Macroeconomics Canada in the Global Environment Canadian 9th Edition Parkin Solutions Manual

Macroeconomics Canada in the Global Environment

Canadian 9th Edition Parkin Solutions Manual

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 MONEY, THE PRICE
C h a p t e r
24 LEVEL, AND
INFLATION

Answers to the Review Quizzes

Page 566
1. What makes something money? What functions does money perform? Why do
you think packs of chewing gum don’t serve as money?
Money is any commodity or token that is generally acceptable as a means of payment.
Money has three functions: medium of exchange (generally accepted in exchange for goods
and services), unit of account (an agreed measure for stating the prices of goods and
services), and store of value (money can be held and exchanged for goods and services
later). Packs of chewing gum do not function as money because they are not particularly
good as a store of value—gum deteriorates. Additionally, packs of gum are not generally
accepted in exchange for goods and services, so packs of gum are not a medium of
exchange.
2. What are the problems that arise when a commodity is used as money?
Commodities are not used as money because of several problems. Some commodities are
bulky. Some commodities change in value over time. Using a commodity that changes in
value would be awkward. Prices would change simply because the commodity’s value
changed. Additionally, using a commodity as money has a higher opportunity cost than using
currency and bank deposits because the commodity has an alternative use that must be
foregone.
3. What are the main components of money in Canada today?
The main components of money in Canada today are currency and deposits at banks and
other depository institutions.
4. What are the official measures of money? Are all the measures really money?
The official measures of money are M1 (the sum of currency outside banks, personal
chequable deposits, and non-personal chequable deposits) and M2 (the sum of M1, personal
non-chequable deposits, non-personal non-chequable deposits, and fixed term deposits). All
of the components of M1 are truly money because all the components serve as a means of
payment. Some of the components of M2 are not a means of payment so they are not
money. They are liquid assets. Because these deposits can be quickly and easily converted
into a means of payment—they are counted as money.
5. Why are cheques and credit cards not money?
Cheques and credit cards are not money because they are not a means of payment. A
cheque is an order to transfer a deposit from one person to another. The deposits are money
but the cheques are not. A credit card is an ID card that allows a person to take out a loan at
the instant he or she buys something. The loan still must be repaid with money so the credit
card is not a means of payment, that is, it is not money.

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330 CHAPTER 24

Page 570
1. What are depository institutions?
A depository institution is a financial firm that takes deposits from households and firms.
2. What are the functions of depository institutions?
Depository institutions create liquidity, pool risk, lower the cost of borrowing, and lower the
cost of monitoring borrowers.
3. How do depository institutions balance risk and return?
Banks earn a higher return by using the funds they acquire from their deposits to buy higher-
yielding, riskier assets such as loans. But these assets are risky. If the loans fail, then the
bank might not have sufficient funds to repay their depositors. If the bank undertakes too
much risk, then its depositors might rush to withdraw their deposits, which would cause the
bank to fail. But if the bank forgoes all risky assets its profit will be much lower. So the bank
must balance its search for higher return against the risk that earning the return entails.
4. How do depository institutions create liquidity, pool risks, and lower the cost of
borrowing?
Liquidity is the property of being easily convertible into a means of payment without loss in
value. Depository institutions create liquidity by borrowing short and lending long—taking
deposits and standing ready to repay them on short notice or on demand and making loan
commitments that run for terms of many years.
Depository institutions pool risk because they use funds obtained from many depositors to
make loans to many borrowers. As a result, if a borrower defaults, no one depositor bears
the entire loss because the loss is spread over all depositors.
Depository institutions lower the cost of borrowing because they specialize in borrowing. A
firm that wants to borrow a large sum of money need only visit one depository institution to
arrange such a loan. In the absence of depository institutions, the firm would need to
undertake many transactions with many lenders, which would be a costly process.
5. How have depository institutions made innovations that have influenced the
composition of money?
Financial innovation has brought large changes in the composition of money. Since 1989,
and expressed as percentage of M2, chequable deposits have shrunk from 48 percent to 14
percent. Non-chequable deposits have increased from 22 percent to 32 percent, and fixed
term deposits have expanded from 25 percent to 50 percent. The use of currency has
decreased from 5 percent to 4 percent.

