Money Supply Problem

You are hired by the Chair of the Federal Reserve to manage the trading desk at the New York Fed and the Chair tells you that he wants you to increase the money supply (M1) by 33 percent. He/she warns you to be careful because in these uncertain times, the money multiplier tends to become very unstable. He/she suggests that you stay ‘closely connected’ with the banking sector and he gives you a list of phone numbers to do so. Note that in this problem we are targeting the growth rate of M1.

Reserve Market

Initial Conditions

rr/D= .10

C = 400 b

D = 2000 b

ER = 00 (not a typo)

M = C + D

a) (6 points) Show your work!

i. Calculate the MB.

ii. Calculate the money multiplier.

iii. What is the money supply (use mm x MB to calculate this)?

So you decide to inject $100 billion in reserves via open market purchases with phone in hand. Recall, the Chair said to watch that multiplier and so you start making some calls. Just as you suspected, the banks aren’t making any loans, that is, they are sitting on all $100 billion in excess reserves.

b) (6 points) Given these new conditions, redo part a).

c) (6 points) Now the Chair calls and asks you how things are going and you tell him/her that you injected $100 billion in the system but it didn’t work. In the space below, write down what you would say to the chair (i.e., explain why the injection did not work).

Now you get some calls from bankers and you learn that there has been some ‘internal substitution’ within the M1 money supply. In particular, households prefer to hold more currency relative to deposits, i.e., the currency to deposit ratio rises. The numbers are as follows:

rr/D= .10

C = 800 b

D = 1600 b

ER =100 b

d) (6 points) redo part a)

e) (6 points) Now the Chair is not pleased with your work, and calls again. Assuming that the money multiplier is now stable (i.e., the value in part d), what must you do, in terms of open market operations, to hit the 33 percent money growth rate desired by the chair and the FOMC? Please show all work!

f) (10 points) Calculate the total percent change in the monetary base, the money multiplier, and the money supply (from part a) to part e)) and compare to the actual real world percent changes since this crisis began in August of 2007 to the end of 2010. Please use the following links and click “view data” on the upper left to obtain the actual real world values. For the monetary base start in August 2007 (this is monthly data), for the money multiplier start 8/15/07 (bi-weekly data) and for M1 start at 8/13/2007 (also weekly data)).

g) (20 points) Graphing exercise: In the space below, draw two diagrams with a graph of the Monetary Base on the left and the Money Supply on the right. Locate as point A, the conditions that prevailed in part a), locate as point B, the conditions that prevailed in part b), locate as point C, the conditions that prevailed in part d) and finally, locate as point D, the conditions that prevailed in part e). Helpful hints: don’t worry about labeling interest rates, the variable on the vertical axis, since there are none in this problem. Simply draw vertical lines (as we did in the lecture) labeling the value of the MB and MS on the horizontal axis with the appropriate points (A, B, C, D). If the curve doesn’t change (hint, this happens with MS but not MB), simply label it with the appropriate A = B or whichever applies.

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