Money Demand =2500-100i Loanable Funds Demand = 1000 –100i Initial Reserves: $10

Question

Money Demand =2500-100i

Loanable Funds Demand = 1000 –100i

Initial Reserves: $100

GDP gap = -$500

Reserve Ratio: 5%

MPC=0.8

Tax Revenue: $200

Government Purchases: $200

1. What is the Money Supply in this economy?

2. What is the initial demand for Loanable funds/Investment?

Suppose that the Fed implements monetary policy to return the economy to equilibrium.

3. What value of bonds should the Fed buy/sell?

4. Suppose the Fed decides to change the reserve requirement instead. What will

the new reserve requirement be?(Round your answer to 2 decimals. You may use

results from before).

5. If the Government decided to change the tax, what will the new level of tax be?

6. Fiscal policy: What is the new level of government spending?

Please provide explanation on these answers to help me understand.

Thanks.

Explanation / Answer

(1)

Money supply = Initial reserves / Required Reserve ratio

= $100 / 0.05 = $2,000

(2)

Money supply = Money demand [Assuming money market is in equilibrium]

2,000 = 2,500 - 100i

100i = 500

i = 5%

So, initial money demand = 2,500 - 100i = 2,000 ( = money supply)

(3)

The economy is in disequilibrium because there is a negative GDP gap, indicating that

Potential GDP - Actual GDP = 500

So, Fed has to increase money supply by 500, to achieve the equilibrium which will increase actual GDP to the level of potentian GDP.

So, Fed has to buy bonds in open market worth $500 to increase money supply and restore equilibrium.

(4)

Revised money supply = $2,000 + $500 = $2,500

Initial reserves = $100

So, revised Reserve Ratio = Initial reserves / Revised money supply

= $100 / $2,500

= 0.04

= 4.00%

(5)

Alternatively, government may want to reduce tax to increase GDP by lowering taxes.

MPC = 0.8

So, MPS = 1 - MPC = 1 - 0.8 = 0.2

Tax multiplier = - MPC / MPS = - 0.8 / 0.2 = - 4

This tax multiplier of -4 means that, with every $1 decrease in taxes, GDP will increase by $4.

So, to increase GDP by $500, decrease in tax = ($500 / 4) = $125

So, tax has to decrease by $125.

New level of tax = $(200 - 125) = $75

(6)

Change in GDP = Change in government spending + Change in tax

$500 = Change in government spending + $125

Change in government spending = $(500 - 125) = $375 (Increase)

So, new government spending = $(200 + 375) = $575

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