Page 574
1. What is the central bank in Canada and what functions does it perform?
The Bank of Canada is Canada’s central bank, a public authority that supervises other banks
and financial institutions, financial markets, and the payments system, and conducts
monetary policy. The Bank of Canada is the banker to banks and government, the lender of
last resort, and the sole issuer of bank notes.
2. What is the monetary base and how does it relate to the Bank of Canada’s
balance sheet?
The monetary base is the sum of Bank of Canada notes, coins, and depository institution
deposits at the Bank of Canada. The Bank of Canada’s liabilities together with coins issued
by the Royal Canadian Mint make up the monetary base.
3. What are the Bank of Canada’s two main policy tools?
The Bank of Canada’s two main policy tools are the open market operation and bank rate.

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 MONEY, THE PRICE LEVEL, AND INFLATION 331

4. How does an open market operation change the monetary base?

The monetary base is the sum of Bank of Canada notes, coins, and depository institution
deposits at the Bank of Canada. Depository institution deposits at the Bank of Canada are
bank reserves. When the Bank of Canada conducts an open market operation, it buys
securities and pays for them with newly created reserves or it sells securities and is paid with
reserves held by banks. In both cases the monetary base changes.

Page 576
1. How do banks create money?
Banks create money by creating deposits. And banks create deposits by making loans
because part or all of the loans they make will be deposited in another bank. Consider a
student who takes out a loan and purchase books at the university bookstore. The bookstore
deposits the proceeds into its bank in its chequing account. The loan has created new
deposits at the bookstore’s bank.
2. What limits the quantity of money that the banking system can create?
The quantity of money that the banking system can create is limited by the monetary base,
desired reserves, and desired currency holding.
3. A bank manager tells you that she doesn’t create money. She just lends the
money that people deposit. Explain why she’s wrong.
When the bank manager makes a loan, the recipient of the funds makes a deposit in a bank.
This deposit is money that was created by the loan. So the bank manager does create money.
Page 581
1. What are the main influences on the quantity of real money that people and
businesses plan to hold?
The quantity of real money demanded depends on the nominal interest rate, real GDP, and
financial innovation. An increase in the nominal interest rate decreases the quantity of real
money demanded because the nominal interest rate is the opportunity cost of holding money.
An increase in real GDP increases the
demand for real money. And, financial
innovations that make it less costly to get
by with less money on hand decrease the
demand for money. An increase in the
price level increases the nominal demand
for money but the quantity of real money
demanded is independent of the price
level.
2. Show the effects of a change in the
nominal interest rate and a change in
real GDP using the demand for money
curve.
A decrease in the nominal interest rate
increases the quantity of real money
demanded. Figure 24.1 shows that a
decrease in the nominal interest rate
results in a movement downward along the
demand for money curve.
A change in real GDP changes the

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332 CHAPTER 24

demand for money. An increase in real

GDP increases the demand for money
and shifts the demand curve for real
money rightward from MD0 to MD1, as
shown in Figure 24.2.
3. How is money market equilibrium
determined in the short run?
In the short run, the nominal interest rate
adjusts to restore equilibrium to the
money market. When the quantity of
money demanded equals the quantity
supplied, the nominal interest rate is at its
equilibrium level.
4. How does a change in the supply of
money change the interest rate in the
short run?
In the short run an increase in the supply
of money lowers the interest rate and a
decrease in the supply of money raises
the interest rate. Suppose the Bank of Canada decreases the supply of money. People find
themselves holding less money than the quantity demanded. They now enter the loanable
funds market to sell bonds. The decrease in the demand for bonds lowers their price and
raises the interest rate.
5. How does a change in the supply of money change the interest rate in the long
run?
In the long run, the economy is at full employment, and a change in the supply of money
does not change the interest rate. Suppose the Bank of Canada increases the supply of
money. In the short run the nominal interest rate and the real interest rate fall. People want to
borrow and spend more. The demand for goods increases but the increase in demand for
goods cannot be met by an increase in supply because the economy is already at full
employment. So there is a general shortage of all kinds of goods and services. The shortage
of goods and services forces the price level to rise. As the price level rises, the real supply of
money decreases. The nominal interest rate and the real interest rate rise. As the interest
rate rises, spending plans are cut back, and eventually the original full-employment
equilibrium is restored. At this new long-run equilibrium, the price level has risen but nothing
real has changed.

