ECON 205: MACROECONOMIC THEORY AND POLICY

Tutorial # 03
ANSWERS

Topic # 14: A Model of Money Supply

Question 1

What is the difference between the money supply and the monetary base?

Answer

Both M and B consists of two components:

Money supply=C + D , where : {+¿ D ←C ←Currency

Demand deposits

Monetary base=C+ R , where:

{ C ←Currency
'
+¿ R ← Bank s reserve deposits

The difference lies in the second component.

Question 2

The Model of Money Supply establishes a link between the money supply M and monetary base
B. Write the formula establishing the precise relationship between M and B, and specify the
meaning of all the symbols you are using (e.g. M denotes money supply).

Answer

M =mm × B

where

{
M ← Money supply
1+ a
mm= ← Money multiplier
a+ b
B : Monetary base

{
C
a :Currency−deposit ratio=
D
R
¿ b : Reserve−deposit ratio=
D

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 {
C :Currency
D: Deposits
R: Banks ' reserves

Question 3

The economists applying for a position at the central bank have been given the following data:
Amount of currency in the economy: $100 billion (C=100);
Demand deposits: $400 billion ( D=400); and
Banks’ reserve deposits: $160 billion ( R=160)

The governor of the central bank is asking them to calculate

(a) The monetary base;

(b) The money multiplier; and
(c) The money supply using the money multiplier

Answer

(a) Monetary Base B

B=C + R=100+ 160=260

(b) Money Multiplier

First of all, they need two ratios

C 100 R 160
a= = =0.25 and b= = =0.40
D 400 D 400

Therefore, the money multiplier mm is

1+ a 1+0.25 1.25
mm= = = ≈ 1.923076
a+b 0.25+ 0.40 0.65

(c) Money Supply

The basic proposition of the model of money supply is

M =mm × B ≈ 1.92 ×260 ≈ 499.99976

Note

By definition,

M =C + D=100+ 400=500

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Question 4

Suppose that the information provided in Question 3 corresponds to a country that is currently in
a deep recession. A newly appointed central bank governor orders the withdrawal of $ 50 billion
of notes and coins from the financial system.

Assume that D and R remain as in Question 3.

(a) What is the new value of the money supply after the monetary policy decision has been
implemented?
(b) Did the money multiplier increase?
(c) What is the effect of the monetary policy decision on the level of economic activity?

Answer

(a) The money supply after the policy has been implemented is

M =C + D=50+ 400=450

(b) Yes, because after the policy has been implemented

{
C 50
= =0.125
D 400
R 160
¿ = =0.40 ← Does not change
D 400

and therefore,

1+ a 1+0.125 1.125
mm= = = ≈ 2.142857
a+b 0.125+ 0.40 0.525

(c) The reduction in the monetary base aggravates the recession. Under conditions of deep
recession, the central bank has to increase the monetary base to stimulate economic
activity.

Question 5

The money multiplier is always greater than one. True or False? Explain

Answer

True.

Proof by contradiction. Assume that mm< 1.

Therefore,

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 1+ a
mm= <1  1+a< a+b  1<b  b> 1
a+b

But this contradicts the fact that

R
b= <1 ← Always
D

Critical Thinking

Question 6

This question is about economic logic applied to an economy in two different situations.

Initial situation:
(a) The nominal interest rate is zero.
(b) Both income velocity of money and real GDP are constant.
(c) The money multiplier is equal to three (3).
(d) The monetary base quadruples.

New Situation:
In the New Situation (a) and (b) remain the same as in the Initial Situation, but the money supply
has doubled, the price level has increased by 10%, and the banks keep much of their available
funds in reserve. Analyse the following conclusions derived from the preceding information:

The foregoing

(a) Rejects the strong version of the Quantity Theory of Money;

(b) Rejects the Model of Money Supply; and
(c) Proves that the central bank is unable to perfectly control the money
supply.”

Answer

 Strong version of the Quantity Theory of Money: Rejected ← Correct

The strong version of the Quantity Theory of Money predicts that the price level should double.
Therefore, the information provided is incompatible with the prediction of the strong version of
the quantitative theory.

