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ECONOMICS A02Y - INTRODUCTORY ECONOMICS (A Mathematical Approach) Fourth In-Class Test: March 15, 1999 – Answers 1. All banks hold 5% in reserves. There is a deposit of $100,000 to the bank; this bank holds $5,000 in reserves and makes $95,000 of additional loans. This $95,000 constitutes an increase in the money supply created by this bank on its own. Unless additional money is deposited in this bank, its role in the money creation process stops there. The correct answer is (P). 2. The increase in the money supply brought about by Scrooge McDuck’s deposit of cash into the banking system can be calculated as 1/R x $95,000 = $1,900,000. All of this increase in the money supply comes about through an increase in loans by banks. In other words, the total increase in the amount of loans throughout the economy is $1,900,000. The correct answer is (P). 3. The central bank sells $5,000 of bonds. A citizen buys the bonds with money from a chequing deposit. The initial effect is to reduce reserves in the Munchkinland Bank by $5,000. Deposits have fallen to $195,000. The Bank obviously has fewer reserves than its desired ratio of 5%. It will have to retire and call in loans to bring its reserves back to the desired ratio. The eventual reduction in deposits will be 1/0.05 x $5,000 = $100,000. At this point, the new level of deposits will be $100,000, and the reserves of $5,000 will be just sufficient to meet the desired ratio. The correct answer is (O). 4. The Central Bank buys $100,000 worth of Treasury Bills. This will initially increase chequing deposits in the Bank of Munchkinland by $100,000. After the multiple expansion of loans and deposits takes place, there will be 1/0.05 x $100,000 = $2,000,000 of additional deposits. Together with the original amount of $200,000 of deposits, there will be $2,200,000 of deposits in the chartered bank. The correct answer is (W). 5. C = 100 + 0.9(Y – TA + TR) = 100 + 0.9(Y – 0.16Y + 150 – 0.4Y) C = 100 + 0.9Y – 0.144Y + 135 – 0.36Y = 235 + 0.72Y AE = C + I + G + (X – IM) = 235 + 0.72Y + 300 + 270 + 245 – 0.22Y = 1050 + 0.5Y The condition for equilibrium is AE = Y or Y = 1050 + 0.5Y Therefore, Y – 0.5Y = 1050 or Y* = 1/0.5 x 1050 = 2,100. The correct answer is (O). 6. The Government Budget Balance is defined as GBB = TA – TR – G, which is 0.16(2100) – 150 + 0.4(2100) – 270 = 336 – 150 + 84 – 270 = 0. The correct answer is (L). 7. The actual deficit is zero. The structural deficit can be found by evaluating the GBB function at Potential GDP. The GBB function is GBB = 0.16Y – 150 + 0.4Y – 270 = -420 + 0.2Y. At Potential GDP = 2,500, the GBB = -420 + 0.2(2,500) = +80. In other words, there is a structural surplus of 80. The cyclical deficit can be found as the actual GBB minus the structural GBB or 0 – 80 = -80. In other words, there is a cyclical deficit of 80. The correct answer is (Y). 8. AE = 0.9(Y – 0.2Y) + 120 + G0 + 180 – 0.12Y = 0.6Y + 300 + G0 In equilibrium, AE = Y or Y = 0.6Y + 300 + G0 Y – 0.6Y = 300 + G0 or Y* = 1/0.4 x (300 + G0), or Y* = 750 + 2.5G0. When G0 = 100, Y* = 1,000. If potential GDP = 1,200, there is a recessionary gap of 200. The correct answer is (G). 9. Since Y* = 750 + 2.5G0 and Potential GDP = 1,200, we can find the appropriate amount of Government spending by: 1,200 = 750 + 2.5G0, or G0 = 450/2.5 = 180. The correct answer is (I). 10. Y* = 750 + 2.5G0 and GBB = TA – TR – G = 0.2Y – G0 = 0, so G0 = 0.2Y. Substituting the second equation into the first, we have Y* = 750 + 2.5(0.2Y) = 750 + 0.5Y. Therefore, 0.5Y = 750, or Y = 1,500. This is the level of Y that will balance the government’s budget. To find the level of G0 use G0 = 0.2Y = 0.2(1,500) = 300. The correct answer is (O). 11. The technological change will cause a shift to the right of the Aggregate Supply Curve. The new equilibrium will be down and to the right on the existing Aggregate Demand Curve (a movement along the AD curve) where the new Aggregate Supply curve crosses AD. The correct answer is (G). 12. Monetary policy can be affected by the “You can lead a horse to water but you can’t make him drink” effect (you can lower interest rates, but businesses may not be willing to spend more, in the depth of a recession), and by the liquidity trap (you may not be able to lower interest rates, if citizens are willing to hold onto any additional money supply created). The correct answer is (F). 13. If citizens change the amount of currency they want to hold (relative to the amount of bank deposits they want to hold), this will change the amount of deposits held in banks and therefore change the money supply. If chartered banks decide to hold excess reserves, this will reduce the amount of loans they give out and will reduce the multiplied effect of any changes in the amount of deposits: This will change the money supply. The correct answer is (F). 14. A rise in nominal wages can eliminate an inflationary gap. When wages rise, this shifts the SRAS to the left, and if it continued, the inflationary gap will eventually be eliminated. A rise in the interest rate will reduce several types of spending, shifting the AD curve to the left (investment spending, consumer spending, and net exports through a change in the exchange rate). This could also eliminate an inflationary gap. The correct answer is (F).