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Answers to Questions in Textbook

1. Financial markets are exchanges where securities or financial instruments, such as stocks and bonds, are bought and sold. So borrowers obtain funds directly from savers in financial markets. Financial intermediaries are institutions which issue liabilities, such as deposits in a bank, to savers and lend those funds to borrowers. Thus, financial intermediaries indirectly provide the link between savers and borrowers. Financial intermediaries exist for two reasons. For a saver with a small amount of funds, a financial intermediary can spread the risk of lending among a large number of borrowers. As an example, consider a person who has $5,000 in a savings account at a bank which has 10,000 outstanding loans. The person is in essence lending 0.50 to each borrower, thereby considerably reducing the risk of any one borrower defaulting on the loan. Furthermore, it is unlikely that the saver would be able to find 10,000 people needing to borrow 0.50 each, and the cost of negotiating that many loans is likely to outweigh the interest generated by the loans. A second reason why financial intermediaries exist is that they are large enough to hire specialists who can evaluate the risks involved in making loans to individual borrowers, something an individual saver cannot do. For example, a loan officer at a bank is likely to have more information than depositors concerning not only the general business conditions in an area, but also specific information with respect to the ability of a particular borrower to repay a loan. Borrowers in financial markets need to be large enough to either be widely known for repaying loans and/or being able to pay the costs of providing the information that is legally required to sell securities in financial markets. On the other hand, people and businesses who obtain funds from financial intermediaries tend to either be too small to be able to afford to provide the information legally required to use financial markets, or their reputations for repayment may only be known to people at the financial intermediaries. 2. Despository institutions consist of commercial banks and thrift institutions. Commercial banks get their deposits from both households and businesses and make loans to both groups. Thrift institutions obtain funds mainly from the savings accounts of households, although they also obtain funds from deposits into checking accounts. Traditionally, thrift institutions made real estate loans; they continue to do so, but since deregulation, they have broadened their lending activities into other areas. Contractual savings institutions receive retirement savings from people and their employers. The institutions invest these funds in financial markets and use the proceeds to pay out retirement benefits. Investment intermediaries differ in how they obtain funds. Finance companies obtain funds in financial markets, which they lend to households. People saving for retirement are from whom mutual funds obtain funds, which are invested in financial markets. Money market mutual funds get their money from people seeking the relative safety provided by the purchase made by these funds of short-term securities. The main distinction between depository institutions and contractual savings institutions is that depositors in the former do so for broader reasons, whereas users of contractual savings institutions do so in order to provide for retirement. Likewise, depository institutions make a broader variety of loans both in terms of whom they lend to and for how long, whereas contractual savings institutions are interested in investments that will enable them to pay retirement benefits. Finally, while investment intermediaries differ from each other as well as depository and contractual savings institutions, in terms of from whom they obtain funds or to whom they lend funds, they have in common that they either use financial markets to obtain funds, as is the case of finance companies, or they buy assets sold in financial markets, as is the case of both mutual and money market mutual funds.

