1(i). Suppose the behavior of the broad-money supply process in the banking system of a

hypothetical economy is characterized by the following supply (Rs) and demand for cash

reserves (Rd) model :

Rs = MB = Rd = C + BCRT (equilibrium condition);

BCRT = RR + ER (definition of total bank reserves)

C = 0.25D (currency holdings of the non-bank public)

RR = RRd + RRt [total desired cash reserves against bank deposits]

RRd = 0.05D (desired cash reserves against demand deposits)

RRt = 0.02T (desired cash reserves against term deposits)

T = 0.8D (definition of term deposits)

ER = ER d + ER t [total idle excess reserves held against bank deposits]

ER d = 0.002D (idle excess reserves held against demand deposits)

ER t = 0.001T (idle excess reserves held against term deposits).

M1 = C + D

M2 = C + D + T

D = Deposits

M1 = MB [1 + c]/ [c + RRd + RRt +ERd + ERt]

currency/deposit ratio (c) = C/D

Given that the economy is facing severe unemployment pressures, the government

implements an expansionary fiscal policy to stimulate the economy by decreasing taxes

and, as an indirect effect, the currency/deposit ratio (c), drops to 20%.

If the narrowly-defined money supply (M1) in existence is $2550 million, first, find the

initial monetary base and the value of the broadly defined money supply (M2) and, then,

calculate the percentage changes in the equilibrium values of the narrow (M1) and broad

money (M2) supplies because of the government's policy stance. Explain and illustrate

your answers with the appropriate diagrams, where necessary.

(ii) Calculate the percentage changes in the equilibrium values of both the narrowly

defined and broadly defined money supply if the central bank had used INSTEAD an

expansionary unconventional monetary policy by purchasing both private sector and

federal government securities in the financial market worth $500 million. Explain and

illustrate your answers with the appropriate diagrams, where necessary.

(iii) Which of the two policies will have the most effect on the equilibrium interest rate in

the short run? Why? Explain and illustrate your answers with the appropriate diagrams,

where necessary.

(iv) If BOTH POLICIES are used SIMULTANEOUSLY to deal with the problem in this

economy, calculate the percentage changes in (a) the monetary base; (b) total bank

reserves; (c) the narrow money supply; and (d) the broad money supply. Comment on

your answers.