 Rejection of the Model of Money Supply ← Incorrect

A huge expansion of the monetary base does not necessarily lead to a significant expansion of the
money supply. If banks choose to hold substantial quantities of excess reserves (the banks keep
much of their available funds in reserve) rather than making loans, this provokes a large decline in
the money multiplier mm . Therefore, the Model of Money Supply is consistent with the
information provided (No rejection).

 Central bank unable to perfectly control the money supply ← Correct

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The central bank has no absolute control of the money supply. The reserve-deposit ratio b is
determined by the business policies of the banks and laws regulating banks.

Question 7

‘Fine-tuning’ means that policy variables are continuously adjusted in response to small
disturbances in the economy. The empirical evidence supports the view that more independent
central banks are strongly associated with lower and more stable inflation. What is false in the
following justification of the empirical findings?

“Assuming that the value of the money supply M is established by discretion

rather than by rule, it is better to allow the central bank to make decisions free
from political influence because the governor of the central bank has perfect
control of M , and thereby, can do fine-tuning of M with particular precision.”

Answer

The control of M by the central bank is imperfect because the behaviour of households and banks
affect the value of M via the money multiplier mm .

Topic # 14: Appendix I

The Great Crash of 1929 and Keynes

Question 1
What came first, the Great Depression or the Great Stock Market Crash.

Answer
The Great Stock Market Crush of 1929.

Question 2
Keynes argued that investment demand fluctuates because of pessimism and optimism. What
term did he use to refer to these changes in attitude?

Answer
Animal spirits.

Topic # 14: Appendix II

Monetarism Failed

Question 1
It is generally agreed that monetarism failed. Why?

Answer
Monetarists were unable to show that the money supply M is the principal cause of
inflation/deflation because they did not provide an explicit model of cause-effect relations proving
that M causes P .

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Question 2
According to monetarism, monetary policy would be better conducted by the rule of constant
money growth between 3-5 per cent per year than by discretion. Was this rule ever implemented?

Answer

I do not know of any single example of a central bank that had ever used Friedman’s rule.

Topic # 15: AD-AS Model

Part II

Question 1

The Aggregate Demand curve ( AD curve , for short) is a graph that shows the quantity of goods
and services that households, firms, and the government want to buy at any price level. What are
the two assumption that one has to make in order to derive the AD curve from the
Quantity Theory of Money ?

Answer

The velocity v is constant and the money supply M is fixed.

Question 2

The following assumptions describe an economy:

 The Quantity Theory of Money holds;

 The income-velocity of money is v=0.10;

 The nominal money supply is M =12,500 ;

Find the equation of the AD curve .

Answer

{Mv=0.10
=12,500
 v × M =0.10 ×12,500=1250

Therefore, the equation of the AD curve is

P ×Y =1250 ← Equationof the AD curve

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Topic # 15: AD-AS Model

Part III

Question 3

Suppose that the production function of an imaginary economy is

Y =F ( L, K ) =5× √ L × √ K

Use a calculator to find an answer to each of the following questions.

(a) The economy is producing 75 units with the input combination( L , K )=( 64 , 36). Is the
economy producing 75 units efficiently?

Answer

No, because the output level Y =75 can be produced using less labour and less capital. For
example, Y =75 can be produced with the input combination ( L , K )=( 25 ,9).

(b) What is the maximum output level that can be produced with the input combination
( L , K )=( 64 , 36)?

Answer

F ( 64 ,36 )=5 × √ 64 × √ 36=5 ×8 × 6=240

(c) The output level Y =75 can only be produced efficiently with the input combination
( L , K )=( 25 ,9). True or false? Explain.

Answer

False. There are many input combinations able to produce Y =75 efficiently. These input
combinations satisfy the equation 5 × √ L× √ K=75

For example, Y =75 can be produced with

L=
√ 1 and K=5625
25

or L=9 and K=25.

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Question 4

The Aggregate Supply curve ( AS curve , for short) is a graph that shows the quantity of goods and
services that firms choose to produce and sell at any price level.

To understand short-run economic fluctuations, we need to examine both the long-run AS curve
and the short-run AS curve . One AS curve is vertical and the other positively sloped. Which is
which? Why?

