ECON1002 TUTORIAL 7

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ECON1002 Introductory Macroeconomics, Semester 2, 2024 1

Tutorial Tasks

READING GUIDE: REVIEW WEEK 6 LECTURE AND TEXTBOOK CHS 9 AND 10. Also, Review Week 6 Lecture Supplement and the related articles.

Key Concepts: Bank creation of money; the Quantity Theory; Open market operations; The Reserve bank and interest rate targeting, Policy reaction function, Monetary policy in the Keynesian model.

REVIEW OF CONCEPTUAL UNDERSTANDING

These are to be attempted before the tutorial. They will not normally be covered in the tutorial, maybe, except for a quick review, time permitting. The answers are typically found in the textbook and lecture notes.

  1. What is money? Is cryptocurrency money?
  2. Why is it important for the Quantity Theory that the velocity of circulation be constant? Is it likely that the velocity of circulation is constant? Explain.
  3. What do you understand by the open market operations?
  4. How is monetary policy conducted though setting interest rates?
  5. Define policy reaction function. Sketch a policy reaction function relating to the Reserve Bank’s setting of the real interest rate.
  6. What is the mechanism by which monetary policy affects the economy?

PRACTICE PROBLEMS (FOR IN – CLASS DISCUSSION)

STUDENTS SHOULD BE PREPARED TO PRESENT ANSWERS TO THE PROBLEMS WITH AN ASTERISK (*).

N.B. THERE ARE 3 PROBLEMS WITH * THIS WEEK. ANY TWO PROBLEMS WITH * CAN BE CHOSEN FOR STUDENTS TEAM BASED PRESENTATION.

  1. During World War II an Allied soldier named Robert Radford spent several years in a large German prisoner – of – war camp. At times more than 50,000 prisoners were held in the camp, with some freedom to move about within the compound. Radford later wrote an account of his experiences. He described how an economy developed in the camp, in which prisoners traded food, clothing and other items. Services, such as barbering, were also exchanged. Lacking paper money, the prisoners began to use cigarettes (provided monthly by the Red Cross) as money. Prices were quoted, and payments made, using cigarettes.
  1. In Radford’s POW camp, how did cigarettes fulfil the three functions of money?
  2. Why do you think the prisoners used cigarettes as money, as opposed to other items of value such as squares of chocolate or pairs of boots?
  3. Do you think a non – smoking prisoner would have been willing to accept cigarettes in exchange for a good or service in Radford’s camp? Why or why not?

TUTORIAL 7 (Week beginning Sept. 16)

ECON1002 Introductory Macroeconomics, Semester 2, 2024 2

Tutorial Tasks

  1. Real GDP is $8 trillion, nominal GDP is $10 trillion, M1 is $2 trillion, and M3 is $5 trillion.
  1. Find velocity for M1 and for M3.
  2. Show that the quantity equation holds for both M1 and M3.

*3. When a central bank increases bank reserves by $1, the money supply rises by more than $1. The amount of extra money created when the central bank increases bank reserves by $1 is called the money multiplier.

  1. Explain why the money multiplier is generally greater than 1. In what special case would it equal 1?
  2. The initial money supply is $1000, of which $500 is currently held by the public. The desired reserve – deposit ratio is 0.2. Find the increase in money supply associated with increases in bank reserves of $1, $5 and $10. What is the money multiplier in this economy?
  3. Find a general rule for calculating the money multiplier.
  4. Suppose the Reserve Bank wanted to reduce the money multiplier, perhaps because it believes that change would give it more precise control over the money supply. What action could the Reserve Bank take to achieve its goal?

*4. An economy is described by the following equations:

C = 2,600 + 0.8(Y – T) – 10,000r

IP = 2,000 – 10,000r

G = 1,800

NX = 0

T = 3,000.

The real interest rate, expressed as a decimal, is 0.10 (that is, 10 percent).

  1. Find a numerical equation relating planned aggregate expenditure to output.
  2. Solve for short run equilibrium output. Show your results graphically using the Keynesian cross diagram.
  1. Consider the economy as described in terms of the equations in Question 4 above.
  1. Potential output Y* equals 12,000. What real interest rate should the Reserve Bank set to bring the economy to full employment? You may take as given that the multiplier for this economy is 5.

ECON1002 Introductory Macroeconomics, Semester 2, 2024 3

Tutorial Tasks

  1. Repeat part (a) for the case in which potential output Y* = 9,000.

*6. Suppose the Reserve Bank follows the following policy reaction function.

Rate of inflation, π Real interest rate set by Reserve Bank, r
0.00 0.02 (= 2%)
0.01 (= 1%) 0.03
0.02 0.04
0.03 0.05
0.04 0.06

For this economy, the relationship between short – run equilibrium output Y and the real interest rate r set by the Reserve Bank is given by

Y = 1,000 – 1,000r.

Potential output is Y* = 960. What can you infer about the Reserve Bank’s objective for the inflation rate in the long – term?

Some questions on monetary policy issues for in – class discussion

  1. What is the zero lower bound? Why does it cause problems for monetary policy?
  2. Why do central banks adopt inflation targeting? What are the pros and cons?