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Universidad Carlos III de Madrid – Department of Economics

Principles of Economics - Problem Set 10

Conceptual Questions

Write down a short and concise answer. When you are asked to solve the question in class,
explain the concept clearly and give examples or pieces of evidence.

1. What does liquidity mean and why it is important for defining what money is?
The ease at which an asset is converted as medium of exchange. It is
important for the definition of money because, given that money is the a medium of
exchange, it has infinite liquidity

2. What is the mechanism that allows banks to multiply money?

3. The mechanism used by banks to multiply money is called interest rates, which are
supplied to clients in a high rate and demanded in a low rate. Also, banks make
loans. They keep only a fraction of deposits (reserve).

4. What is the money multiplier?

The money multiplier indicates the amount of money generated for each euro the
bank has in reserve. It is a share of the deposits kept as reserve.

5. Why the quantity demanded of money is positively related to the price level?
The higher the price level is, the more money people need to buy the same amount
of goods and services. Hence, ceteris paribus, they want more cash.

6. What does the Quantity Theory say about the causes of inflation?
If the money supply grows more than the value of the production, the value of
money will tend to decrease, and the price level will tend to increase. If there is no
growth in the production of goods, inflation rate will be (more or less) proportional
to the growth rate in the money supply

7. How the central banks can influence the money supply?

Changing the discount rate, through open market operations, or changing the
required reserve-deposit ratio.

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 Problems

1. A central bank conducts a $10 million open-market purchase of government bonds.

a. If the required minimum reserve ratio is 20%, what is the largest possible
increase in the money supply that could result?
10 million * (1/0.2) = 10*5 millions = 50 millions

b. Explain. What is the smallest possible increase? Explain.

Even if the required minimum reserve ratio is 20%, banks can decide to
keep a higher percentage and it can even reach the 100% level. If banks
keep 100% reserves, the increment will only be 10 millions * (1/1) = 10
millions, despite the lower reserve ratio.

2. Suppose that this year’s money supply is $4,000 billion, the

nominal GDP is $20,000 billion, and real GDP is $5,000 billion.
a. What is the price level? What is the velocity of money?
Price level: 20,000 / 5,000 = 4
Velocity: P*Y/M= 4*5,000/4,000= 5

b. Suppose that velocity is constant and the economy’s output of goods

and services rises by 5% this year. What will happen to nominal GDP
and the price level next year if the Central Bank keeps the money
supply constant?
Y is the real GDP and, given that next year it will hold that MV=PY;
4,000*5=P*1.05*5,000, so the price level will be P = 3.809. Therefore, the
nominal GDP = 3.809*(1.05*5,000) =20,000 billion

c. What money supply should the Central Bank set next year if it wants to
keep the price level stable?
Given the equation M=PY/V, if P=4, then M=4*(5,000*1.05)/5 = 4,200.
The money supply should increase to accommodate the growth in the real
GDP

d. What money supply should the central banks set next year if it wants
inflation of 10 percent?
When P=4.4, and M=PY/V, M=4.4*(5,000*1.05)/5 = 4,620. The money
supply should increase more than the price level because there exists a real
GDP growth.

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3. Suppose that changes in bank regulations expand the availability of
credit cards so that people need to hold less cash.
a. How does this event affect the demand for money?
If people need to hold less cash, the demand for money shifts to the left,
because there will be less money demanded at any price level

b. If the Fed does not respond to this event, what will happen to the price
level?
If the Fed does not respond to this event, the shift to the left of the demand
for money combined with no change in the supply of money leads to a
decline in the value of money (1/P), which means the price level rises

c. If the Fed wants to keep the price level stable, what should it do?
If the Fed wants to keep the price level stable, it should reduce the money
supply from S1to S2 in the next Figure. This would cause the supply of
money to shift to the left by the same amount that the demand for money
shifted, resulting in no change in the value of money and the price level.

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 Other questions

1. You take $100 you had kept under your mattress and you decide to deposit them
in your bank account. If this $100 stays in the banking system as reserves and if
banks hold reserves equal to 10 percent of deposits, by how much does the total
amount of deposits in the banking system increase? By how much does the money
supply increase?
Initially, deposits rise in 100, which increases the reserves in the same quantity, 100.
Then, the bank loans out 90 (10% reserve ratio) and 10 are kept as reserves. The 90 are
deposited in other banks that keep 9 as reserves and loan out 81 that are deposited in
other banks and so on… In the limit, there will be a money supply of
100*(1+0.9+0.9^2+0.9^3+…) =100/ (1-0.9). Summarizing, since the multiplier is 3
1/0.1=10, money supply increases in 100*1/0.1=1000. This is the final increase in
deposits. Nevertheless, in this case we are supposing that individuals deposit every loan
that they receive in the bank and do not keep any cash; hence, the increase in deposits
is equal to the increase in the money supply.

2. Which list ranks assets from least to most liquid?

a. currency, demand deposits, money market mutual funds
b. currency, money market mutual funds, demand deposits
c. money market mutual funds, demand deposits, currency
d. demand deposits, money market mutual funds, currency

3. When conducting an open-market operation, if a Central Bank

a. buys government bonds, it increases the money supply.
b. buys government bonds, it decreases the money supply.
c. sells government bonds, it increases the money supply.
d. All of them are false.

4. Under a fractional-reserve banking system, banks

a. hold more reserves than deposits.
b. generally lend out a majority of the funds deposited.
c. cause the money supply to fall by lending out reserves.
d. All of the above are correct.

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5. When the Central Bank decreases the discount rate, commercial banks will
a. borrow more from the Central Bank and lend more to the public. The money
supply increases.
b. borrow more from the Central Bank and lend less to the public. The money
supply decreases.
c. borrow less from the Central Bank and lend more to the public. The money
supply increases.
d. borrow less from the Central Bank and lend less to the public. The money
supply decreases.

6. The economy of Mainland uses gold as its money. If the government discovers a
large reserve of gold on their land
a. the supply of money decreases and the value of money rises.
b. the supply of money increases and the value of money falls.
c. the demand for money increases and the value of money rises.
d. the demand for money decreases and the value of money falls.

7. Suppose the money supply tripled, but at the same time velocity doubled and real
GDP was unchanged. According to the quantity equation the price level
a. is 1.5 times its old value.
b. is 3 times its old value.
c. is 6 times its old value.
d. is the same as its old value.

8. The classical dichotomy argues that changes in the money supply

a. affect both nominal and real variables.
b. affect neither nominal nor real variables.
c. affect nominal variables, but not real variables.
d. do not affect nominal variables, but do affect real variables.