Econ 100 Principles of Economics

Quiz 05
Roll Number:
Total Time: 60 mins
15.

Total Marks: 50

Explain how each of the following changes the money supply.

a. the Fed buys bonds
b. the Fed raises the discount rate
c. the Fed raises the reserve requirement

ANS:
a.
b.
c.

If the Fed buys bonds, it pays for them with reserves so banks will have more reserves and can lend
more which will create more deposits and so more money.
If the Fed raises the discount rate banks will borrow less from the Fed, and so have fewer reserves,
which decreases the money supply.
If the Fed raises the reserve requirement, banks will have to hold more of their deposits as reserves and
so will have less to lend out. With less to lend out, deposits and the money supply decrease.

13. If the reserve ratio is 20 percent, how much money can be created from $100 of reserves? Show your work.
ANS:
(1/.20) $100 = $500.
4.

Using separate graphs, demonstrate what happens to the money supply, money demand, the value of money,
and the price level if:
a. the Fed increases the money supply.
b. people decide to demand less money at each value of money.

ANS:

a.
b.

The Fed increases the money supply. When the Fed increases the money supply, the money supply curve
shifts right from MS1 to MS2. This shift causes the value of money to fall, so the price level rises.
People decide to demand less money at each value of money. Since people want to hold less at each
value of money, it follows that the money demand curve will shift to the left from MD1 to MD2. The
decrease in money demand results in a lower value of money and so a higher price level.

13.

Suppose that velocity and output are constant and that the quantity theory and the Fisher effect both hold.
What happens to inflation, real interest rates, and nominal interest rates when the money supply growth rate
increases from 5 percent to 10 percent?

ANS:
Inflation and nominal interest rates each increase by 5 percent points. There is no change in the real interest rate or
any other real variable.
3.
Why are net exports and net capital outflow always equal?
ANS:
Net exports and net capital outflow are always equal because every international transaction is an exchange. When a
seller country transfers a good or service to a buyer country, the buyer country gives up some asset to pay for this
good or service. The value of that asset equals the value of goods and services sold. Hence, the net value of goods
and services sold by a country (NX) must equal the net value of assets acquired (NCO).
5.

Derive the relation between savings, domestic investment, and net capital outflow using the national income
accounting identity.

ANS:
Start from the national income accounting identity,
(1) Y = C + I + G + NX.
Recall from Chapter 25 that national saving is the income that is left after paying for current consumption and
government expenditure,
(2) S = Y - C - G.
Rearranging, (1) we obtain Y - C - G = I + NX, and substituting in (2)
(3) S = I + NX.
Because net exports also equal net capital outflow, we can also write this equation as
(4) S = I + NCO.
15.

Suppose that money supply growth continues to be higher in Turkey than it is in the United States. What does
purchasing-power parity imply will happen to the real and to the nominal exchange rate?

ANS:
Higher money growth leads to higher prices, so prices will rise more in Turkey than in the United States. Under
purchasing-power parity, this has no affect on the real exchange rate. However, in order for a dollar to buy as many
goods in Turkey as it buys in the United States when prices are rising faster in Turkey, the nominal exchange rate
must be rising so that a dollar buys more Turkish lira.
9.

Suppose a presidential candidate promises to increase the government budget surplus and claims that doing so
will stop U.S. citizens from investing in foreign companies and increase the value of the dollar. Evaluate this
promise.

ANS:
An increase in the government budget surplus will cause U.S. interest rates to fall. The decline in interest rates will
increase domestic investment, but it will also cause Americans to look for higher returns abroad, which means that
net capital outflow rises rather than falls as promised. To take advantage of these higher returns, Americans will
supply more dollars in the foreign-currency exchange market and the dollar will depreciate rather than appreciate as
promised.

14.

Fill in the table below with the direction of the variables that change in response to the events in the first
column.

U.S. real
interest rate

U.S. domestic
investment

U.S. net
capital
outflow

U.S. real
exchange rate
of domestic
currency

U.S. real
exchange rate
of domestic
currency
appreciates

U.S. trade
balance

U.S. trade
balance

U.S. government
budget deficit
increases
U.S. imposes
import quotas
capital flight
from the United
States

ANS:
U.S. real
interest rate

U.S. domestic
investment

U.S. government
budget deficit
increases

rises

falls

U.S. net
capital
outflow
falls

U.S. imposes
import quotas

no change

no change

no change

appreciates

no change

capital flight
from the United
States

rises

falls

rises

depreciates

rises

5.

falls

Explain how an increase in the price level changes interest rates. How does this change in interest rates lead to
changes in investment and net exports?

ANS:
When the price level increases, the purchasing power of money held on hand and in bank accounts declines. This
decline makes people feel less wealthy so that they lend less. The reduction in lending causes the interest rate to rise.
The rise in interest rates discourages spending on investment goods so that the aggregate quantity of goods and
services demanded decreases. As the interest rate increases, the supply of dollars in the market for foreign-currency
exchange falls as people wish to purchase fewer foreign assets. This makes the dollar appreciate which decreases net
exports.

11.

Suppose that a decrease in the demand for goods and services pushes the economy into recession. What
happens to the price level? If the government does nothing, what ensures that the economy still eventually gets
back to the natural rate of output?

ANS:
A decrease in aggregate demand causes the price level to fall. If the government takes no action to counter this, then
the actual price level will be below the price level that people expected. Individuals will eventually correct their
expectations about the price level. As they do so, prices and wages will adjust accordingly, shifting the aggregate
supply curve to the right. For example if wages are sticky, in light of the lower price level, firms and workers will
eventually make bargains for lower nominal wages. The reduction in wages lowers costs of production, so firms are
willing to produce more at any given price level. Consequently, the short-run aggregate supply curve shifts right.
The rightward shift in aggregate supply eventually causes output to rise back to the natural rate.
4.

Describe the process in the money market by which the interest rate reaches its equilibrium value if it starts
above equilibrium.

ANS:
If the interest rate is above equilibrium, there is an excess supply of money. People with more money than they want
to hold given the current interest rate deposit the money in banks and buy bonds. The increase in funds to lend out
causes the interest rate to fall. As the interest rate falls, the quantity of money demanded increases, which tends to
diminish the excess supply of money.
10.

Suppose that the government increases expenditures by $150 billion while increasing taxes by $150 billion.
Suppose that the MPC is .80 and that there are no crowding out or accelerator effects. What is the combined
effects of these changes? Why is the combined change not equal to zero?

ANS:
The multiplier is 1/(1-MPC) = 1/(1-.8) = 1/.2 = 5. The increase of $150 in government expenditures leads to a shift
of $150 billion x 5 = $750 billion in aggregate demand. The increase in taxes decreases income by $150 and so
initially decreases consumption by $150 billion x MPC = $150 billion x .8 = $120 billion. This change in
consumption will create a multiplier effect of $120 billion x 5 = $600. Thus the net change is $750 billion - $600
billion = $150 billion. The changes dont cancel each other out, because a tax increase decreases consumption by
less than the tax increase.