Page 583
1. What is the quantity theory of money?
The quantity theory of money is the proposition that, in the long run, an increase in the
quantity of money creates an equal percentage increase in the price level.
2. How is the velocity of circulation calculated?
The velocity of circulation is the average number of times a dollar of money is used annually
to buy the goods and services that make up GDP. The velocity of circulation equals nominal
GDP divided by the quantity of money.

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 MONEY, THE PRICE LEVEL, AND INFLATION 333

3. What is the equation of exchange?

The equation of exchange is given by the formula MV = PY, where M is the quantity of
money, V is the velocity of circulation, P is the price level, and Y is real GDP. The equation of
exchange is always true by definition.
4. Does the quantity theory correctly predict the effects of money growth on
inflation?
The long-run historical and international evidence on the relationship between money growth
and the inflation rate support the quantity theory. The data suggest a marked tendency for
countries with high money growth rates to have high inflation rates.

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334 CHAPTER 24

Answers to the Study Plan Problems and Applications

1. Money in the Canada today includes which of the following items?
 Cash in CIBC’s cash machines
Money includes currency outside the banks. Currency inside cash machines is not money.
 Bank of Canada dollar bills in your wallet
The dollar bills inside your wallet are money.
 Your Visa card
Your Visa card is not money.
 Your loan to pay for school fees
The loan is not money.
2. In July 2011, currency held by individuals and businesses was $57 billion;
chequable deposits owned by individuals and businesses were $211 billion; non-
chequable person deposits were $163 billion; non-chequable business deposits
were $29 billion; and fixed term deposits were $303 billion. Calculate M1 and M2
in July 2011.
M1 consists of currency held by individuals and businesses plus chequable deposits owned
by individuals and businesses. In July 2011 M1 is $57 billion + $211 billion, which is $268
billion.
M2 consists of M1 plus all other deposits. In July 2011 M2 is $268 billion + $163 billion + $29
billion + $303 billion, which is $763 billion.
3. Europe’s Banks Must Be Forced to Recapitalize
E.U. banks must hold more capital. Where private funding is not forthcoming,
recapitalization must be imposed by E.U. governments.
Source: Financial Times, November 24, 2011
What is the “capital” referred to in the news clip? How might the requirement to
hold more capital make banks safer?
The “capital” means owners’ capital; that is, funds the owners have invested in the bank.
When loans or other assets go bad, the bank incurs a loss and the bank’s capital decreases.
If enough losses are incurred, the bank’s capital might be totally eliminated, in which case the
bank fails because the bank has no further cushion to absorb more losses. The requirement
to hold more capital makes the possibility of failure less likely.
4. The Bank of Canada sells $20 million of securities to the Bank of Nova Scotia.
Enter the transactions that take place to show the changes in the following
balance sheets.
The first balance sheet to the right Bank of Canada
shows the balance sheet of the Bank of
Assets Liabilities
Canada. The Bank of Canada’s assets
(millions) (millions)
decrease by $20 million because the
Bank of Canada now has $20 million Securities Bank of Nova Scotia’s
fewer securities. The Bank of Canada’s $20 reserve deposit $20
liabilities also decrease by $20 million
because the Bank of Nova Scotia pays for its purchase using the reserves that it has on
deposit at the Bank of Canada.

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 MONEY, THE PRICE LEVEL, AND INFLATION 335

The second balance sheet to the right shows the

Bank of Nova Scotia
balance sheet of the Bank of Nova Scotia. The
Bank of Nova Scotia gains assets in the form of Assets Liabilities
securities of $20 million. Simultaneously it also (millions) (millions)
decreases its reserve deposit of $20 million Securities
because it pays for the government securities +$20
using its reserve deposits at the Bank of Reserve deposit
Canada. $20

