Principles of Macroeconomics Exam #2 Review – Guided Study Notes

Q1a. If the required reserve ratio is 10%, what are the required reserves for this bank?

Background

Topic: Money Creation and Reserve Requirements

This question tests your understanding of how banks are required to hold a fraction of deposits as reserves, based on the required reserve ratio set by the central bank.

Key Terms and Formula:

• Required Reserves: The minimum amount of reserves a bank must hold against deposits, as mandated by the central bank.

• Required Reserve Ratio (RRR): The percentage of deposits that must be held as reserves.

Formula:

$\text{Required Reserves} = \text{Required Reserve Ratio} \times \text{Deposits}$

Step-by-Step Guidance

1. Identify the required reserve ratio: $\text{RRR} = 10\% = 0.10$.

2. Identify the total deposits: $\text{Deposits} = \$500,000$.

3. Set up the formula: $\text{Required Reserves} = 0.10 \times \$500,000$.

Try solving on your own before revealing the answer!

Q1b. If the required reserve ratio is 10%, what (if any) are the excess reserves for this bank?

Background

Topic: Excess Reserves

This question checks your ability to distinguish between required and excess reserves, which are reserves held by banks above the required minimum.

Key Terms and Formula:

• Excess Reserves: Reserves held by a bank beyond what is required.

Formula:

$\text{Excess Reserves} = \text{Total Reserves} - \text{Required Reserves}$

Step-by-Step Guidance

1. Recall the total reserves: $\$75,000$.

2. Recall the required reserves from part (a).

3. Set up the formula: $\text{Excess Reserves} = \$75,000 - \text{Required Reserves}$.

Try solving on your own before revealing the answer!

Q1c. Suppose this bank is the entire banking system. Given the information above, what is the maximum amount the money supply can be increased by?

Background

Topic: Money Multiplier and Money Creation

This question tests your understanding of the money multiplier and how excess reserves can lead to an increase in the money supply.

Key Terms and Formula:

• Money Multiplier: The factor by which a change in reserves will change the money supply.

Formula:

$\text{Money Multiplier} = \frac{1}{\text{Required Reserve Ratio}}$

$\text{Maximum Change in Money Supply} = \text{Excess Reserves} \times \text{Money Multiplier}$

Step-by-Step Guidance

1. Calculate the money multiplier: $\frac{1}{0.10}$.

2. Recall the excess reserves from part (b).

3. Set up the formula: $\text{Maximum Change in Money Supply} = \text{Excess Reserves} \times \text{Money Multiplier}$.

Try solving on your own before revealing the answer!

Q1d. If this bank is one bank operating in a multi-bank system and it makes a loan for $25,000 that is deposited in another bank, how (if any) does this loan affect the money supply?

Background

Topic: Money Creation in a Multi-Bank System

This question examines your understanding of how loans and deposits circulate through the banking system, affecting the money supply.

Key Terms and Formula:

• Loan Creation: When a bank makes a loan, it increases the money supply by the amount of the loan, which can then be multiplied as it is redeposited and re-loaned throughout the system.

Step-by-Step Guidance

1. Recognize that the initial loan of $25,000 increases deposits in another bank.

2. Recall that in a multi-bank system, the total increase in the money supply is the loan amount multiplied by the money multiplier.

3. Set up the formula: $\text{Total Increase in Money Supply} = \text{Loan Amount} \times \text{Money Multiplier}$.

Try solving on your own before revealing the answer!

Q1e. If the Federal Reserve purchases $20,000 worth of bonds from this bank, how does this purchase impact the t-account? What type of monetary policy is the Federal Reserve engaging in with this action?

Background

Topic: Open Market Operations and Monetary Policy

This question tests your understanding of how the Fed's open market operations affect a bank's balance sheet and the broader money supply, as well as the type of policy being used.

Key Terms and Formula:

• Open Market Operations: The buying and selling of government bonds by the Federal Reserve to influence the money supply.

• Expansionary Monetary Policy: Actions by the Fed to increase the money supply, typically by purchasing bonds.

Step-by-Step Guidance

1. When the Fed buys bonds, the bank's reserves increase by the amount of the purchase.

2. The bank's holdings of bonds decrease by the same amount.

3. Identify the type of monetary policy: purchasing bonds increases reserves and is considered expansionary.

Try solving on your own before revealing the answer!

Q2a. The economy is at potential output, but foreign economies slow dramatically. What fiscal policies would you recommend? Demonstrate both verbally and graphically how your recommended policy would impact the economy.

Background

Topic: Fiscal Policy Response to External Shocks

This question tests your ability to recommend appropriate fiscal policy when an external shock (like a slowdown in foreign economies) affects domestic output, and to explain the effects using both words and diagrams.

Key Terms and Concepts:

• Expansionary Fiscal Policy: Increasing government spending or cutting taxes to boost aggregate demand.

• Aggregate Demand (AD): The total demand for goods and services in the economy.

Step-by-Step Guidance

1. Recognize that a slowdown in foreign economies reduces U.S. exports, shifting the AD curve to the left.

2. Explain that this creates downward pressure on output and prices, potentially causing a recessionary gap.

3. Recommend expansionary fiscal policy (increase government spending or cut taxes) to shift AD back to the right.

4. On a graph, show the initial equilibrium at potential output, the leftward shift of AD, and the policy-induced rightward shift back to potential output.

Try sketching the AD-AS diagram and outlining your policy recommendation before checking the answer!

Q2b. The economy has been operating above potential output causing inflationary pressures to rise. What fiscal policies would you recommend? Demonstrate both verbally and graphically how your recommended policy would impact the economy.

Background

Topic: Fiscal Policy Response to Inflationary Gaps

This question tests your understanding of contractionary fiscal policy and how it can be used to reduce inflationary pressures.

Key Terms and Concepts:

• Contractionary Fiscal Policy: Decreasing government spending or increasing taxes to reduce aggregate demand.

• Inflationary Gap: When actual output exceeds potential output, leading to upward pressure on prices.

Step-by-Step Guidance

1. Identify that the economy is above potential output, causing inflation.

2. Recommend contractionary fiscal policy (decrease government spending or increase taxes) to shift AD to the left.

3. On a graph, show the initial equilibrium above potential output, the leftward shift of AD, and the return to potential output.

Try sketching the AD-AS diagram and outlining your policy recommendation before checking the answer!

Q2c. A new technology is invented that significantly raises potential output. What is the effect on the economy? Demonstrate both verbally and graphically.

Background

Topic: Economic Growth and Aggregate Supply

This question tests your understanding of how technological progress affects the long-run aggregate supply (LRAS) and the overall economy.

Key Terms and Concepts:

• Long-Run Aggregate Supply (LRAS): The total output an economy can produce when using all resources efficiently.

• Technological Progress: Increases productivity and shifts LRAS to the right.

Step-by-Step Guidance

1. Recognize that new technology increases potential output, shifting LRAS to the right.

2. Explain that this can also shift the short-run aggregate supply (SRAS) to the right if productivity increases in the short run.

3. On a graph, show the rightward shift of LRAS (and possibly SRAS), leading to higher output and lower prices.

Try sketching the AD-AS diagram and explaining the effects before checking the answer!