Indicate whether each of the following statements is true, false or uncertain and explain why. Most of the marks depend on the quality of the explanation unsupported answers will receive little or no marks. Each question is worth 5 marks for a total of 20 marks.

(1)The current pandemic has caused households to pull back on spending and increase their savings. This could actually lead to higher growth in GDP per capita in long run.

False, Because

(2)The same factors that cause wages and salaries to adjust slowly (or not at all) in a recessionary gap will also cause long run adjustment in an inflationary gap to be slow.

False

(3)If the Bank of Canada purchases $5 million worth of government bonds and the total supply of money in circulation in the economy rises by $80 million, the implied reserve ratio of commercial banks must be 16%.

(4)Even if a bank is in a stable financial position, a mistaken belief that the bank is in financial trouble can actually cause the bank to collapse.

Table 1: First Canada Bank

Total Assets

Total Liabilities and Capital

Reserves

400

Deposits

8000

Gov't Bonds

1000

Loans

7400

Capital

800

Total

8800

Total

8800

Part B: Long Questions

Answer the following two multi-part questions. Each question is worth 10 marks for a total of 20 marks.

1. Consider an economy with one commercial bank, First Canada Bank, whose balance sheet is described in Table 1.

(a)Determine the reserve ratio of First Canada Bank and the initial money supply in the economy.

(b)Suppose that 1000 in loans from First Canada Bank are found to be toxic (ie, they will not be paid back.) Explain carefully why this could cause a run on the bank.

(c)Now suppose that all of the bank's loans are in good condition. The Bank of Canada (the central bank that oversees First Canada Bank) purchases $100 in government bonds using newly created money. After the money multiplier process is completed, what will be the new level of the money supply in the economy and what will be the total amount of loans on First Canada Bank's balance sheet?

(d)Finally suppose that instead of purchasing government bonds, the Bank of Canada sells 50 in government bonds to First Canada Bank. After the money multiplier process is completed, what will be the new level of the money supply in the economy and what will be the total amount of loans on First Canada Bank's balance sheet?

2. Suppose the Bank of Canada wants to use monetary policy to affect the level of

GDP in Canada. Assume that initially GDP is at its potential level, so that Y*=Yp

(a)Explain how a decrease in the money supply Ms affects the price of bonds.

(b)Explain how this change in the price of bonds affects the interest rate in the economy.

(c)Explain how the resulting change in the interest rate affects the equilibrium level of GDP. Use an AD-AS diagram in your answer.

(d) Does the monetary policy described above lead to a permanent change in equilibrium GDP? Why or why not?