Practice Problem Answers



Practice Problem Answers

1. What are the three principal uses of Money?

Money acts as a unit of value (the dollar in the U.S.), a medium of exchange (you can exchange it for goods or services), and a store of value (money retains value over time.)

2. What is the distinction between fiat and commodity money?

Commodity money has its own intrinsic value, fiat money has no intrinsic value and is money by government decree.

3. Consider the following information:

|Item |Amount in billions of dollars |

|Currency outstanding |5 |

|Checking accounts |9 |

|Savings accounts |30 |

|Money Market Mutual Funds |20 |

|Travelers Checks |1 |

|Stocks and bonds |50 |

|Credit Card balances |30 |

a. What is M1?

M1 is the sum of currency outstanding and checking balances = $5 + $9 + $1 = $15. Credit Card balances are debts and not considered money. Neither are stocks and bonds because they are not a medium of exchange.

b. What is M2?

M2 is M1 plus Savings and Money Market Mutual Funds In this case, M2 = $15 + $50.

4. What does the money supply equal in terms of currency, deposits, reserves, and the reserve ratio?

Money supply = Currency in the hands of the public + deposits in the banking system. This also is given by Currency in the hands of the public + bank reserves/reserve ratio.

5. If a bank’s reserves increase by $10,000 and the actual reserve-deposit ratio is 0.10, how much will the money supply change assuming that the public doesn’t hold any additional cash?

Bank deposits will increase by $10,000/0.10 = $100,000. This will increase the money supply by $100,000.

6. Suppose the public holds $200 million in currency, the reserve-deposit ratio is 0.05, and the bank holds $300 million in reserves, what is the money supply?

Money supply = currency held by the public + bank deposits. Bank deposits = $300/.05= $6,000. Money supply = $200 million + $6,000 million = $6,200 million.

7. If the FED conducts an open-market sale of bonds, what will happen to the money supply?

The money supply will decrease because by selling bonds in doing so they decrease the amount of money banks have in reserves.

8. Suppose the Fed purchases $1,000 in bonds. How much will the money supply change if the reserve-deposit ratio is 0.10 assuming the public holds no extra currency?

If the Fed purchases $1,000 from the public, reserves will initially increase by $1,000. Bank deposits will ultimately be = $1,000/0.10 = $10,000. Since deposits increase by $10,000 and currency remains the same, the money supply will increase by $10,000.

9. How will higher interest rates affect savings, consumption, and investment.

Higher interest rates will increase savings, decrease consumption, and decrease investment.

10. If the Fed lowers the real interest rate, what will happen to short-run equilibrium output?

Lowering the interest rate will increase consumption and investment, shifting the aggregate demand curve rightward. The new equilibrium will be at a higher level of output.

11. If potential output equals 4,000 and short-run equilibrium output equals 3,500, there is a recessionary gap and the Federal Reserve must lower interest rates in order to close the gap. 

12. How does the Fed reduce inflation, and what are the likely consequences of the Fed trying to reduce inflation to AD, AS, and unemployment?

In order to reduce inflation, the Fed will increase interest rates, which will shift AD to the left, which will reduce output (and increase unemployment) in the short run.

13. How does the Fed reduce unemployment, what are the likely consequences of the Fed trying to reduce unemployment to AD, AS, and inflation?

In order to reduce unemployment, the Fed will decrease interest rates, which will shift AD to the right, which will increase inflation.

14. Suppose the MPC in the economy equals 0.8, and for every 1% increase in interest rates, investment spending decreases $20 billion. By how much does the Federal Reserve need to increase interest rates in order to decrease aggregate demand by $200 billion?

The multiplier is 1/(1-MPC) = 1/0.2 = 5, so if investment decreases by $40 billion, aggregate demand decreases by $200 billion ($40 billion*5). In order to decrease investment by $40 billion the FED needs to increase interest rates by 2%.

15. What is the demand for money?

The demand for money represents how much of one’s assets are held in the form of money (cash + checking in the case of a narrow definition of money)

16. What is the opportunity cost of holding money? 

The nominal interest rate

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17. Refer to the figure above. If the Federal Reserve wants to raise the interest rate to 7%, it must decrease the money supply to 300. 

18. Refer to the figure above. If the Federal Reserve wants to set the nominal interest rate at 1%, it must conduct open market purchases to set the money supply at 900. 

19. An increase in the nominal interest rate will decrease the quantity of money demanded, and is represented with a movement upward along the money demand curve.

20. How would a decrease in output affect the Money Demand Curve?

A decrease in output (which is equivalent to income) would decrease the amount of money that is held at any given interest rate. Therefore, the Money Demand Curves shifts to the left.

