Suppose that the demand for money function was MD = 4Y 1000i where MD is the quantity of money demanded, i is the rate of intest (an interest of 5 means 5 percent in this problem), and Y is 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.

a) Suppose the Bank of Canada reduces the target for the overnight rate, prompting commercial 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?

b) 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?