Answer

Long-run AS curve : Vertical, because in the long-run the quantity supplied does not depend on
the price level P.

Short-run AS curve : Positively sloped because wages are sticky.

Topic # 15: AD-AS Model

Part IV

Question 5

The following assumptions describe an economy:

 The Quantity Theory of Money holds;

 The income-velocity of money is v=0.10;

 The nominal money supply is M =12,500 ;

 The production function is Y =F ( L, K ) = 5 × √ L× √ K ; and

 The endowment of resources is given by the input combination ( L , K )=( 625,100 ) .

Calculate the long-run equilibrium for this economy.

Answer

Derivation of the AD curve

{Mv=0.10
=12,500
 v × M =1250

Because the quantity Theory holds, P ×Y must be equal to v × M :

P ×Y =1250 ← Equationof the AD curve

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Derivation of the AS curve

To find the equation of the long-run AS curve we need two ingredients

{Y =F ( L , K ) ← Production function
¿ ( L , K ) ← Resource endowments

F ( 625,100 ) = 5 × √ 625 × √ 100=¿ 5 ×25 ×10=1250

0
Y =1250 ← Equationof the long−run AS curve

Macroeconomic Equilibrium

We put together demand and supply

{
0
P× Y =1250 ← AD curve
0
¿Y =1250 ← AS curve

In this system the only unknown is P .

From
0
P ×Y =1250

it follows that
∎
P ×1250=1250  P =1

Therefore, the long-run equilibrium is

( Y 0 , P∎ )=(1250 ,1)← Long−run macroeconomic equilibrium

Question 6

Explain the context in which Keynes said: “In the long-run we are all dead.”

Answer

Here is the context for Keynes’ quotation:

The long run is a misleading guide to current affairs. In the long run
we are all dead. Economists set themselves too easy, too useless a task
if in tempestuous seasons they can only tell us that when the storm is
past the ocean is flat again.

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He was slamming economists for being optimistic about near-term troubles merely because in the
long term equilibrium will return.

Question 7

Find the short-run equilibrium of the economy in Question 5 where the short-run AS curve has
the following equation:

P=12.5 × Y

Answer

The relevant equations are:

(S) {P=12.5
P ×Y =1250 ← Equation of the AD curve
× Y ← Equation of the short−run AS curve

This is a system of two equations for the two unknowns P and Y .

Determination of the equilibrium value of Y

Inserting the second equation P=12.5 × Y into the first equation, yields

( 12.5 ×Y ) ×Y =1250  2
12.5 ×Y =1250  2
Y =100

The equation Y 2=100 has two solutions

{ {
2
Y =+10 (+10) =( +10 ) × (+ 10 )=100
because
Y =−10 2
(−10) =(−10 ) × (−10 )=100

The variable Y cannot be negative because Y is real GDP. Therefore, we discard Y =−10 and keep
Y =10.

Determination of the equilibrium value of P

We know that the equilibrium value of is Y is10 . With this value of Y we return to the system (S)
to determine the equilibrium value of P . Using the second equation in the system (S), we find

P=1 2.5 ×Y =12.5 × 10=125

Therefore, the short-run equilibrium is

( Y , P )=( 10 , 125 ) ← Short−run macroeconomic equilibrium

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Topic # 16: Monetary Policy in Australia (Generalities)

Question 1

What are the three objectives of the Reserve Bank of Australia (RBA) established by the
Reserve Bank Act 1959?

Answer

 Objective 1: The stability of the currency

 Objective 2: The maintenance of full employment

 Objective 3: The economic prosperity and welfare of the people of Australia

Question 2

What is the cash rate? Why the cash rate is important?

Answerc\\;;;;

The interest rate that financial institutions charge on loans or pay to borrow funds in the overnight
money market is known as the cash rate.

The cash rate is important because it has influence on other interest rates such as, for example,
lending rates including personal loans, mortgage and credit cars.

Question 3

What is the inflation target band for monetary policy in Australia?

Answer

2−3 per cent , on average, over time.

Question 4

The inflation target band involves the observed value of the CPI inflation rate. The |¿|publishes
two CPI inflation rates. Which inflation rate is relevant for the RBA Board decisions? Why?

