1. Explain how each of the following events affects the monetary base, the M1 mo
ID: 1109003 • Letter: 1
Question
1. Explain how each of the following events affects the monetary base, the M1 money supply , and the M2 money supply of these respective countries (ignore the multiplier).
a)In the U.S., the Federal Reserve Bank buys US Treasury bonds in the open market.
b) The Chinese Central Bank raises the required reserves ratio for domestic commercial banks.
c) The European Central Bank (ECB)decreases the discount rate and banks in the Euro - Zone respond by borrowing from the ECB.
d) The Russian Central Bank sells part of its (U.S.Dollar) foreign currency (international) reserves to Russian commercial banks , in an effort to increase the value of the Ruble, the Russian currency
e) In Switzerland, individual savers react to the increase in the domestic real risk - free interest rate.
2. From 2007 to 2011 the U.S. monetary base increased by 200 percent, but M1 and M2 increased by 40 percent and 25 percent respectively. What do you think caused this explosion in the monetary base? Why do you think M1 and M2 did not increase by the same percentage as the monetary base?
3. The United States federal budget deficit is expected to continue to decrease during the 2015 fiscal year.
Using a graph and written explanations for all your answers, and keeping everything else equal, describe the effect of this fall in the deficit on the real loanable funds market:
a) What will happen, if anything, to the demand for real loanable funds? Why?
b) What will happen , if anything, to the supply of real loanable funds? Why?
c) What will happen to the equilibrium real risk - free interest rate?
4.Using a supply and demand graph as well as written explanations, explain what would happen to the demand, supply, and the equilibrium Real Risk -Free Interest rate (RRFR) in the domestic real loanable funds (credit) market for each of the following scenarios:
a.USA: Due to bright economic conditions, US consumers feel more confident about the future.
b.Colombia: Due to higher domestic interest rates, foreigners invest massively in Colombian government bonds (issued in Colombian Pesos).
c.Venezuela: Individuals convert their domestic savings into US dollars.
d.Canada: To boost domestic spending, the Canadian government imposes a 5% tax on all checking and near-money deposits.
Explanation / Answer
Monetary base includes total amount of money circulated which is in the hands of public and reserves deposted at central bank by commercial banks.
M1 is a measure of money supply that includes all physical money - both paper and coins - also assets which is very liquid such as checking account, demand deposit etc.
M2 is a measure of money supply that includes all elements of M1 as well "near money". Near money refers to those assets which is less liquid such saving depostis, long term deposits, securities etc.
1)
a) If federal reserves bank buys US Treasury bonds in the open market then it will reduces its monetary base because reserves deposited at federal bank would fall. This process of buying bonds from commercial banks would increase money supply which leads to fall in interest rates. With fall in interest rate more people would apply for loan or liquid asset such checking deposit. Hence, it will increase M1 money in the economy. As M2 money includes M1, so it M2 would also increase but at the same time with fall in interest would make people less likely to deposit money in savings account which would reduces "near money".
b) The Chinese Central Bank raises the required reserves ratio for domestic commercial banks would increase the monetary base as the reserves deposited at central bank by commercial bank increase. With rise of reserve ratio, money supply decreases which would increase the interest rate. With rise in interest rate, demand for highly liquid asset falls and hence M1 money falls. M2 includes M1 and near money, M1 falls but at the same time "near money" rises as people are more likely deposit money in savings account and invest money in long term assets.
c) The European Central Bank (ECB)decreases the discount rate and banks in the Euro - Zone respond by borrowing from the ECB would reduces reserves deposited at central bank, fall in reserves leads to fall in monetary base. Fall in monetary base would increase money supply in commercial bank, reduces the interest rate. M1 money would increase with fall in interest rate. As, M2 includes M1, it will also increases but "near money" would fall and shift to M1 as people fall shift from less liquid asset to highly liquid asset.
d) The Russian Central Bank sells part of its (U.S.Dollar) foreign currency (international) reserves to Russian commercial banks in exchage of domestic currency in order to appreciate the domestic currency by increasing the demand for it. This process of buying and selling would increase the Monetary base as more money would transfer from commercial bank to central bank. At the same time, lonable funds would fall which would increase the interest rate which would lead to fall in M1 money. M2 money would increase as demand for near money would increase.
e) With the rise of domestic real risk - free interest rate, currency in the hands of individual would reduce and demand for "near money" would increase. Fall in currency in the circulation would reduce the monetary base and M1 money. But with the rise of "near money" M2 will increase.
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