CALCULATORS ARE ALLOWED

Part A: COMPULSORY QUESTION (70 marks)

1(i). Suppose the behavior of the broad-money supply process in the banking system of a hypotheticaleconomy is characterized by the following supply (Rs) and demand for cash reserves (Rd) model [in which all the relevant variables are as defined in class]:

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).

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 governments policy stance. Explain and illustrate your answers with the appropriate diagrams, where necessary. (15 points)

(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.

(15 points)

(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.

(5 points)

(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.

(15 marks).

(v) Under the relevant assumptions, use the Keynesian IS(GT)/LM framework to determine and explain the short run effects of the total policy package on the general equilibrium level of income (Y) and the level of the interest rate (R) in this economy. (5 points)

(vi) Under the relevant assumptions, use the Monetarist IS(GT)/LM framework to determine and explain the long run effects of the total policy package on the general equilibrium level of income (Y) and the level of the interest rate (R) in this economy.

(5 marks)

(vii) Now, suppose banks in this hypothetical economy hold borrowed reserves (BR), according to the following relation: BR/MB = 5[R - b]; in which, R and b are respectively the market interest rate and the bank rate (measured in fractional units)and MB is the initial value of the monetary base. If the bank rate is 2.5 per cent and the market rate of interest is 4 per cent, calculate the percentage changes in the values of borrowed reserves (BR) AND non-borrowed reserves (NBR) after the implementation of the policy package.

(5 marks)

(viii) Lastly, suppose there is a sudden adverse global economic shock that causes expected inflation to increase in this economy, what will be the likely short term and long-term effects on the money supply and the interest rates of this economy? [Hint: Recall the MP curve]. Explain carefully.

(5 marks)