Answer

The CPI inflation rate relevant for monetary policy decisions is the underlying inflation rate.
Reason: the underlying inflation rate is the inflation rate resulting from the removal of items

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subject to exceptional circumstances. See Table 2 in Topic # 6.

Question 5

(a) What is the adjustment variable used by the RBA to comply with the agreement with the
government?
(b) Suppose the RBA decides to reduce the level of this variable. How would the RBA go
about this policy decision?

Answer

(a) The cash rate.

(b) Through open market operations, purchasing bonds.

Question 6

Why is the RBA interested in the behaviour of the Australian labour market?

Answer

The RBA pursues the lowest rate of unemployment that can be sustained without inflation
becoming an issue.

Question 7

The RBA uses the notion of spare capacity to evaluate the situation in the Australian labour
market. What are the four indicators to assess the spare capacity?

Answer

The indicators of spare capacity in the labour market are:

¿
Indicator 1: Gap between the actual unemployment rate and the NAIRU (U −U ), as well as the
underemployment rate.

Indicator 2: Flexibility of labour supply. There are of various sources of flexibility, including labour
force participation with particular regard to women and older Australians, net overseas migration,
and free mobility of workers between Australia and New Zealand.

Indicator 3: Matching of people with jobs, i.e. the comparison between people looking for jobs
and the jobs that are available.

Indicator 4: Wages growth

Question 8

Suppose that you are the governor of a central bank. The monetary rule you must follow is “When
the inflation rate is beyond 3% you must increase the policy rate.” You are facing two different
situations.

Initial Situation

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The currency-deposit ratio is a=0.20

The reserve-deposit ratio is b=0.05

The monetary base in the initial situation is B0=100 ($ billion)

The money supply in the initial situation (or “current level of the money supply”) is M 0.

Cash rate ¿ 4 %

New Situation

The currency-deposit ratio is a=0.20

The reserve-deposit ratio is b=0.05

The money supply in the new situation is M 1.

Underlying inflation rate 5 %

Headline inflation rate 2.5 %

Task 1  Refers to the Initial Situation

What is the value of the money multiplier in the initial situation?

Answer

Money multiplier

1+ a 1.20
mm= = =4.8
a+b 0.25

Task 2  Refers to the Initial Situation

What is the value of the money supply in the initial situation?

Answer

M 0=mm × B 0=4.8 × 100=480($ Billion)

Task 3

Assuming that you want to reach a level of the money supply M 1 equal to 720($ billion),
by how much you have to increase the monetary base B?

Answer

B0=100  Initial Situation

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 B1=?  New Situation

Money supply in the new situation is

M 1=mm × B1

but

M1 is equal to 720( $ billion),

so that

720=4.8 × B1

Consequently,

720
B 1= that is, B1=150
4.8

The increase in the monetary base is

∆ B=B1 −B 0=150−100=50

The monetary base B has to be increased by $ 50 billion.

Task 4  Refers to the New Situation

Faced with the New Situation, what would you do with the cash rate (increase, decrease
or leave the cash rate intact)?

Answer

Increase the cash rate because the underlying inflation rate is to the right of the target
band

2%  ^P  3%
Task 5  Refers to the New Situation

How would you increase the cash rate with open market operations?

Answer

Selling bonds.

Critical Thinking  NEW

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Question 8

You are the chief economist of an investment bank. Careful reading of the Appendices I and II of
Topic # 19 shows the RBA narrative boils down to the following sentence: The RBA Board will not
increase the cash rate until the underlying inflation rate is sustainably within the 2 to 3 % target
range. This narrative baffles the CEO of the investment bank in question and she asks you to
explain whether the RBA is following a fixed monetary rule or a discretionary approach to
monetary policy. How would you go about this?

Answer

At first glance, it appears that the RBA Board is following a fixed monetary rule. Nevertheless, it is
not. The key fuzzy word is “sustainably.” The RBA does not define the meaning of “sustainably
within the 2 to 3 % target range.”