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3. Money-market instruments, such as large-denomination negotiable certificates of deposit and U.S. Treasury bills, have short maturities, usually less than one year, small fluctuations in price, and minimal risk. Capital-market instruments, such as stocks and corporate and U.S. government bonds, have longer maturities, larger fluctuations in price, and greater risk. 4. The two most important functions of money are as a medium of exchange and as a store of value. Currency and checking accounts serve both functions. A credit card is a medium of exchange but not a store of value, and a passbook savings account is an example of an asset that is a store of value but not a medium of exchange. 5. M1 consists of currency, transactions accounts (demand deposits and other checkable deposits), and travelers checks. M2 is M1 plus savings deposits, time deposits, and money-market mutual funds. The main difference between M1 and M2 is that M1 consists exclusively of those assets that serve as mediums of exchange. Although M2 contains some assets that may serve as mediums of exchange, namely, money-market deposit accounts and money-market mutual funds, it also contains assets that serve solely as stores of value. 6. For each definition of money, the money multiplier is (1 + c)/(e + c). Now, take the case of M1 versus M2. The former does not include savings deposits, time deposits, or money market mutual funds, but the latter does. If individuals with holdings in these types of accounts keep different proportions in cash than other components of M2, then c will change and so may the money multiplier. Alternatively, the institutions involved may hold different reserve ratios for these types of accounts, and again the money multiplier may change. 7. High-powered money consists of those assets that can support a multiplier expansion of money. Bank reserves fit this description, for a bank receiving additional reserves can loan out the new excess part of the reserves, thus beginning the expansion process. Cash held by the public also fits this description, for it has the potential to support an expansion. If the cash were deposited in a bank, it would become new reserves and could support an expansion. 8. The required conditions for money creation are: (1) the equivalence of cash and deposits for purposes of spending, (2) the willingness of people to deposit the funds they receive when the proceeds of a bank loan are spent in an account at the bank that made the loan, (3) the existence of a fractional reserve held by the banks, and (4) the existence of people willing to borrow funds at a cost that covers the expenses of a banker. In the Great Depression, Condition 2 was only marginally met and Condition 4 was in many instances completely absent. Also affecting the operation of the banking system at that time was the fact that banks chose to hold a higher fraction of their deposits in reserves. 9. The Fed purchases $200 million worth of bonds in the open market. If a bank is selling the bonds, this action immediately increases its reserves by $200 million. If a bank in not selling the bonds, it gets involved when whoever is selling them deposits the proceeds of the sale in an account at the bank. At that time, some of the $200 million will be held as reserves to support that new deposit, and the rest of it will be excess. In either case, the amount of high-powered money has increased by $200 million and there will be a multiple expansion of the money supply. 10. In both cases, the limit to the expansion of money or income is determined by the marginal leakages involved. For both types of multipliers, the expansion terminates only when the amount of money leaking out of the system is equal to the initial injection. For both, we find that the real world multipliers are smaller than would be expected by simple formulas because the number and types of leakages are complex. In the case of the money multiplier, for example, we also have to take into account the flow of high-powered money into cash as well as reserves.

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11. a.

The money supply will decline because banks will have fewer reserves to lend. There is no change in H, high-powered money, but an increase in the publics currency holding increases the cash-holding ratio c, which causes the money multiplier M/H to decrease. This occurs because when c rises, a smaller portion of H is in the banking system to be multiplied through the process of bank lending. b. The money supply will rise because the publics cash-holding ratio c will decrease. The money multiplier will rise and, with a given H, so will the money supply. c. Discount loans from the Fed increase H and increase the money supply, ceteris paribus. d. The money supply falls because e, banks reserve-holding ratio, increases. The money multiplier is lowered because of a decrease in banks lending volume.

12. There are three major sources of changes in the money supply. First is the quantity of reserves. The Fed can control these through open-market operations as well as establishing the required reserve ratio (e). It can also affect the amount of reserves through its discounting operations. The other major determinant of the money supply is the cash-holding ratio. One reason that the Fed found it difficult to control the money supply was that people continuously switched their holdings of cash between bank deposits (M1) and near money assets (e.g., M2). Equally important, however, was the unwillingness of the Fed to allow interest rates and nominal income to swing as violently as would have been necessary to meet the money supply growth rate targets. 13. Baumol and Tobin showed that the interest sensitivity of the demand for money is based on a transactions motive shared by almost everyone. This was an improvement over the speculation-based theory suggested by Keynes. Thus, the theoretical underpinnings of the positively sloped LM curve were placed on solid grounds. 14. Tobin and Friedman make the demand for money a function of both income and wealth. They both treat the decision to hold money as part of the portfolio-balance process. The principal difference between them is their identification of alternatives to money. Tobin concentrates on other financial assets, and Friedman suggests that any category of expenditure may be a substitute for money. This distinction underlies their different views of the transmission mechanism by which monetary policy affects spending. Tobin concentrates on interest-sensitive goods, such as investment and consumer durables. Friedman suggests a broader group of goods and services. 15. Disintermediation refers to how ceilings on some interest rates can cause financial intermediaries to lose the funds that they use to lend when other interest rates rise above the interest rate ceilings. By ending interest rate ceilings, deregulation of financial markets eliminated the disintermediation that was an especially severe problem for depository institutions, particularly thrift institutions. Depository institutions were the main source of funding for mortgages. Therefore, once depository institutions were deregulated and disintermediation was no longer a problem, the ability of these institutions to make loans in the face of rising interest rates increased. Therefore, volatility in the housing market declined as a result of deregulation. 16. Since deregulation meant that depository institutions were less subject to disintermediation, residential construction expenditures became less sensitive to a change in the interest rate. This made the IS curve steeper. Financial deregulation also allowed banks to pay interest on some types of checking accounts. That meant the demand for money was also less responsive to a change in the interest rate, resulting in a steeper LM curve.

