Problem SetJan 14

Question 1

Money Definition (3 Pts) – a current medium of exchange that is accepted for payment for a good/serviceExample (2pts) – Federal Reserve Notes

(dollars, coins)

Bond (3pts)– a certificate issued by a government or a public company promising to repay borrowed money at a fixed rate of interest at a specified time.Example (2pts) – Federal bond

Question 1 Stock (3pts) – private ownership in

a company or business.Example (2pts) – Share of Apple

or Starbucks

B. Time Value of MoneyPresent Value (3pts) – less than or

equal to future value, amount of money Some example (2pts) using the

formula $ / (1+r) ^ years

Future value (3pts) – value or worth of a sum of money in the future that assumes an interest rateExample (2pts) using the above

formula or a calculation of a money plus an interest rate.

C. Measures of Money SupplyTotal amount of money assets in the

economy at a certain time

M1 – highest liquidity – in current circulation - ex. Coins, dollars, checkable deposits

M2 – medium liquidity – ex. bank reserves

M3 – lowest liquidity – M2 plus long term deposits ex. Deposit of $1 million dollars

D. How banks create moneyBanks create money through loans

(3pts)

Reserve Ratio (2pts) 1/r

E. Money DemandDefinition: At any given time,

people demand a certain amount of money for every day purchases.

Inverse relationship between nominal interest rates and the amount of money demanded

Graph on board

Money MarketDefinition: Money is a commodity

(something to be bought and sold). Money market is short term part of the financial market including the lending, borrowing, buying and selling of financial assets.

Example – deposit, treasury notes

Graph on board

Loanable funds marketDefinition: Amount of money from

banks and lending institutions available for firms and households to finance expenditures (investment, consumption)

Graph on board

#2 – Tools of Central BankOpen Market Operations – activity by the

central bank to buy or sell bonds on the open market

Discount Rate – minimum interest rate set by the Fed Reserve for lending to other banks

Reserve Requirement – central bank regulation that sets minimum fraction banks must keep in their reserves from deposits

3 pts for definition

2pts for each example

B. Quantity Theory of MoneyDefinition: Money supply has a direct

relationship with price level

Money * Transaction Velocity = Price * Monetary value of output

M * V = P * Y

3pts for definition

2pts for just writing or explaining the equation (numerical example not needed)

Real V. Nominal Interest Rates

Real – percentage increase of purchasing power the borrower pays(adjusted for inflation) Real = nominal – expected inflation

Nominal – percentage increase in the money supply the borrower pays (not adjusted for inflation)Nominal = real interest rate + expected inflation

3pts for definition

2pts for an example

FRQ 1

A. Draw correctly labeled AD/AS graph showing the economy operating below full employment (2pts)

B. Fed should purchase bonds (increases money supply) Correctly labeled money market graph (1pt)

C. Rightward shift of the money supply curve, and lowering of interest rates (1pt)

FRQ 1D. Decrease Interest rates interest

sensitive expenditures to decrease. (1pt)

E. AD would increase increase in output and PL. (1pt)

F. If no action was taken, wages and other production costs would eventually fall, AS would shift to the right, PL would fall and output would rise (1pt)

FRQ #3 – 8pts – 2pts eachA. Reserve ratio = 100% = $5000 increase

in the money supply, because gov purchased that much In bonds

B. .9 * $5000 = $4500Money supply multiplier = 10, max increase =

$5,000 *10 = $50,000

C. Increase would be > $50,000. Can’t lend out full amount in reserve

D. > $50,000. Banks will not get the maximum amount. More cash held in the hands of the public reduces bank deposits, so there is less money in the reserves.