Problem Set #4 (Due: Monday 4/17/17 in class)
Directions: Show all work and label your answers clearly. Please staple your problem sets.
Quantity Theory of Money
1. (Former exam question) For the following problem, assume the following: velocity = 5, the money supply=100, and real output = 50.
a) What must be the price level according to the quantity theory of money?
b) If real output is growing by 3%, prices are growing at 8% and velocity is constant, what must be the growth rate of the money supply next year?
c) Describe what open market operation the Federal Reserve could pursue to increase the money supply. Also describe carefully how and why (nominal) interest rates are affected by the Fed’s actions.
d) If banks hold just the required reserve ratio (equal to 10% of deposits) and the public desires to hold 10% of its deposits as currency, what would be the effect of an open market purchase of bonds from the public equal to $100 on the money supply, prices, output, velocity and money demand (according to the classical model)?
2. The October 4, 2007 New York Times article entitled “Gold, Oil Rise as Dollar Declines Again” states:
“After the U.S. government reported an uptick in jobless claims and the
biggest drop in factory orders in seven months, the dollar fell against the
euro. At the same time, the euro got a slight boost when the European
Central Bank agreed to keep interest rates steady at 4 percent. The was
widely expected, but some political and business leaders had called for
a rate cut -- which would have made the euro less attractive to invest in.”
a) Explain using the supply and demand model for the dollar why higher weak U.S. jobs and output numbers might cause the value of dollar to fall. Illustrate your answer graphically.
b) Explain using the supply and demand model for the dollar why an ECB interest rate cut would lead to a stronger dollar. Illustrate your answer graphically.
3. In 1998, Russia had a financial crisis as a result of its default on government bonds.
a) Explain and show graphically the effects of the crisis on the value of the ruble.
b) Explain and show graphically how the Russian government could intervene to try to stabilize the value of the ruble. Also explain why such an intervention might fail.