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A steeper IS curve means that any given shift of the LM curve results in a smaller change in real GDP and a larger change in the interest rate. Likewise, a steeper LM curve means that any given shift of the IS curve results in a smaller change in real GDP and a larger change in the interest rate. The combined effects of steeper IS and LM curves are greater volatility of the interest rate and greater stability in real GDP. Finally, the impact of financial deregulation on the effectiveness of monetary and fiscal policy is ambiguous. As we learned in Chapter 4, a steeper IS curve makes fiscal policy more potent and monetary policy less potent, other things being equal. But we also learned in Chapter 4 that a steeper LM curve makes fiscal policy less potent and monetary policy more potent. Therefore, it is not clear what the combined impact of financial deregulation is on the effectiveness of the monetary and fiscal policy. 17. The money-multiplier shock reduces the growth rate of the money supply. In the short run, this reduces the real money supply and the LM curve shifts to the left, raising the real interest rate and reducing real GDP. The shock also reduces the growth rate of nominal GDP, resulting in a movement down along the SP curve, reflecting decreases in both the output ratio and the inflation rate. In the long run, when expected inflation adjusts downward in response to lower actual inflation, the SP curve shifts downward and the output ratio rises. Meanwhile, the lower inflation rate increases the real money supply and shifts the LM curve to the right, lowering the real interest rate and raising real GDP. During this episode the real GDP, real interest rate, inflation rate, and output ratio have been unstable. 18. The relative advantages and disadvantages of each type of rule depend on the source of economic fluctuations. A fixed money supply target prescribed by a money supply rule, compared with an interest rate target, diminishes the fluctuations in real output that occur when changes in business and consumer optimism, net exports, and government spending beset the economy with unstable commodity demand. In this instance, the money supply target is preferable to the interest rate target but not as desirable as a real GDP target. The disadvantage of a real GDP target is that it is likely to produce more inflation than a money supply target when real GDP fluctuations are caused by supply shocks. The interest rate target is most advantageous when unstable money demand causes the LM curve to shift unpredictably, in which case adherence to a fixed money supply target would produce larger rather than smaller fluctuations in real output. 19. For the Fed to be able to target real GDP when there is instability in commodity demand, it must change the interest rate in response to fluctuations in commodity demand. Therefore, the Fed must decrease the money supply in order to increase the interest rate when commodity demand rises, and it must increase the money supply in order to lower the interest rate when commodity demand decreases. Therefore, the Fed must sell bonds in open market operations when commodity demand increases, and it must buy bonds when commodity demand decreases. For the Fed to target real GDP when there is instability in the demand for money, it must stabilize the interest rate. Therefore, the Fed must increase the money supply when the demand for money rises, and it must decrease the money supply when the demand for money drops. Therefore, the Fed must buy bonds in open market operations when the demand for money increases, and it must sell bonds when the demand for money decreases. 20. There are a number of reasons why American households have moved away from the use of cash and checks to credit and debit cards. First, many more retail stores now accept them, such as grocery stores. Second, the use of debit cards means having to go to the bank less often to get cash. Third, shopping on the Internet or from mail order firms almost always requires the use of a credit card. Fourth, paying bills with a credit card as opposed to a check means not only saving postage, but also fewer trips to the post office to buy stamps. Fifth, some credit card purchases allows one to obtain frequent flier miles even if one isnt buying an airline ticket.

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The use of debit cards instead of checks or cash leaves the demand for money unchanged. A person is simply altering the method by which money, as opposed to income, is spent. On the other hand, using credit cards instead of cash or checks can reduce the demand for money, as the following extreme example illustrates. Persons A and B each spend $2,100 per month. Person A deposits the $2,100 into her account on the first of the month and spends an equal amount every day, writing checks to pay for everything. Person A has, on average, $1,050 in her account. Person B buys everything using her credit card, and has $2,100 in her checking account only on the day that the credit card company automatically redraws the $2,100 for payment of her credit card bill. The other 29 days of the month she has the funds in an investment paying a higher rate of interest than the checking account. On average, person B has $2,100/30 or $70 in her account. Person B, who uses only a credit card, has a much lower demand for money than person A, who uses only checks.