5. In the economy of Nocoin, bank deposits are $300 billion, bank reserves are $15
billion of which two thirds are deposits with the central bank. Households and
firms hold $30 billion in bank notes. There are no coins. Calculate
a. The monetary base and the quantity of money.
The monetary base is $45 billion. The monetary base is the sum of notes, coins, and
depository institution deposits at the central bank. There are $30 billion in notes held by
households and firms, banks’ deposits at the central bank are $10 billion (2/3 of $15 billion),
the banks hold other reserves of $5 billion (which are notes), and there are no coins. The
monetary base is $45 billion.
The quantity of money is $330 billion. In Nocoin, deposits are $300 billion and currency is
$30 billion, so the quantity of money is $330 billion.
b. The banks’ desired reserve ratio and the currency drain ratio (as percentages).
The banks’ desired reserve ratio is 5 percent. The banks’ desired reserve ratio is the ratio of
reserves to deposits that the banks plan to hold. In Nocoin, deposits are $300 billion and
reserves are $15 billion, so the desired reserve ratio equals ($15 billion ÷ $300 billion)  100,
which is 5 percent.
The currency drain is 10 percent. The currency drain is the ratio of currency to deposits. In
Nocoin, currency is $30 billion and deposits are $300 billion, so the currency drain equals
($30 billion ÷ $300 billion)  100, which is 10 percent.
6. China Cuts Banks’ Reserve Ratios
The People’s Bank of China announces it will cut the required reserve ratio.
Source: Financial Times, February 19, 2012
Explain how lowering the required reserve ratio will impact banks’ money creation
process.
Lowering the required reserve ratio decreases banks’ desired reserves. When banks’ desired
reserves decrease they will make more loans so the quantity of money in China increases.

7. The spreadsheet provides data about the demand for money in Minland. Columns
A and B show the demand for money
A B C
schedule when real GDP (Y0) is $10 billion and 1 r
Columns A and C show the demand for money Y 0 Y 1

schedule when real GDP (Y1) is $20 billion. 2 7 1.0 1.5

3 6 1.5 2.0
The quantity of money is $3 billion. What is
4 5 2.0 2.5
the interest rate when real GDP is $10 billion?
5 4 2.5 3.0
Explain what happens in the money market in
6 3 3.0 3.5
the short run if real GDP increases to $20
7 2 3.5 4.0
billion. 8 1 4.0 4.5
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336 CHAPTER 24

When real GDP is $10 billion, the equilibrium nominal interest rate is 3 percent because that
is the interest rate at which the quantity of money demanded equals $3 billion. If real GDP
increases to $20, the quantity of money demanded then exceeds the quantity supplied.
People want to hold more money than is available. They try to increase the amount of money
held by selling bonds. The price of a bond falls, and the interest rate rises to its new
equilibrium of 4 percent.
8. In year 1, the economy is at full employment and real GDP is $400 million, the
GDP deflator is 200 (the price level is 2), and the velocity of circulation is 20. In
year 2, the quantity of money increases by 20 percent. If the quantity theory of
money holds, calculate the quantity of money, the GDP deflator, real GDP, and the
velocity of circulation in year 2.
The quantity of money in year 1 is $40 million. The equation of exchange is MV = PY, so M =
PY/V. With P = 2.0, Y = $400 million, and V = 20, M = $40 million. In year 2 the quantity of
money is $48 million because money grows by 20 percent, which is $8 million. The GDP
deflator is 240. Because the quantity theory of money holds and because the factors that
influence real GDP have not changed, the GDP deflator rises by the same percentage as the
increase in the quantity of money, which is 20 percent. Real GDP is $400 million because it
remains equal to potential GDP (the quantity of GDP produced at full employment). The
velocity of circulation is 20. Because the factors that influence velocity have not changed,
velocity is unchanged.
9. In Problem 5, the banks have no excess reserves. Suppose that the central bank
of Nocoin increases bank reserves by $0.5 billion.
a. Explain what happens to the quantity of money and why the change in the
quantity of money is not equal to the change in the monetary base.
The quantity of money increases by $3.67 billion. The quantity of money increases by the
change in the monetary base multiplied by the money multiplier. The money multiplier is 7.33
(see part b), so when the monetary base increases by $0.5 billion, the quantity of money
increases by $3.67 billion.
The change in the quantity of money is not equal to the change in the monetary base
because of the multiplier effect. The open market operation increases bank reserves and
creates excess reserves, which banks use to make new loans. New loans are used to make
payments and some of these loans are placed on deposit in banks. The increase in bank
deposits increases banks’ reserves and increases desired reserves. But the banks now have
excess reserves which they loan out and the process repeats until excess reserves have
been eliminated.
b. Calculate the money multiplier.
The money multiplier is 7.33. The money multiplier is equal to (1 + C/D) ÷ (R/D + C/D), where
C/D is the currency drain ratio and R/D is the banks’ reserve ratio. From the problem, C/D =
0.1 and R/D = 0.05, so the money multiplier equals (1 + 0.1) ÷ (0.1 + 0.05), which equals
7.33.

