Economics 101 – Chapters 4, 5 and 10 Homework 3

1) In a dramatic episode discussed in chapter 4, the money supply fell 28 percent from 1929 to 1933, which some economists blame for causing the Great Depression of the 1930s. The money supply fell, despite a rise in the monetary base, because both the currency-deposit ratio and the reserve-deposit ratio increased. Use the model of the money supply from chapter 4 and the data in the table below to answer the following hypothetical questions.a) What would have happened to the money supply if the currency-deposit ratio had risen but the reserve-deposit ratio had remained the same?b) What would have happened to the money supply if the reserve-deposit ratio had risen but thecurrency-deposit ratio had remained the same?c) Which of the two changes was more responsible for the fall in the money supply? Explain what this means in terms of the behavior of depositors and of banks. Note that there were many bank failures in 1929 in which depositors lost their deposits.2) Suppose that in Korea the velocity of money is constant, real GDP grows by 6% per year each year, the money stock grows by 9% per year, and the nominal interest rate is 7%. a) Using the quantity theory of money and the Fisher relation, what should be the inflation rate and the real interest rate in Korea?b) Suppose the central bank of Korea decides to lower inflation by lowering the money supply growth rate to 8% (all else constant). Now what would be the equilibrium values of inflation and the real interest rate?3) Suppose the real side of an economy is characterized by:Y = 80K1/2 L1/2K=100 and L= 100G = 3000T = 3000I = 2000 – 6000rC = 600 + .6(Y-T)And suppose the nominal side of this economy is characterized by:Real money demand:(M/P)d = 0.2Y – 1000rNominal money supply:M = 3000Where P is aggregate price level, and M is nominal stock of money.a) Compute the following: Real GDP (Y), real interest rate (r ), real wage rate (W/P, in units of goods), aggregate price level (P), and a nominal wage rate (W, in terms of money). b) Suppose that the government raises the money supply 10% from 3000 to 3300. Report the new values for each of the variables in part (a) above. Does the Classical Dichotomy hold in this economy? Explain.4) Economic Fluctuations: A significant scare a decade ago related to the change of the millennium, “Y2K.” One worry the Federal Reserve had was that bank computers and ATMs might malfunction on January 1 of the new century. Analyze this situation in terms of aggregate demand and aggregate supply curves from chapter 9 (based on the quantity theory of demand where price is fixed in the short run but flexible in the long run). Regard this as a fall in money velocity that is temporary, just affecting the short run but returning to normal in the long run.a) Which should the Federal Reserve have worried about: a possible recession or excessive inflation? Explain.b) Discuss what monetary policy actions you would suggest to prevent any such problems. (Be specific about what you would do in the short run and in the long run.)

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