Dr Philip Lowe has explicitly recognized this (intentional) ambiguity:

We do not have a specific a definition as to what “sustainably in the

target range’ means. The actual rate of inflation is relevant as are the
trajectory and the outlook. So too is the breadth of price increases and
the factors driving them.

Quotation from Lowe, Philip, ‘The Year Ahead’, Address to the National Press Club of Australia,
Reserve Bank of Australia, 02 February, 2022.

Topic # 17: The Phillips Curve

Question 1

The domestic price level Pdepends on the nominal wage W and other factors, denoted by ∝, such
as, for example, the cost of space on container ships, global factors such as import prices (e.g.
price of semiconductors), competition from abroad (actual and potential), slack in major
economies (not just at home), oil prices and other commodity factors. To separate the impact of
nominal wage from that of other factors, it is convenient to write the domestic price level as
follows:

P ( t ) =∝(t)× W (t )

This allows us to decompose the domestic inflation rate into two components. What are those
components?

Answer

Denoting the domestic inflation rate is denoted by ^

P, the two components are:

^
^P ( t ) =❑(t)+ ^ (t)
W where:
{^ )← rate og growthof other factors
❑(t
^ (t )← rate of growth of nominal wage
W

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Question 2

The Phillips curve is an empirical relationship between the unemployment rate U and inflation.
Inflation can be measured using price inflation ^ ^ (t). This, in turn, generates
P ( t ) or wage inflation W
two types of Phillips curves. Draw these curves using a two panel diagram.

Answer

Figure A shows two types of Phillips curve. The horizontal axis measures U in both panels.

Price Phillips curve {Vertical

Phillips curve
^
axis P

Wage Phillips curve { Phillips curve

^ (t)
Vertical axis W

In the left panel we see a Price Phillips curve and in the right panel we see a Wage Phillips curve.

Figure A

Topic # 17: Appendix

The Phillips Curve: History and Policy Implications

1. Brief History of the Phillips curve

Question 1

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A trade-off between unemployment U and inflation is called Phillips curve.

(a) A trade-off between U and price inflation, call it ^

P, is called Price Phillips curve. Who
discovered the Price Phillips curve?
^ , is called Wage Phillips curve. Who
(b) A trade-off between U and wage inflation, call it W
discovered the Wage Phillips curve?

Answer

Price Phillips curve: discover by Irving Fisher in 1926.

Wage Phillips curve: discover Alban W. Phillips in 1958.

2. Phillips Curve: Policy Implications

Question 2

Samuelson and Solow drew a policy implication from the Phillips curve and generated a debate
that it is still on today. What was that policy implication?

Answer

An unemployment-inflation trade-off was available for exploitation by policymakers.

 To reduce unemployment U policymakers must accept higher inflation ( ^

P ↑) .
 And vice versa, to reduce inflation ( ^
P ↓) , policymakers must raise unemployment (U ↑).

Question 3

Friedman and Phelps challenged the Samuelson-Solow policy implication. What was their
argument?

Answer

There is a trade-off between actual unemployment U and the inflation rate ^

P in the short-run but
not in the long-run.

Sacrifice Ratio

Question 4

Consider an economy that went to a process of disinflation for four years. As a result, 18.0
percentage points of annual GDP were lost and inflation fell 6.0 percentage points. What was the
economy’s sacrifice ratio? How would you interpret the number representing the sacrifice ratio.

Answer

The sacrifice ratio is the percentage of output lost for each 1 point reduction in the inflation rate:

Sacrifice ratio=s=
x
y
where: {x=% Y↓
^↓
y =% P

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In the present case,

{x=18 %
y=6 %

Therefore,

18 %
Sacrifice ratio=s= =3
6%

Reducing inflation by 1 percentage point requires a sacrifice of 3 per cent of a year’s GDP.

Question 5

If policymakers could reduce inflation without causing any recession at all, what would be the
value of the sacrifice ratio?

Answer

Sacrifice ratio ≈ 0

Rational Expectations

Question 6

According to the rational expectations approach, inflation can decline without a rise in
unemployment and fall in output. How come?

Answer

If policymakers are credibly committed to reducing inflation, rational people will understand the
commitment and will quickly lower their expectations of inflation.

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