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 MONEY, THE PRICE LEVEL, AND INFLATION 337

Answers to Additional Problems and Applications

10. Sara withdraws $1,000 from her savings account at the TD Bank, keeps $50 in
cash, and deposits the balance in her chequable account at the TD Bank. What is
the immediate change in M1 and M2?
M1 increases by $1,000; M2 does not change. M1 is the sum of currency held by individuals
and businesses and chequable deposits owned by individuals and businesses. M2 consists
of M1 plus all other deposits—non-chequable deposits and fixed term deposits—held by
individuals and businesses. The withdrawal of $1,000 from a savings account leaves M2
unchanged because the $1,000 goes into M1 types of money, which is part of M2. The $50
held as cash and the $950 held in a chequable account increase M1 by $1,000.
11. Rapid inflation in Brazil in the early 1990s caused the cruzeiro to lose its ability to
function as money. Which of the following commodities would most likely have
taken the place of the cruzeiro in the Brazilian economy? Explain why.
a. Tractor parts
It is unlikely that tractor parts would be used as money because tractor parts are heavy and
unwieldy to carry around for use as a medium of exchange.
b. Packs of cigarettes
Packs of cigarettes would likely be used as a substitute for money because they are light to
carry around, are durable, and can be easily divided into fractions of packs for making
change.
c. Loaves of bread
Loaves of bread would be unlikely to be used as a substitute for money because they would
spoil too rapidly.
d. Impressionist paintings
Impressionist paintings would be unlikely to be used as a substitute for money because they
would be unwieldy to carry around and because their quality and value differs dramatically
from one artist to another.
e. Baseball trading cards
Baseball cards would be unlikely to be used as a substitute for money because most
Brazilians are unfamiliar with baseball (and unlikely to value the cards) and because the
cards are not very durable.
12. Are You Ready to Pay by Smartphone?
Starbucks customers can now pay for their coffee using their smartphone. Does
this mean the move to electronic payments is finally coming?
Source: The Wall Street Journal, January 20, 2011
If people can use their smartphones to make payments, will currency disappear?
How will the components of M1 change?
People will probably carry less currency because the smartphone will substitute for currency,
but currency won’t disappear because currency is still used in some parts of the economy,
such as in the underground economy. As a component of M1, currency will be smaller and
most of M1 will be chequable deposits.

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338 CHAPTER 24

Use the following news clip to work Problems 13 and 14.

Investment in the Future
The RBC says lines of credit for education are popular and the size of loans to students
has been going up as tuition costs have increased. Compared to “good debt” like a
mortgage, student loan rates are higher, because the debt is riskier. Financial
institutions know that students need help and have created financial-management Web
sites and other educational material to help students.
Source: Winnipeg Free Press, September 17, 2011
13. Explain how this news clip illustrates the attempts by banks to maximize profits.
Why are interest rates on student loans higher than those on mortgages?
Bank reserves pay low or zero interest. To maximize profit, a bank wants to hold higher-interest
bearing loans. So to maximize profit a bank will want to minimize the reserves that it holds. And
it does this by increasing the number of loans. So by making loans to students and charging a
higher interest rate, banks are maximizing their profit. But banks always face the risk of their
loan customers defaulting. By creating financial-management Web sites and other educational
material to help students, default risk decreases, and bank profit is maximized.
A student loan is a riskier loan than a mortgage for a bank to hold. If a mortgage holder
defaults, the bank takes possession of the house, which it can sell and recoup its losses. But if
a student defaults on a loan, there is no tangible asset for the bank to repossess.
14. Why would banks create Web sites to educate students about financial
management?
Banks, like all firms, have one goal, and that is to maximize profit. So banks create Web sites
to educate students about financial management as a means to maximizing profit.
15. How does financial regulation in Canada help minimize the cost of bank failure?
Does it bring more stability to the banking system?
Financial regulation in Canada brings more stability to the banking system. The Office of the
Superintendent of Financial Institutions supervises the banks and other depository institutions
and ensures that their balance sheets have a high enough capital ratio and their assets are
sufficiently liquid to withstand stress. The Canada Deposit Insurance Corporation operates a
system of deposit insurance that insures deposits held at Canadian banks up to $100,000 in
case of a bank failure. And the Bank of Canada ensures that the banks and other depository
institutions have adequate liquidity.
16. Explain the distinction between a central bank and a chartered bank.
A central bank is a public authority that supervises other banks and financial institutions,
financial markets, and the payments system, and conducts monetary policy.
A chartered bank is a private firm, chartered under the Bank Act of 1992 to receive deposits
and make loans.
17. If the Bank of Canada makes an open market sale of $1 million of securities to a
bank, what initial changes occur in the economy?
If the Bank of Canada sells $1 million of securities to a bank, the Bank of Canada’s holdings
of securities decrease by $1 million and the bank’s holdings of securities increase by $1
million. The bank pays for the purchase with its reserves, so the reserves held by the Bank of
Canada decrease by $1 million and the bank’s reserves decrease by $1 million. The amount
of the bank’s assets does not change, though the composition changes (more securities,
fewer reserves). The Bank of Canada’s assets and liabilities both decrease by $1 million.

