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Introduction to Macroeconomic Theory and Policy
Problem Set No. 5

Prof. Monsod/Adriano/Mariano/Vital/Paraguya 1st Semester AY 2010-2011

Submission is on August 12, 2010, Thursday, during the discussion class. Please use yellow paper.

I. True or False. Determine whether the following statements are true or false. If false, explain briefly in one sentence.
1. Monetary policy is effective with perfectly flexible wages and prices.
2. Monetary policy is always more effective in an open economy than a closed economy.
3. The primary economic function of the financial system is to match one person’s saving with another person’s investment.
4. On the basis of the transactions demand component of the demand for money the demand for money falls as nominal
income falls.
5. The “excess reserves” of a commercial bank consist of money held by the bank in excess of that fraction of its deposits
required by law.
6. The “demand for money” means the same thing as the sum of “assets and transactions demand for money.”
7. Two assumptions are made with the money-supply multiplier: that all money remains in checking accounts, and that no
banks retain excess reserves.
8. The commercial bank is the main financial institution that creates checkable money, mostly in the form of demand deposits.
9. The contraction of the money supply tends at first to make money "tight"-more expensive and less available.
10. An increase in the discount rate would be a signal of a tightening in the money supply.

II. Problem Solving. Show all necessary solutions.

1. Maria deposits P10,000 in Bank A. These funds had for a long time been hidden and out of circulation. The legal
minimum reserve requirement for banks is 25 percent of deposits. Bank A is one among many banks. Unless Bank A is
already short on reserves, this deposit would enable the bank, if it wished, to increase its loans by at least?
2. If a deposit of P100 in the banking system can lead to a total expansion in bank deposits of P400, then the required reserve
ratio must be?
3. Assuming a required 5 percent reserve ratio, a monopoly bank which receives a cash deposit of P1,000 is in a position to
lend out an extra?
4. Assuming a 15 percent required reserve ratio and a desire on the part of banks to keep 5 percent in excess reserves, a P100
cash deposit can result in a maximum total demand deposit expansion of?
5. Assume that the required reserve ratio is 20 percent and that a particular bank has cash and Central Bank Reserve balances
of P25million, loans and securities of P75 million, and deposits of P100 million. This bank can make additional?
6. If banks hold a 30 percent reserve ratio, an initial increase in bank reserves of P30 will lead to an eventual increase in loans
7. Suppose that a one-year bond pays P100 of interest plus the original principal of P1000 when the bond matures. If current
market rates of interest are 9%, how much should you be willing to pay for this bond?
8. If banks hold a 30 percent reserve ratio, an initial increase in deposits of P45 will, if P12 leaks immediately into currency
holdings of the public, eventually lead to increase in deposits of?
9. Assuming a 10% reserve ratio, a P1,000 withdrawal from a checking account, made to pay for the purchase of a
government bond, would result in how much decrease in deposits?
10. If banks hold a 10 percent reserve ratio, and the public splits increases in its money holdings equally between currency and
deposits, then an $80 increase in the money supply must imply that currency in the hands of the public has risen by
________ and that reserves have risen by_________?

III. Essay.
1. There are three main operations of Central Bank. Describe and explain the short run effects of the following activities of the
Central Bank to the economy. Assume that the economy is closed.
a.) The Central Bank decided to increase bank reserves through open-market operations.
b.) The Central Bank decided to temporarily increase the interest rates. How about temporary increase in discount rates? Make
sure to explain the effects of the interest and discount rate policies during its implementation and after its termination.
c.) The Central Bank implemented a permanent decrease in the reserve-ratio requirements on deposits with banks and other
financial institutions.
T of F
1. F – If prices and wages are perfectly flexible, inflation can occur. This can be shown graphically using
the classical model of the macroeconomy with a vertical supply curve. Inflation will occur without any
increase in output.
2.F – Not necessarily because the monetary policy can also negatively affect exports and imports.
3. T
4. T

5. T
6. T
7. T
8. T
9. T
10. T

II. Problem Solving

1. P7,500
2. 1/4
3. 19k
4. 500
5. P5 million

6. P70
7. P1,009
8. P110
9. P10,000
10. P40 and P4 respectively

III. Essay
A. With an open market transactions: Increase reserves -> increase MS -> decrease interest rates ->
increase investments and increase consumption -> AD increase -> GDP increase + inflation.
B. During implementation: Increase interest rate -> decrease investments -> AD decrease -> GDP
decrease + deflation
After implementation: Investments will go back to pre-policy levels (increase investments) -> AD
increase -> GDP increase + inflation but take note that the level of GDP before the policy is implemented
is the same as after its terminations
C. Decrease reserve-ratio requirement -> increase MS -> decrease interest rates -> increase
investments and consumption -> AD increase -> GDP increase + inflations