QUIZ 5: Macro – Spring 2009
Name: ______________________
Section Registered (circle one) T/Th 8:30-10:00 T/Th 10:00-11:30 T 6:00-9:00
Question 1 (12 points – 3 points each)
In this question, we will explore the link between the banking system and the aggregate money supply in the economy. Given the assumptions below, you should answer the subsequent parts to this question. All answers are numbers. Lastly, throughout the problem, assume the bank can adjust total loans (TL) freely if they want (i.e., they can make new loans and call in old loans at will).
Put your answer in the box . No work need be shown. All answers will be either awarded full credit
(3 points) or no credit (0 points). There is little (if any) math that needs to be done to answer these questions. Most of the questions can be answered with simple intuition or simple arithmetic (adding, multiplying, etc.). Calculators are allowed (but you shouldn’t need them).
Baseline assumptions : 1.
2.
3.
The required reserve ratio ( system ( TC = 0). m) equals 5%.
Banks only hold required reserves ( m* = m ).
No one in the economy holds cash outside the banking
4. Total deposits in the entire banking system equals $1 trillion
( TD = $1 trillion).
Lets write down some equations:
Money supply (MS) = Total deposits in banking system (TD) + Total currency held outside the banking system (TC)
Total Reserves (TR) = (m*) TD (where m* is the actual reserve ratio held by the banks)
Monetary Base = TR + TC
Total Loans (TL) = TD – TR
Given the baseline assumptions, what must be true (given the above equations).
MS = $1trillion (TD) + $0 (TC) = $1 trillion
TR = .05 * $1trillion = $50 billion
Base = $50 billion (TR) + 0 (TC) = $50 billion
TL = $1 trillion (TD) - $50 billion (TR) = $950 billion a. Given the baseline assumptions, what is the
$50 billion (See above). monetary base ( Base ) in this economy?

b. Suppose the required reserve ratio declines to 2.5%. Relative to the baseline scenario, how much will total reserves (TR) change as a result of the change in the reserve ratio (inclusive of the subsequent change in banking lending that results)? Assume all other baseline assumptions hold (aside from m now equaling 2.5%).
What happens when we change the reserve ratio to 0.025 (holding all the other assumptions constant)?
There is zero change in reserves (change in total reserves = 0).
Math explanation:
Lets use the money multiplier where the initial deposit is the total reserves in the economy (that is what is held in the banking system that banks can leverage).
TD = (1/m*) * TR (which in this case is like the original initial deposit)
= $50 billion/0.025
= $2 trillion
TR = $50 billion (which is 0.025 * $2 trillion)
What does this mean? TL increased by $1 trillion
Intuitive explanation:
There was originally $50 billion in the banking system as reserves initially. There were no new reserves injected into the system. That means that at the end, there could only be $50 billion of reserves in the banking system.
All the increase in the money supply comes from the generation of new loans. This occurred because banks can leverage their initial reserves to a higher extent by making more loans based on the same amount of reserves (because banks could hold lower reserves from every level of deposits).
The net effect is that deposits increase, the reserve ration falls – yet the total reserves remain unchanged. c. Suppose we return to the original baseline scenario (m = 5%). Now suppose that the only change to the baseline assumptions is that banks now hold excess reserves such that the desired reserves held by the banks equal 10% of total deposits (m* = 10% > m = 5%).
Assume all other baseline assumptions hold. Given the change in bank behavior (inclusive of their subsequent change in total loans), what would be the new level of the money supply
(MS) in the economy?
TD = (1/m*) * TR (which in this case is like the original initial deposit)
= $50 billion/0.1
= $500 billion

d. Suppose we return to the original baseline scenario (banks now hold no excess reserves).
Suppose that households are fearful that the banking system will collapse and pull out $1 billion from the banking system (i.e., $1 billion of reserves (TL) leave the banking system while total currency held outside the banking system (TC) increases by $1 billion). How much would the money supply (MS) change if households removed $1 billion from the banking system?
I will give some partial credit for this question (in two situations).
The actual answer:
ΔMS = ΔTD + ΔTC
In this question, TC changes (that was the whole point of the question). What happens to TD as we pull $1 billion out of the banking system? The money multiplier process kicks in.
ΔTD = (1/.05) * (-1 billion)
= -20 billion
ΔMS = ΔTD + ΔTC = -20 billion + 1 billion = -19 billion
The answer to this question is -19 billion.
I will give 2 points (out of 3) if your answer was -20 billion.
I will also give 2.5 points if you used the actual money multiplier equation:
MS = [(cu + 1)/(cu +m*)] Base
People tried to use this equation and got an answer that was really close (-18.7 billion). The answer was not exactly equal to -19 billion because people used the ex-ante (cu) as opposed to the ex-post (cu). Why did the ex-ante cu differ from the ex-post cu? Because the money multiplier changed the level of deposits in the economy as $1 billion was removed from the banking system.
Question 2 (4 points – 2 points each)
Circle all the true statements below pertaining to the Murphy model (as discussed in class). a. All else equal , an increase in the marginal propensity to consume out of current income
(holding permanent income constant) will increase the net benefits of increasing government spending during large recessions (Y << Y*).
I had this as true. In our model, the higher the value of (b) (which represents the marginal propensity to consume out of current income holding PVLR fixed), the higher the estimated government spending multiplier. We did this in class. I thought this was an easy question. Some people were getting confused (particularly the large recession part

of the question). I just wanted to make an easy question based on the Murphy model.
The higher the government spending multiplier, the more idle resources will be used from a given increase in government spending (all else equal). b. A prominent argument against increasing government spending during recessions is the government spending diverts resources from the private sector and that the government then uses those resources inefficiently (relative to the private sector).
This is definitely true. This was easy (and comprised the bulk of our lecture last week in class).
Essentially everyone got this correct (even before I announced both answers were true).
All people will get credit for question 2 no matter what they put as answers.
In retrospect, these were fine questions (it was hard to test the Murphy model through true/false questions – i would have preferred a short answer question, but that increases the burden on my TA). I would have like a cleaner concept to test. Regardless, nearly all of you had both true before I revealed the answers to you.
Question 3 (4 points)
The article “And the Money Comes Pouring In” (Economist (7/15/2006)) recounts that by the end of fiscal year 2006 (which is September 30 2006) budget deficits were 30% lower than predicted 6 months prior. The reason that deficits were lower resulted from an increase in total tax revenues and not from changing government spending or transfers. The article then discussed how President Bush promptly proclaimed that the lower deficits were the result of his tax policy (he believes that he was on the right side of the Laffer Curve and that by cutting labor income tax rates he actually increased total tax revenues).
The article disagrees with President Bush’s claim. List one reason (as described in the article) why it is unlikely that the President’s tax cuts caused government budget deficits to fall. The article gives many reasons - you just need to describe one. Your answer should not be more than one sentence (it could even be less than one sentence).
The article had lots of reasons. We will give credit for any in the article. The simple ones include:
Most of the increase in tax receipts was from corporate taxes or from non-W2 person income (like capital gains taxes). We will grade this pretty easily.