35B101: Macroeoconomics for EOR

Problem Set 3

This problem set is due by September 19, 2017, 10:45 am CET. Upload your solutions to Blackboard. Late
problem sets will not be accepted. I recommend uploading computer typed solutions to ensure your answers are
legible. If your answers are illegible to the extent that I cannot recover their meaning, I will count them as incorrect.
In order to get partial credit for wrong answers but correct approaches, make sure to include your approach in the
answer. This problem set will be graded and counts towards your course requirement as described in the syllabus.

Exercise 1: Fractional Reserve Banking

a)
Show that each e1 of reserves generates e(1/rr) of money under fractional reserve banking with an unlimited
number of banks. (Hint: Start writing out the infinite series and then use the algebraic result for the sum of an
infinite geometric series.)

b)
Explain why and how an increase in the amount of money stored in deposits (without changes in cash holdings or
reserves) changes the money supply.

c)
How does the increased use of debit cards affect the monetary multiplier? Why?

Exercise 2: Leverage
Assume a bank has a leverage ratio of 20. Owners have provided the bank with capital of e1,000,000. All remaining
liabilities are equally divided into deposits and debt. 40% of the banks total assets are loans, with the rest kept
in reserves. Write down the balance sheet. How does the balance sheet change if the value of all the banks assets
rises by 10 per cent.

Exercise 3: Hyperinflation
a)
During a conflict between two countries (lets call them domestic and foreign), an economist may have come up
with the idea to use domestic government funds to buy foreign goods on a large scale to increase their enemys
money supply, eventually leading to hyperinflation. Do you think this is a good idea? Why?

b)
Name two reasons why armed conflict increases the likelihood for hyperinflation.

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Exercise 4: Quantity Theory of Money
An economy produces with Y = K L at constant returns to scale and = .5. K, L = 1000 are given. The
government does not interfere with the private sector: G = T = 0 and the marginal propensity to consume is .5.
M
Assume I(r) = 1000 500 r and P = 10, 000.

a)
If the money demand function reads L() = a(r + e ) Y , what value does a need to have when expected inflation
is zero?

b)
Now assume that a = 2. Whats the expected inflation rate?

c)
Whats the nominal interest rate?