University of Michigan

Econ 102: Principles of Macroeconomics

Spring 2024
Instructor: Oleg Zamulin

Problem set 5
Suggested answers

1. Suppose that Fed wants to increase the money supply. Explain the mechanism of how each of
the following actions would help achieve that goal.

a. The Fed buys a bond in the open market from a Wall Street trader

Answer: This would directly increase the monetary base. When the Fed buys a bond, it
issue new cash and injects it into the system.

b. The Fed lends money to a bank through a discount window

Answer: The money is lent to a bank and becomes bank reserves, which is not part of
money supply, so initially the money supply is unchanged. But then banks would use
those reserves to make loans, which then become someone’s deposits or cash holdings,
which is money supply.

c. The Fed lowers the required reserve ratio

Answer: This increases the money multiplier, as banks now can use the same amount of
reserves to give out more loans.

d. The Fed lowers the interest rate on excess reserves

Answer: If this interest rate is lowered, the banks would be less interested in holding
excess reserves and will increase their lending. The reserve ratio will fall, money
multiplier will increase, and so will the money supply.

2. Suppose banks hold 20% of their deposits in reserves and people hold no cash on hand except
for cases specifically indicated below.

a. What is the money multiplier in this economy?

Answer: the general formula for the multiplier is (cr+1)/(cr+rr). Here cr = 0, rr = 0.2,
hence money multiplier is 5.

b. Suppose the Fed sells a bond worth $1,000 in the open market. By how much would the
money supply ultimately change?

Answer: The monetary base decreases by $1,000, and the money supply decreases by
$5,000. The intuition is that bank reserves go down by $1,000, which immediately brings
 down the reserve ratio. To recover the reserve ratio back to the desired 0.2, banks need
to reduce their lending, which in turn reduces the amount of deposits in the economy.
Deposits need to go down by $5,000 to restore the reserve ratio.

c. Suppose the Fed lends $1,000 to a bank through the discount window. By how much
would the money supply ultimately change?

Answer: This time monetary base increases by $1,000, so money supply goes up by
$5,000. At first, bank reserves go up by $1,000, but deposits do not increase. Banks are
free to lend out the whole $1,000, which they do, creating $1,000 of deposits. At the next
step, only $1000×0.8 = $800 will be lent out, then $1000×0.82 = $640, and so on, until
the money supply ultimately increases by $5,000.

d. Suppose one person withdraws $1,000 from her bank account and puts it into her
wallet. By how much would the money supply change in this case? In your answer,
assume that the effect of this one transaction on currency ratio is negligible, so cr
remains at 0.

Answer: When the $1,000 was in the bank, it could be loaned out and would ultimately
generate the money supply of $5,000. But after it is withdrawn, bank reserves fall by
$1,000, so banks no longer keep 20% of deposits in reserves as they want to. Then, they
reduce their lending to recover their reserve ratio, and ultimately the amount of deposits
in the system goes down by $5,000 since the money multiplier is 5. However, now there
is extra $1,000 of cash in the system, so the total effect on the money supply is -$4,000.

e. Now suppose that banks decide to keep 10% rather than 20% of their deposits in
reserves. What would happen to the money supply in such a situation?

Answer: The money multiplier will become 10, so the money supply will double.

f. Now suppose banks again keep 10% of their deposits in reserves, but instead people
decide to keep 20% of their money as cash. What happens to money supply in such a
situation?

Answer: This means that currency ratio cr changes. It is tempting to think that now
cr=0.2, but remember that cr = C/D. 20% in cash means that out of each dollar, people
hold 20 cents in cash and 80 cents in deposits, so cr = 20/80 = 0.25. This makes the
money multiplier (cr+1)/(cr+rr) = 1.25/0.35 = 3.57 instead of 5. So the money supply will
shrink to 3.57/5 of what it was originally.

3. The Fed and other central banks normally operate through targeting interest rates, rather than
money supply. The primary interest rate the Fed targets is called the Federal Funds Rate, the
rate banks charge each other at the interbank market.

a. The Federal Funds Rate is a market rate, so the Fed does not control it directly. How
then can the Fed target it?
 Answer: The Federal Funds Rate reflects supply and demand of liquidity in the banking
system. If the rate is high, that means there is a shortage of liquidity, if it is low, that
means there is excessive liquidity. The Fed can inject or withdraw liquidity from the
system via open market operations, thus affecting its supply and influencing the Federal
Funds Rate.

b. Suppose the Fed wants to lower the Federal Funds Rate. What does it do to achieve that
goal and why can this be considered equivalent to increasing the money supply?