Answers to Problems in Textbook

1. M1 consists of currency, demand deposits, other checkable deposits, and travelers checks. Therefore, M1 equals $758.2 + 303.0 + 301.2 + 6.5 = $1,368.9 billion. M2 consists of everything in M1, plus money market mutual funds, savings deposits, and small-denomination time deposits. Therefore, M2 equals $1,368.9 + 885.3 + 3,838.2 + 1,177.0 = $7,269.4 billion. Since the amount of the money supply equals the money multiplier times the amount of highpowered money, the amount of high-powered money equals the amount of the money supply divided by the money multiplier. The money multiplier equals (1 + c)/(e + c), where c is the fraction of deposits that people want to hold in cash, and e is the fraction of deposits that banks hold in the form of reserves. Therefore, the money multiplier equals (1 + 0.08)/(0.07 + 0.08) = 1.08/15 = 7.2. Therefore, the amount of high-powered money necessary for the Fed to have a money supply equal to $6,228 billion equals $6,228/7.2 = $865 billion. The money multiplier equals (1 + c)/(e + c), where c is the fraction of deposits that people want to hold in cash, and e is the fraction of deposits that banks hold in the form of reserves. Therefore, the money multiplier equals (1 + 0.1)/(0.15 + 0.1) = 1.1/0.25 = 4.4. b. The amount of the money supply equals the money multiplier times the amount of high-powered money. Therefore, the money supply equals 4.4($1,500) = $6,600 billion. c. The money supply increases because the amount of high-powered money increases when the Fed buys bonds. The amount of the increase equals 4.4($30) = $132 billion. If banks borrow fewer reserves from the Fed, the money supply decreases due to a decline in the amount of highpowered money. The amount of the decrease in the money supply equals 4.4($6) = $26.4 billion. d. The money supply must decrease by $6,660 $6,424 = $176 billion. In order to decrease the money supply, the Fed needs to reduce the amount of high-powered money, which it can do by selling bonds. It needs to sell $176/4.4 = $40 billion in bonds. a. Your average demand for money will be C/2, where C = [(2)(2)(2400)/0.05] = $438, and thus your average money holding is $219. b. If the interest rate rises to 10 percent, your average money holding will decline to $310/2 = $155. This change is consistent with expectations, as people are expected to hold less money as the interest rate rises, ceteris paribus. a.

2.

3.

4.

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5.

To find each of the points on the IS curve, substitute the value of the interest rate into the equation for the IS curve. The points are: (11,750, 3); (11,500, 4); (11,250, 5); (11,000, 6); and (10,750, 7). To find each of the points on the LM curve, substitute the value of the interest rate into the equation for the LM curve. The points are: (10,750, 3); (11,000, 4); (11,250, 5); (11,500, 6); and (11,750, 7). b. The equilibrium level of income and the equilibrium interest rate are where both the commodity and money markets are in equilibrium, which occurs at the intersection of the IS and LM curves. At that point, income equals 11,250 and the interest rate equals 5. c. The fall in housing prices would cause household wealth to drop, resulting in a decline in consumption expenditures and therefore, a fall in autonomous planned spending. A decline in the value of the dollar would result in a rise in exports and a fall in imports, resulting in increases in net exports and therefore, autonomous planned spending. d. If autonomous planned spending drops by 200 billion, then the new equation for the IS curve is Y = 2.5(4,800) 250r or Y = 12,000 250r. The points on the IS curve IS are: (11,250, 3); (11,000, 4); (10,750, 5); (10,500, 6); and (10,250, 7). a. If autonomous planned spending increases by 200 billion, then the new equation for the IS curve is Y = 2.5(5,200) 250r or Y = 13,000 250r. The points on the IS curve IS are: (12,250, 3); (12,000, 4); (11,750, 5); (11,500, 6); and (11,250, 7). e. Monetary policymakers maintain the interest rate at 5 percent under the first option. Therefore, real GDP varies between 10,750 and 11,750 as autonomous planned spending varies between 4,800 and 5,200, respectively. Under the second monetary policy option, both the interest rate and real GDP rise and fall as autonomous planned spending increases and decreases, respectively. Graphically, the increases and decreases in real GDP and the interest rate are shown by movements up and down the LM curve as the IS curve shifts due to changes in planned expenditures. The LM curve does not change because monetary policymakers do not change the real money supply when autonomous planned expenditures change. The fluctuations in real GDP range between 11,000, where the IS curve IS intersects the LM curve, and 11,500, where the IS curve IS intersects the LM curve. The fluctuations in the interest rate range between 4, where the IS curve IS intersects the LM curve, and 6, where the IS curve IS intersects the LM curve. Monetary policymakers increase and decrease the real money supply in order to lower or raise the interest rate so as to maintain real GDP equal to 11,250, natural real GDP, when autonomous planned spending falls and rises, respectively, under the third policy option. Therefore, the interest rate varies between 3 and 7 as autonomous planned spending fluctuates between 4,800 and 5,200, respectively. f. The first policy is the least desirable because it results in the largest fluctuations in real GDP. Therefore, if monetary policymakers try to maintain a fixed interest rate, unemployment would rise the most when autonomous planned spending falls, and inflation would also rise the most when autonomous planned spending increases. The third policy option is the most desirable since by maintaining output equal to natural real GDP, neither unemployment nor inflation change as autonomous planned spending fluctuates. g. A decline in autonomous planned spending would put downward pressure on the interest rate as the fall in income would reduce the demand for money. Therefore, to maintain the interest rate at its current level, monetary policymakers would have to sell Treasury bills in open market operations in order to reduce the real money supply. An increase in autonomous planned spending would put upward pressure on the interest rate as the rise in income would cause an increase in the demand for money. Therefore, to maintain the interest rate at its current level, monetary policymakers would have to buy Treasury bills in open market operations in order to increase the real money supply.

