Assignment 3: Problem Set ECON172

1. Please answer the following questions (chapter 29):

(a) Do you think a plastic credit card is considered as money? Explain your answers by discussing
each of the three functions of money.
No, I don’t think that a plastic credit card is considered as money. Credit cards are like a promise
to pay later. The three functions of money are medium of exchange, unit of account, and store of
value. Medium of exchange is what buyers give to sellers when purchasing an item. When using a
credit card, the buyer is not actually paying, but postponing the payment. Instead, the check or
balance in the checking account that is given to pay the credit card bill would be a medium of
exchange. Similarly, credit cards are also not a unit of account because credit can’t be used to post
prices and record debts. It is also not a store of value because credit cards don’t hold money so that it
can be used in the future.

(b) Suppose the required reserve ratio is 20%. What is the maximum amount of total money supply
that can be created from an initial deposit of $200? In general, why might the actual amount of total
money creation be less than the maximum?
If the required reserve ratio is 20%, the money multiplier, which is the reciprocal of reserve ratio,
is 5. For each dollar of reserve, the maximum amount of money that can be created is 5 dollars. With
an initial deposit of $200, the maximum amount of total money supply is 5*$200=$1,000. The actual
amount of total money creation may be less than the maximum because of three reasons. First, banks
may choose to hold excess reserves, or reserves beyond the required amount of reserves, so they are
less likely to run out of cash. Second, households may not be willing to make lots of loans. If not all
money left after banks keep required reserves are loaned, money is not created to its maximum. Third,
response to the deposit of $200 is not instantly made. The maximum money multiplier is calculated
under the assumption that the process of money creation continues infinitely to the third, fourth, fifth,
… bank, and so on, which we cannot expect to happen at once and to happen for surely.

(c) The Fed (central bank of the U.S.) is responsible for regulating the U.S. monetary system and
controlling the quantity of money — money supply — that is available in the economy. What are the
Fed’s tools of monetary control. Explain at least two tools.
The Fed’s tools of monetary control can be grouped into two – influencing the quantity of reserves
and influencing the reserve ratio. One way to influence the quantity of reserves is through open-
market operations. Open-market operations is the purchase and sale of U.S. government bonds by the
Fed. If the Fed wants to increase reserves, it buys bonds from the public sector. To decrease reserves,
the Fed sells bonds to the public sector. One way Fed influences reserve ratio is altering reserve
requirements. Increasing reserve requirements makes banks hold more money, so less money creation
is made. Decreasing reserve requirements allow banks to loan out more money, so money supply
increases. However, it may not be very effective because more banks now decide to hold excess
reserves.

2. Please answer the following questions (chapter 30):

(a) Explain the classical dichotomy and money neutrality.
Classical dichotomy is the assumption that nominal variables are separated from real variables.
Nominal variables are measured in monetary units but real variables are measured in physical units.
Therefore, nominal variables are affected by monetary system, but real variables like production are
affected by things like technology and is unrelated to money supply. Under classical dichotomy
monetary changes are irrelevant to real variables, and this proposition is called money neutrality.

(b) Based on those concepts in the above, a doubling of the money supply, holding all else constant,
causes prices to rise and real GDP to stay constant . Fill in the blanks.

(c) If inflation is less than expected, who benefits — debtors or creditors? Explain.
If inflation is less than expected, creditors benefit because they expected to get paid in dollars with
less value. However, since inflation is less than expected, the value of money decreases less than
expected. Therefore, they receive loan repayments in dollars that have higher value than expected. For
debtors, they are worse off because they have to pay in higher value money than expected.

3. Please answer the following questions (chapter 31 and 32):

(a) Last year country A‘s residents purchased $700 billion of goods and services from and sold $500
billion of goods and services to residents of foreign countries. Its domestic investment was $1,100
billion. What was country A‘s saving? Show your work.
In an open economy, Y=C+I+G+NX. Savings is Y-C-G, which equals I+NX. Therefore, savings
equals domestic investment + net exports. Imports is $700, exports is $500, domestic investment was
$1,100.
S = $1,100 + ($500 - $700) = $900.
Country A’s saving is $900.

(b) The nominal exchange rate is 32 Russian rubles per dollar. The price of a bushel of
wheat is 260 rubles in Russia and $7 in the U.S. What is the real exchange rate?
Show your work.
Nominal exchange rate (e) = 32 rubles per dollar
Real Exchange Rate (ε) = (32 rubles per dollar)*($7 per bushel of U.S. Wheat)/(260 rubles per bushel
of Russian Wheat)
=0.86 bushels of Russian wheat per bushel of U.S. corn.(rounded to second decimal point)

(c) (Bonus: 0.5 pts each) Suppose that Congress is considering an investment tax credit,
which subsidizes domestic investment.
i. How does this policy affect national saving, domestic investment, net capital outflow,
the interest rate, the exchange rate, and the trade balance? Use a graphical
approach to your answers.

Investment tax credit gives firms incentive to increase investment at any interest rate, therefore, shifts
the demand curve for loanable funds to the right. As a result, the real interest rate rises. Higher interest
rate attracts buyers of domestic assets. Therefore, net capital outflow decreases. The net capital
outflow determines the supply for foreign-currency exchange. Since less people want to buy foreign
assets, supply in foreign-currency exchange market shifts to the left. This causes real exchange rate to
appreciate. Appreciation in turn reduces net exports, so trade balance moves toward deficit.

ii. Representatives of several large exporters oppose the policy. Why might that be the case?
Several large exporters may oppose the policy because they are worse off from the policy since exports
decrease. To the country as a whole, the policy could increase investment and contribute to economic growth.
However, not all firms benefit from the policy as investment occurs in some parts of the economy. Because of
real exchange rate appreciation, large exporters cannot export as much as before. Their products have relatively
higher prices than products produced in foreign countries, and their competitiveness in international market is
low.