Download ECON 3133-02 Lecture #6: Monetary Policy and Money Supply and more Study notes Economics in PDF only on Docsity! Lecture #6 ECON 3133-02 September 13, 2005 Coverage: Chapter 4 Reading assignment: Chapter 4. Class questions: 1. Suppose the Federal Reserve wishes to increase the money supply. What are three ways in which they could do so? a. The Federal Reserve can change the discount rate, the rate the Federal Reserve charges member banks to borrow from them. To specifically increase the money supply, the Federal will LOWER the discount rate. b. The Federal Reserve can change reserve requirements, where the required reserve ratio is the fraction of each deposit that each member bank is required to keep as reserves in their vaults or on deposit at the Federal Reserve. A DECREASE in required reserve ratio will increase the money supply. c. The Federal Reserve (most likely) could implement open market operations, which is the buying and selling of government bonds on the open market. To increase the money supply the Fed will BUY governments bonds on the open market. 2. Nominal and real GDP. a. Below, provide the definition for real GDP in year t in base year prices using a price index other than the GDP deflator. Yt = $Yt/Pt (note that we implicitly multiply by the price index in the base year, which is one). b. Use your expression in a. to provide an expression for nominal GDP as a function of real GDP and current prices. Recall that nominal GDP is given by $Yt . Thus, we can rearrange the expression above to obtain the following: $Yt = Yt Pt 3. Suppose that real money demand is given by: )25.0( tt d t iY P M −= a. Suppose that real output is equal to $100, the price level is fixed and equal to 1, and the nominal supply of money is equal to $20. What is the equilibrium interest rate? We are given real money demand above. Real money supply is given by: 20$ 1 20$ === P M P M st In equilibrium, demand and supply are equal. Thus, Yt(0.25-it) = $20 Plugging in $100 for real output, and solving for the interest rate yields: $100(.25-it) =$20 .25-it =.20 it=.05 b. Suppose the Federal Reserve targets an interest rate that is two points higher than your answer in a. At what level should they set the nominal money supply assuming the price level is equal to 1? The interest rate above is 5%. Here, the Federal Reserve will target a rate equal to 7% (which is two points higher). If the Federal Reserve is successful in hitting their target, then money demand will be: $100(.25-.07)= $18 The Federal Reserve knows that the real supply of money must equal $18 to increase the interest rate to the desired level. Since the price level is 1, the nominal supply is equal to the real supply of money. Thus, the Federal Reserve decreases the nominal money supply to $18, causing the desired increase in it.
