Question 2: Targeting the rate of interest and changes in bank reserves (40 points) Suppose that the demand for money function was M = 4y - 1000 i where Mo is the quantity of money demanded, i is the rate of intest (an interest of 5 means 5 percent in this problem), and Yis real national income, which currently is 1500. The supply of money is 1000, currency in circulation outside the banking system is 100, the target reserve ratio is 10 percent, there is no cash drain in the banking system, and the recessionary gap is 250.The price level does not change in this problem. 1. What is the equilibrium value for the intest rate? What is the level of cash reserve of the banking system? 2. Suppose that the Bank of Canada estimates that a reduction of the rate of interest to 4 percent would move the economy to full employmentGiven this estimate, what would be the quantity of money demanded at full employment? 3. Suppose the Bank of Canada reduces the target for the overnight rate, prompting commer- cial banks to reduce the market rate of interest to 4 percent. Are the commercial banks experiencing a situation of excess cash reserves or of too little cash reserves? What is the size of this excess/insufficient cash reserve when Y = 1500? 4. What will the commercial banks do to eliminate excess/insufficient cash reserves? By how much should the level of cash reserves of the banking system change for the economy to move to full employment? Question 2: Targeting the rate of interest and changes in bank reserves (40 points) Suppose that the demand for money function was M = 4y - 1000 i where Mo is the quantity of money demanded, i is the rate of intest (an interest of 5 means 5 percent in this problem), and Yis real national income, which currently is 1500. The supply of money is 1000, currency in circulation outside the banking system is 100, the target reserve ratio is 10 percent, there is no cash drain in the banking system, and the recessionary gap is 250.The price level does not change in this problem. 1. What is the equilibrium value for the intest rate? What is the level of cash reserve of the banking system? 2. Suppose that the Bank of Canada estimates that a reduction of the rate of interest to 4 percent would move the economy to full employmentGiven this estimate, what would be the quantity of money demanded at full employment? 3. Suppose the Bank of Canada reduces the target for the overnight rate, prompting commer- cial banks to reduce the market rate of interest to 4 percent. Are the commercial banks experiencing a situation of excess cash reserves or of too little cash reserves? What is the size of this excess/insufficient cash reserve when Y = 1500? 4. What will the commercial banks do to eliminate excess/insufficient cash reserves? By how much should the level of cash reserves of the banking system change for the economy to move to full employment
