Economics 102Professor McClelland

Fall 2007

Problem Set #8

DUE MONDAY, NOV. 5, IN LECTURE, URIS G-01

Problem sets are to be turned in at the beginning of the lecture.

Boxes will be provided at the back of Uris G-01.

Place your problem set answers in the box with your TA’s name and section on it.

No credit will be given for late problem sets.

  1. If you expect interest rates to rise in the future, you should:
  1. buy bonds now because as the interest rate rises, bond values rise.
  2. buy bonds now because the opportunity cost of money will fall as the interest rate rises.
  3. hold onto cash now because as the interest rates rise, bond values fall.
  4. lend money now, because you will be making less money lending in the future.
  1. Suppose only three goods are used to calculate the Consumer Price Index (CPI): rice, shirts and books. Prices for these goods are noted below, as are the quantities used for constructing a CPI. (The quantities represent the annual consumption of a typical urban family of four.)

Year 1 / Year 2
Unit Price / Quantity / Unit Price / Quantity
Rice (per bag) / $2.00 / 35 / $3.00 / 40
Shirts / $19.00 / 20 / $28.00 / 10
Books / $35.00 / 10 / $40.00 / 15

If the quantities of year 1 are used to calculate the price index, what is the rate of inflation between year 1 and year 2?

OVER

Economics 102Problem Set #8

  1. Let:

C = consumption, I = investment spending, G = government spending, Tx = tax revenue, Y = national income, MS = money supply, MD = money demand (LP), i = interest rate.

Assume for a given economy:

(i)consumers spend $400 billion plus 90% of after-tax income, or

,

(ii)investment demand varies inversely with the interest rate, such that

,

(that is, if the interest rate is 10%, investors want to invest $700 billion minus 10% of $2,000 billion, or $500 billion in total),

(iii)currently government spending and taxes are both equal to $200 billion, or

,,

(iv)the total money demand or liquidity preference schedule for this economy is an inverse function of the rate of interest and is given by the equation

,

(that is, if the interest rate is 10%, the demand for money will be $800 billion minus 10% of $1,000 billion, or $700 billion in total),

(v)the required reserve ratio for banks in this economy is 15%. No bank holds excess reserves, and everybody keeps their money in the bank. The total of reserves in the banks is $90 billion.

FOR EACH ANSWER TO THE FOLLOWING QUESTIONS,SHOW ALL YOUR WORK.

  1. (a) What is the total money supply? (HINT: begin with (v) above.)

(b)What is the equilibrium interest rate? (HINT: it is the result of supply of and demand for money.)

(c)What is the equilibrium level of national income?

  1. The economy is in a slump and the head of the central bank wants to increase the equilibrium level of national income to $10,000 billion using open market operations. Should she (the head of the central bank)buy or sell bonds to achieve this goal? How much in bonds (give a dollar figure) should shebuy or sell?