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 MONEY, THE PRICE LEVEL, AND INFLATION 339

18. Set out the transactions that the Bank of Canada undertakes to increase the
quantity of money.
The Bank of Canada has two main policy tools it uses to increase the quantity of money:
 The Bank of Canada could use an open market purchase of securities from banks.
When the Bank of Canada buys securities, it pays for the purchase by increasing banks’
reserves. The increase in banks’ reserves increases the monetary base and allows
banks to make more loans, which then increase the quantity of money.
 The Bank of Canada could lower bank rate. Bank rate is the interest rate that the Bank
of Canada charges on loans to major depository institutions. Bank rate acts like an
anchor for other short-term interest rates, and with lower interest rates, banks are less
likely to hold reserves and instead use their reserves to make loans. And when banks
make more loans, deposits increase, and the quantity of money increases.
19. Describe the Bank of Canada’s assets and liabilities. What is the monetary base
and how does it relate to the Bank of Canada’s balance sheet?
The Bank of Canada has two main assets: Canadian government securities and loans to
depository institutions. The Bank of Canada also has two main liabilities, Bank of Canada
notes and depository institution deposits (the reserves that depository institutions hold at the
Bank of Canada). The monetary base is the sum of coins, Bank of Canada notes, and
depository institution deposits at the Bank of Canada. Coins are only a small part of the
monetary base. The two largest components of the monetary base, Bank of Canada notes
and depository institutions deposits at the Bank of Canada, are the Bank of Canada’s two
liabilities.
20. U.S. Federal Reserve Minutes Show Active Discussion of QE3
The U.S. Federal Reserve discussed “a new large-scale asset purchase program”
commonly called “QE3.” Some members said such a program could help the
economy by lowering long-term interest rates and making financial conditions,
more broadly, easier. They discussed whether a new program should snap up
more Treasury bonds or buy mortgage-backed securities issued by the likes of
Fannie Mae and Freddie Mac.
Source: The Wall Street Journal, August 22, 2012
What would the U.S. Federal Reserve do to implement QE3, how would the
monetary base change, and how would bank reserves change?
To implement QE3 the U.S. Federal Reserve would undertake massive (“quantitative”)
purchases of assets. These assets likely would be long-term securities and could include
Treasury bonds and mortgage-backed securities, such as those issued by Fannie Mae or
Freddie Mac. These purchases would increase both the monetary base and banks’ reserves.
21. Banks in New Transylvania have a desired reserve ratio of 10 percent of deposits
and no excess reserves. The currency drain ratio is 50 percent of deposits. Now
suppose that the central bank increases the monetary base by $1,200 billion.
a. How much do the banks lend in the first round of the money creation process?
Banks loan $1,200 billion because the entire increase in reserves is excess reserves.
b. How much of the initial amount loaned flows back to the banking system as new
deposits?
$800 billion flows back to the banks as new deposits. The currency drain, which is the
percentage ratio of currency to deposits, is 50 percent. Of the $1,200 billion that has been