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Under the second option, monetary policymakers would only have to engage in open market operations as needed to maintain the real money supply at its current level. The third option requires monetary policymakers to increase the real money supply when autonomous planned spending decreases in order to reduce the interest rate and stimulate planned spending in an effort to keep output equal to natural real GDP. Therefore, monetary policymakers must buy Treasury bills in open market operations when autonomous planned spending declines. The third option also requires monetary policymakers to decrease the real money supply when autonomous planned spending increases in order to increase the interest rate and reduce planned spending in an effort to keep output equal to natural real GDP. Therefore, monetary policymakers must sell Treasury bills in open market operations when autonomous planned spending rises. 6. a. Given that (M/P)d = .25Y 50r, then at Y =10,000 and r = 0, the demand for money equals .25(10,000) 50(0) = 2,500, which is the amount of the real money supply. At Y =10,400 and r = 2, the demand for money equals .25(10,400) 50(2) = 2,600 100 = 2,500, which is the amount of the real money supply. The same calculations reveal that the demand for money and the real supply of money are equal at the other two points listed as being on the LM curve LMA. Given that (M/P)d = .2Y 40r, then at Y =12,500 and r = 0, the demand for money equals .2(12,500) 40(0) = 2,500, which is the amount of the real money supply. At Y =12,900 and r = 2, the demand for money equals .2(12,900) 40(2) = 2,580 80 = 2,500, which is the amount of the real money supply. The same calculations reveal that the demand for money and the real supply of money are equal at the other two points listed as being on the LM curve LMB. The equilibrium level of income and the equilibrium interest rate are where both the commodity and money markets are in equilibrium, which occurs at the intersection of the IS and LM curves. Given that (M/P)d = .25Y 50r, the IS curve intersects the LM curve LMA at Y = 11,400 and r = 7. At that point, income equals 11,250 and the interest rate equals 5. Given that (M/P)d = .2Y 40r, the IS curve intersects the LM curve LMB at Y = 12,900 and r = 2. When the demand for money is (M/P)d = .25Y 50r, equilibrium income is 11,400, which is less than natural real GDP, 12,000. Therefore, unemployment is too high. When the demand for money is (M/P)d = .2Y 40r, equilibrium income is 12,900, which exceeds natural real GDP, 12,000. Therefore, the inflation rate not only rises, but since real GDP is greater than natural real GDP, inflation is higher than expected, which as shown in Chapter 8, would cause a further rise in inflation, all other things being equal. To find the interest rate that monetary policymakers must target, set natural real GDP equal to the equation of the IS curve to get 12,000 = 13,500 300r. Adding 300r to and subtracting 12,000 from both sides yields 300r = 1,500. Dividing both sides by 300 yields that 5 is the interest rate that monetary policymakers must target in order to keep real GDP equal to natural real GDP. To find what monetary policymakers must set the real money supply equal to in order to reach its interest rate target, given the demand for money is .25Y 50r, compute the demand for money at Y = 12,000 and r = 5. The demand for money equals .25(12,000) 50(5) = 3,000 250 = 2,750. Therefore, in order to reach its target, monetary policymakers must set the real money supply equal to 2,750, given the demand for money is .25Y 50r. To find what monetary policymakers must set the money supply equal to in order to reach its target, given the demand for money is .2Y 40r, compute the demand for money at Y = 12,000 and r = 5. The demand for money equals .2(12,000) 40(5) = 2,400 200 = 2,200. Therefore, in order to reach its target, monetary policymakers must set the real money supply equal to 2,200, given the demand for money is .2Y 40r.

b.

c.

d.

e.