21. If there is an expansionary gap in the economy, the FED will decrease money supply, which will increase interest rates, which will decrease investment and decrease AD, which will decrease inflation.

22. Suppose inflation is 2% and there is an expansionary gap of 5%. According to the Taylor rule, the Federal Funds rate should equal 4 + (5*.5) = 6.5%.

23. Suppose inflation is 1% and there is a recessionary gap of 4%. According to the Taylor rule, the Federal Funds rate should equal 4 - 4*0.5– (2-1)*1.5 = 0.5%.

24. What is the relationship between prevailing interest rates and bond prices?

There is an inverse relationship, in that when interest rates rise, bond prices fall.

25. If a company’s stock trades for $12, and there are 10 million shares, what is their market cap?

The market cap = price/share * number of shares, which in this case equals $12*10 million = $120 million.

26. What are the two ways investors in stocks can earn money?

Through dividends (regular payments based on profits) and capital gains (the price of the stock increases).

27. Suppose investment A is riskier than investment B. Which is likely to have a higher rate of return? What does the risk premium between these two investments equal?

Investment A is likely to have a higher rate of return because risks (or potential losses) are capitalized in the form of higher returns.

The risk premium is given by the returns on A – returns on B.

28. Suppose you invest $5,000 and earn a 6% rate of return for 45 years. How much will your investment be worth? How much will it be worth if you start 10 years earlier and withdraw it in 35 years?

5,000*(1.06)45=$68,823

5,000*(1.06)35=$38,430

29. If 1.00 U.S. dollar is worth 0.75 euro, how much does 1.00 euro worth in terms of dollars?

If 1 U.S. dollar = .75 euro then, 1 euro = 1/.75 U.S dollar = $1.33

30. Use the following exchange rate table to answer the following questions

Country Foreign Currency/Dollar Dollar/Foreign Currency

Swedish (Krona) 6.00

Australian (Dollar) 1.09

a. What is the number of U.S. dollars per Swedish kronar?

1/6.00 = 0.167

b. What is the number of Australian dollars per U.S. dollars?

1/1.09 = 0.92

c. What is the number of Swedish Krona per Australian dollar?

6 = 0.92 ; 6/0.92 = 0.92 / 0.92 = 6.52

31. What groups benefit from and what groups are hurt by a depreciating currency?

Domestic producers of exported goods and foreign consumers of domestic goods (e.g. foreign travelers in the U.S.) benefit from a depreciating currency.

Foreign producers of imported goods and domestic consumers of foreign goods (e.g. U.S. travelers abroad) are hurt by a depreciating currency.

32. A new mp3 player costs 200 U.S dollars. If the exchange rate is $1.50 per euro, how much will the mp3 player cost in Euros?

$200/($1.50/Euro) = 133.33 euros

33. If the exchange rate expressed in euros per dollar increases, what will happen to the price of U.S. goods and services for Europeans?

As the exchange rate increases, the dollar is appreciating against the euro. This makes U.S. goods and services more expensive for Europeans.

34. How will a decrease in the exchange rate for U.S. dollars (expressed in foreign currency per dollar) affect quantities of dollars demanded?

As the exchange rate falls, U.S. goods and services become relatively cheaper. Foreigners will purchase more U.S. goods and services, increasing the quantity of dollars demanded.

35. If the exchange rate moves from 10 Mexican pesos per U.S. dollar to 8 Mexican pesos per U.S. dollar, then the Mexican peso has appreciated and the U.S. dollar has depreciated. 

36. What will happen to a country’s imports and exports if the country maintains an undervalued exchange rate?

That country’s exports will become relatively cheap, and their imports will become relatively expensive. Therefore, we should see imports decrease and exports increase.

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37a.  Refer to the figure above. Based on the figure, if the krone exchange rate is fixed at $0.15 dollars per krone, the krone is overvalued. 

38b. If the krone exchange rate is fixed at $0.15 dollars per krone, there will be an excess supply equal to 5,500 krone?

39c. In order to maintain an exchange rate of $0.15 krones/dollar, what will the Polish government will have to do on foreign exchange markets?

They will have to purchase the excess supply of krone (5,500) in foreign exchange markets to maintain this overvalued exchange rate.

40. Suppose a country exports $50,000 and imports $75,000. What is the country’s trade balance?

Trade balances = Exports – Imports = $50,000 - $75,000 = -$25,000

41. What was the balance of trade in the U.S. in 2011 – for goods and services and for goods alone?

The 2011 goods and services deficit was approximately $560 billion. The 2011 goods deficit was approximately $730 billion.

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