SCHOOL OF ECONOMICS
ECONOMICS 100.1
Introduction to Macroeconomic Theory and Policy
Problem Set No. 5
I. True or False. Determine whether the following statements are true or false. If false, explain briefly in one sentence.
1. Monetary policy is effective with perfectly flexible wages and prices.
2. Monetary policy is always more effective in an open economy than a closed economy.
3. The primary economic function of the financial system is to match one person’s saving with another person’s investment.
4. On the basis of the transactions demand component of the demand for money the demand for money falls as nominal
income falls.
5. The “excess reserves” of a commercial bank consist of money held by the bank in excess of that fraction of its deposits
required by law.
6. The “demand for money” means the same thing as the sum of “assets and transactions demand for money.”
7. Two assumptions are made with the money-supply multiplier: that all money remains in checking accounts, and that no
banks retain excess reserves.
8. The commercial bank is the main financial institution that creates checkable money, mostly in the form of demand deposits.
9. The contraction of the money supply tends at first to make money "tight"-more expensive and less available.
10. An increase in the discount rate would be a signal of a tightening in the money supply.
III. Essay.
1. There are three main operations of Central Bank. Describe and explain the short run effects of the following activities of the
Central Bank to the economy. Assume that the economy is closed.
a.) The Central Bank decided to increase bank reserves through open-market operations.
b.) The Central Bank decided to temporarily increase the interest rates. How about temporary increase in discount rates? Make
sure to explain the effects of the interest and discount rate policies during its implementation and after its termination.
c.) The Central Bank implemented a permanent decrease in the reserve-ratio requirements on deposits with banks and other
financial institutions.
ANSWERS
T of F
1. F – If prices and wages are perfectly flexible, inflation can occur. This can be shown graphically using
the classical model of the macroeconomy with a vertical supply curve. Inflation will occur without any
increase in output.
2.F – Not necessarily because the monetary policy can also negatively affect exports and imports.
3. T
4. T
5. T
6. T
7. T
8. T
9. T
10. T
6. P70
7. P1,009
8. P110
9. P10,000
10. P40 and P4 respectively
III. Essay
A. With an open market transactions: Increase reserves -> increase MS -> decrease interest rates ->
increase investments and increase consumption -> AD increase -> GDP increase + inflation.
B. During implementation: Increase interest rate -> decrease investments -> AD decrease -> GDP
decrease + deflation
After implementation: Investments will go back to pre-policy levels (increase investments) -> AD
increase -> GDP increase + inflation but take note that the level of GDP before the policy is implemented
is the same as after its terminations
C. Decrease reserve-ratio requirement -> increase MS -> decrease interest rates -> increase
investments and consumption -> AD increase -> GDP increase + inflations