Answer: To lower the rate, the Fed needs to inject liquidity, so it buys bonds in the open
market. This increases the monetary base and then leads to an increase in the money
supply. Hence, lowering the rate and increasing money supply are two sides of the same
coin.

4. Consider the implications of the quantity equation, MV = PY.

a. Suppose economy grows at the rate of 3% per year in real terms. Assume velocity of
money is constant. The Fed wants to target zero inflation. What rate of money growth
should the Fed target to achieve this goal?

Answer: We know that %∆M + %∆V = %∆P + %∆Y. It is given that %∆Y = 3 and %∆V = 0.
Inflation is %∆P and Fed wants it to be 0. Then the Fed should increase the money supply
by 3% per year.

b. Now suppose that M = 1000, V = 4, Y = 1000. Assume perfect monetary neutrality.

Suppose the Fed increases money supply by 10%. Calculate the initial and the new price
levels in this economy.

Answer: initially, from equation MV = PY, we have P = MV/Y = 1000×4/1000 = 4. With

perfect monetary neutrality, V and Y do not respond to changes in M. Hence, 10%
increase in M will lead to 10% increase in P, so P will become 4.4.

c. Continue with example in (b) but suppose that in response to increase in M by 10% V
increases to 5.
i. Why would V increase in response to growth in M?

Answer: V is velocity of money, shows how quickly people get rid of it and spend
on consumption of goods and services. If M increases, people may start to
anticipate inflation, which could decrease their demand for money and increase
its velocity, as people will want to get rid of money more quickly.

ii. What would be the new price level in this situation?

Answer: Money increased by 10%, so M = 1100. V is now 5. Y is still 1000. So P =

P = MV/Y = 1100×5/1000 = 5.5

5. Suppose that a government does not know how to collect taxes, but needs to raise $10,000 for
its expenditure. The current money supply in the economy is $1,000,000. To finance its
 expenditure, the government prints extra $10,000, causing a proportional rise in prices (assume
V and Y remain unchanged).

a. Explain why this is frequently called an “inflation tax”. By how much (in dollars) does the
real value of people’s money holdings go down?

Answer: The government now has extra $10,000, but people’s money holdings lose value
because of inflation. Since money supply increases by 1%, prices also rise by 1%, so the
money people hold loses 1% of its real value. 1% of $1,000,000 is $10,000, which is thus
the amount people effectively lose. Note that this is exactly the amount of money the
government “collected”. Government gets money, people lose the same amount, so this
makes it a form of taxation.

b. Explain the benefit and shortcomings of inflation tax relative to other taxes.

Answer: The only real benefit of the inflation tax is that it is easy to collect. Otherwise, it
is generally a bad thing. It causes inflation, which is bad for a number of reasons
described in the next question. Moreover, this tax hurts the poor more than the rich,
because the rich generally have better access to financial instruments that would protect
them from inflation. At the same time, certain moderate inflation is actually desirable,
so the government can collect a part of its revenues using the inflation tax.

6. Inflation is generally considered to be a bad thing. Explain why it is bad and why central banks
do not then target zero inflation.

Answer: There are a number of reasons why inflation is bad.

1) It creates inconveniences for people who need to protect themselves from inflation
using interest-bearing financial instruments, and for firms who are forced to change
prices frequently (shoe leather and menu costs)
2) It distorts relative prices, making investment decisions difficult
3) It increases the risk premium in nominal interest rates, making borrowing more
expensive and thus depressing investment
4) To the extent that inflation is unexpected, it unfairly redistributes wealth from
lenders to borrowers.
5) It increases taxation of savings, because taxes are applied to nominal interest rates
and capital gains, even if real returns on savings are zero or negative.

At the same time, deflation is also a bad thing. Most importantly, once the economy is in
deflation, people start spending less in anticipation of falling prices and thus reduce
aggregate demand. Depressed demand leads to yet more deflation and thus economy
gets caught in a vicious circle of falling prices and demand. To avoid the risk of falling
into such a situation, central banks target inflation above zero.