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340 CHAPTER 24

loaned, $800 billion is deposited back in banks and 50 percent of the deposits, $400 billion,
is kept as currency.
c. How much of the initial amount loaned does not return to the banks but is held
as currency?
Currency increases by $400 billion. The currency drain ratio, which is the percentage of
currency to deposits, is 50 percent. Of the $1,200 billion that has been loaned, $800 billion is
deposited and 50 percent of the deposits, $400 billion, is kept as currency.
d. Why does a second round of lending occur?
A second round of lending takes place because the $800 billion flowing back to the banks as
new deposits means that banks have excess reserves. Of the $800 billion flowing back to the
banks, 10 percent, or $80 billion, is kept as reserves leaving $720 billion that will be loaned in
a second round of lending.
22. Explain the change in the nominal interest rate in the short run if
a. Real GDP increases.
The nominal interest rate rises. When real GDP increases, the demand for money increases.
At the initial interest rate people are holding less money than the quantity they want to hold.
People sell bonds. The price of a bond falls and the nominal interest rate rises.
b. The Bank of Canada increases the quantity of money.
The nominal interest rate falls. When the quantity of money increases, the supply of money
curve shifts rightward. At the initial interest rate people are holding more money than they
want to hold. People buy bonds. The price of a bond rises and the nominal interest rate falls.
c. The price level rises.
The nominal interest rate rises. When the price level rises, the quantity of real money
decreases. The supply of money curve shifts leftward. The demand for money does not
change. At the initial interest rate people are holding less money than the quantity they want
to hold. People sell bonds. The price of a bond falls and the nominal interest rate rises.
23. Figure 24.3 shows the demand for money
curve. If the central bank decreases the
quantity of real money from $400 billion
to $390 billion, explain how the price of a
bond will change.
If the central bank decreases the quantity of
money from $400 billion to $390 billion, the
price of a bond falls. The decrease in the
quantity of money means that at the initial
interest rate, 4 percent a year, people are
holding less money than the quantity they
want to hold. In response people sell bonds.
As people sell bonds, the price of a bond falls
and the interest rate rises, in the figure from
4 percent a year to 6 percent a year.

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 MONEY, THE PRICE LEVEL, AND INFLATION 341

24. Use the data in Problem 7 to work this problem. The interest rate is 4 percent a
year. Suppose that real GDP decreases from $20 billion to $10 billion and the
quantity of money remains unchanged. Do people buy bonds or sell bonds?
Explain how the interest rate changes.
When real GDP decreases, the demand for money decreases. At the initial interest rate of 4
percent, the quantity of money people are holding exceeds the quantity of money they want
to hold. People buy bonds to decrease the quantity of money they are holding. The price of a
bond rises, and the interest rate falls. When the interest rate equals 3 percent a year, people
are holding exactly the quantity of money that they want to hold so 3 percent is the new
equilibrium interest rate.
25. The table provides some data
for the United States in the first 1869 1879
decade following the Civil War. Quantity of money $1.3 billion $1.7
billion
Source of data: Milton
Real GDP (1929 $7.4 billion Z
Friedman and Anna J.
dollars)
Schwartz, A Monetary History
Price level (1929 = X 54
of the United States 1867–
100)
1960
Velocity of 4.50 4.61
a. Calculate the value of X in circulation
1869.
Using the formula MV = PY gives ($1.3 billion  4.5) = (P  $7.4 billion) so that P equals 0.79,
or, as an index number, P = 79.
b. Calculate the value of Z in 1879.
Using the formula MV = PY gives ($1.7 billion  4.61) = (0.54  Y) so that Y equals $14.5
billion.
c. Are the data consistent with the quantity theory of money? Explain your answer.
The quantity theory holds. The quantity theory predicts that the inflation rate equals the
growth rate of the quantity of money plus the growth rate of velocity minus the growth rate of
real GDP. The growth rate of velocity is approximately zero, so the inflation rate equals the
growth rate of the quantity of money minus the growth rate of real GDP. The quantity of
money grew by approximately 27 percent, real GDP grew by approximately 65 percent and
the price level fell by approximately 38 percent. (These percentages are calculated using the
average of the quantity of money, the price level, and real GDP as the base for the
percentage.) The inflation rate, −38 percent (deflation) equals the growth rate of the quantity
of money, 27 percent, minus the growth rate of real GDP, 65 percent.

