Taylor’s ATM example on page 564.

Question 5

Taylor Chapter 19, Problem 9 on Page 499.

A. Using the equation 1 = C/Y + I/Y + X/Y + G/Y, we can solve for R, then use the R to

solve for the spending shares.

R = 0.1013 or 10.13%

C/Y = 0.6897 or 68.97%, I/Y = 0.1590 or 15.90%,

X/Y = -0.0487 or -4.87%, G/Y = 0.20 or 20%

R = 0.0859 or 8.59%

C/Y = 0.6928 or 69.28%, I/Y = 0.1713 or 17.13%,

X/Y = -0.0341 or -3.41%, G/Y = 0.17 or 17%

Note that from the SAM, it makes sense that with a lower government spending share,

interest rate will be lower and other shares higher.

Question 6

Taylor Chapter 19, Problem 10 on Page 499.

A. An increase in foreign demand shifts the X/Y line right, X/Y = 0.05 – 0.95(R – 0.05).

The new interest rate and shares are:

R = 0.1269 or 12.69%

C/Y = 0.6846 or 68.46%, I/Y = 0.1385 or 13.85%,

X/Y = -0.0231 or -2.31%, G/Y = 0.20 or 20%

Thus, compared to the original situation in 9A, interest rate went up, consumption and

investment shares went down, and net export share went up, while government share

remained the same.

6

B. A decrease in C follows from an increase in taxes, and the C/Y line shifts down, C/Y =

0.68 – 0.2(R – 0.05). The new interest rate and shares are:

R = 0.0910 or 9.10%

C/Y = 0.6718 or 67.18%, I/Y = 0.1672 or 16.72%,

X/Y = -0.0390 or -3.90%, G/Y = 0.20 or 20%

Thus, compared to the original situation in 9A, consumption share fell. But investment

and net exports shares rose, while government share remained the same.

C. An autonomous increase in shifts the I/Y: I/Y = 0.3 – 0.8(R – 0.05). Then the new

interest and shares are:

R = 0.1526 or 15.26%

C/Y = 0.6795 or 67.95%, I/Y = 0.2179 or 21.79%,

X/Y = -0.0974 or -9.74%, G/Y = 0.20 or 20%

Thus, compared to the original situation in 9A, interest rate rose, consumption and net

exports shares fell, and investment share rose, while government share remained the

same.

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