Macroeconomics

Assignment 5 1. Let’s find out what counts as money. In this chapter, we used a typical definition of money: “a widely accepted means of payment.” Under this definition, are people using “money” in the following transactions? If not, why not? (25points) 1. Lucy sells her Saab to Karen for $1,000 in cash. 2. Lucy sells her Saab to Karen for $1,000 worth of old Bob Dylan records. 3. Lucy sells her Saab to Karen for $1,000 in checking account balances (transferred by writing a check). 4. Lucy sells her Saab to Karen by Karen promising $1,000 worth of auto detailing services over the next year. 5. Lucy sells her Saab to Karen for $1,000 worth of Revolutionary War—era continental dollars. In transaction 1 and 3, cash and check are used for transactions which are acceptable by all because it is legal tender. However, transaction 2 and 4 would be difficult to trade don’t circulate widely as money. Era continental dollars are no longer widely accepted. 2. If the Federal Reserve wants to lower interest rates via open market operations, should it buy bonds or should it sell bonds? EXPLAIN (15POINTS) The Fed should buy bonds. This will increase the reserve supply and push rates down. This will also raise the demand for bonds, which raises the price of bonds, thus lowering the interest rate on bonds. 3. Practice with money multipliers. Think of the “money supply” (MS) as equal to either Ml or M2. (15 POINTS) 1. RR = 5%, Change in reserves = $10 billion. MM = ?; Change in MS = ? Money multiplier, MM = 1/RR = 1/0.05 = 1/0.05 = 20 Change in money supply = Change in reserves X Multiplier = $ 10 billion X 20 = $ 200 billion B. MM=20; MS=200 billion 2. RR = ?, Change in reserves = $1,000, MM = 5, Change in MS = ? Money multiplier, MM = 5 = 1/RR = 1/RR = 5 =0.2 RR= 0.2 Change in money supply = Change in reserves X Multiplier = $ 1000 X 5 = $ 5000 B. RR=0.2; MS= $5000 3. RR = 100%, Change in reserves = $10 billion. MM = ?, Change in MS = ? Money multiplier, MM = 1/RR = 1/1 = 1 Change in money supply = Change in reserves X Multiplier = $ 10 billion X 1 = $ 10 billion B. MM=1; MS=10 billion 4. When a financial bubble collapses, is that more like a fall in aggregate demand or a fall in the potential growth rate?(5POINTS) A bubble can be defined as an economic cycle which is characterized by a rapid rise in the asset prices and after this, there will be a contraction. When no more investors are ready to buy at the increased price, a massive selloff occurs, and it leads to bubble to collapse. Hence, it can be said that when a financial bubble collapses, the Aggregate demand curve will shift to the left because demand for assets decreases. 5.When a financial bubble collapses, what is more likely to happen as a result: a fall in inflation or a rise in inflation? (5 POINTS) 6.How can the federal reserve bank use monetary policy to control the two economic issues of inflation and unemployment? EXPLAIN. (10 POINTS) During an economic expansion there will be high inflation and unemployment rate will be low. “To prevent the economy from over-heating, the Fed uses contractionary monetary policy to lower aggregate demand and tame inflation”. This is implemented by open market sale of federal securities, and/or by increasing discount rate, and/or by increasing the required reserves ratio, to decrease money supply to decrease aggregate demand and to lower inflation rate. But this policy, by reducing output, will increase unemployment rate, thus there is a trade-off. However, in an economic recession, inflation will be low and unemployment rate will be high. To lower unemployment by boosting aggregate demand, the Fed uses expansionary monetary policy to increase aggregate demand. This is implemented by open market purchase of federal securities, and/or by decreasing discount rate, and/or by decreasing the required reserves ratio, to increase money supply to increase aggregate demand and to lower unemployment rate. But this policy, by increasing output and aggregate demand, will increase inflation rate, thus there is a trade-off too. 7. Not all investors are interested in accepting extra risk in order to receive a higher return. Investors can be classified as risk adverse, risk neutral, or risk seeking. To determine the risk associated with an investment, calculations are made to determine the risk-free rate and the risk premium associated with the investment.                                                                                                                                                  

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