Economics in the News

26. After you have studied Reading Economics in the News on pp. 584-585, answer
the following questions.
a. What changes in the interest rate and the quantity of M2 occurred between 2007
and 2014?
The quantity of M2 money increased from the summer of 2007 from slightly below 50 percent
of GDP to 65 percent of GDP in mid-2014. The interest rate on Government of Canada 3-
month Treasury Bills was a bit more than 4 percent per year during the summer of 2007. The
Bank of Canada cut the interest rate on 3-month Treasury Bills to almost zero in 2009 and then
raised it to 1 percent per year, where it remained in mid-2014.

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342 CHAPTER 24

b. When the interest rate fell, why did the quantity of M2 demanded increase?
When the interest rate falls, other things remaining the same, the opportunity cost of holding
money falls, and the quantity of real money demanded increases.
c. How would you interpret the growth of M2 and the inflation rate during the years
2009-2014 using the quantity theory of money?
The quantity theory of money tells us that
Inflation rate = Money growth rate + Rate of velocity change - Real GDP growth rate
Rearranging,
Rate of velocity change = Inflation rate - (Money growth rate - Real GDP growth rate).
If the inflation rate is less than (Money growth rate - Real GDP growth rate), then the rate of
velocity change is negative. Velocity of circulation is decreasing.
d. Why does Jim Morrow fear inflation when there was no sign of an upturn in its
measured rate in 2014?
In long run, the velocity of circulation is constant, and the inflation rate equals the money
growth rate-the real GDP growth rate. In 2014, the money growth rate-the real GDP growth
rate exceeds the inflation rate. With a constant velocity of circulation, we can expect the
inflation rate to rise.
e. Why might Jim Morrow nonetheless be correct in his concern?
John Morrow might be correct in his concerns because the lag between money growth and
inflation is long and current rising prices could portend future inflation.
27. U.S. Federal Reserve at Odds with ECB over Value of Policy Tool
Financial innovation and the spread of U.S. currency throughout the world has
broken down relationships between money, inflation, and output growth, making
monetary gauges a less useful tool for policymakers, the U.S. Federal Reserve
chairman, Ben Bernanke, said. Many other central banks use monetary
aggregates as a guide to policy decision, but Bernanke believes reliance on
monetary aggregates would be unwise. “There are differences between the United
States and Europe in terms of the stability of money demand,” Bernanke said.
Source: International Herald Tribune, November 10, 2006
a. Explain how the debate surrounding the quantity theory of money could make
“monetary gauges a less useful tool for policymakers.”
The ECB policymakers believe that the quantity theory and its relationship between the
monetary growth rate and the inflation rate are a useful guide for policy. As a result they pay
greater attention to the quantity of money than does the Federal Reserve. Mr. Bernanke’s
statements indicate that he believes that velocity is less stable in the United States because
of instability of the demand for money and financial innovation. Because velocity is less
stable, Mr. Bernanke believes that the quantity theory, and emphasis on monetary
aggregates, is less useful in the United States than in Europe.
b. What do Ben Bernanke’s statements reveal about his view on the accuracy of
the quantity theory of money?
Mr. Bernanke believes that velocity changes make the short-run tie between growth in the
quantity of money and the inflation rate unreliable.

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 MONEY, THE PRICE LEVEL, AND INFLATION 343

28. In the United Kingdom, the currency drain ratio is 38 percent of deposits and the
reserve ratio is 2 percent of deposits. In Australia, the quantity of money is $150
billion, the currency drain ratio is 33 percent of deposits, and the reserve ratio is 8
percent of deposits.
a. Calculate the U.K. money multiplier.
The money multiplier equals 3.45. The money multiplier is equal to (1 + C/D) ÷ (R/D + C/D),
where C/D is the currency drain ratio and R/D is the banks’ reserve ratio. C/D = 38 percent and
R/D = 2 percent, so the money multiplier equals (1 + 0.38) ÷ (0.38 + 0.02), which is 3.45.
b. Calculate the monetary base in Australia.
The monetary base equals $46.2 billion. The monetary base equals the sum of currency and
depository institution deposits at the central bank. The currency drain is 33 percent, so with
the quantity of money equal to $150 billion, currency is $37.2 billion and deposits are $112.8
billion. The banks’ reserve ratio is 8 percent, so reserves are ($112.8  0.08), which is $9
billion. The monetary base equals $37.2 billion + $9.0 billion, which is $46.2 billion.

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Macroeconomics Canada in the Global Environment Canadian 9th Edition Parkin Solutions Manual

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