Practice Problem Answers
1. What are the three principal uses of Money?
Money acts as a unit of value (the dollar in the U.S.), a medium of exchange (you can exchange it
for goods or services), and a store of value (money retains value over time.)
2. What is the distinction between fiat and commodity money?
Commodity money has its own intrinsic value, fiat money has no intrinsic value and is money by
government decree.
3. Consider the following information:
Item
Currency outstanding
Checking accounts
Savings accounts
Money Market Mutual Funds
Travelers Checks
Stocks and bonds
Credit Card balances
Amount in billions of dollars
5
9
30
20
1
50
30
a. What is M1?
M1 is the sum of currency outstanding and checking balances = $5 + $9 + $1 = $15. Credit Card
balances are debts and not considered money. Neither are stocks and bonds because they are not
a medium of exchange.
b. What is M2?
M2 is M1 plus Savings and Money Market Mutual Funds In this case, M2 = $15 + $50.
4. What does the money supply equal in terms of currency, deposits, reserves, and the
reserve ratio?
Money supply = Currency in the hands of the public + deposits in the banking system. This also
is given by Currency in the hands of the public + bank reserves/reserve ratio.
5. If a bank’s reserves increase by $10,000 and the actual reserve-deposit ratio is 0.10,
how much will the money supply change assuming that the public doesn’t hold any
additional cash?
Bank deposits will increase by $10,000/0.10 = $100,000. This will increase the money supply by
$100,000.
6. Suppose the public holds $200 million in currency, the reserve-deposit ratio is 0.05, and the
bank holds $300 million in reserves, what is the money supply?
Money supply = currency held by the public + bank deposits. Bank deposits = $300/.05= $6,000.
Money supply = $200 million + $6,000 million = $6,200 million.
7. If the FED conducts an open-market sale of bonds, what will happen to the money
supply?
The money supply will decrease because by selling bonds in doing so they decrease the amount
of money banks have in reserves.
8. Suppose the Fed purchases $1,000 in bonds. How much will the money supply change
if the reserve-deposit ratio is 0.10 assuming the public holds no extra currency?
If the Fed purchases $1,000 from the public, reserves will initially increase by $1,000. Bank
deposits will ultimately be = $1,000/0.10 = $10,000. Since deposits increase by $10,000 and
currency remains the same, the money supply will increase by $10,000.
9. How will higher interest rates affect savings, consumption, and investment.
Higher interest rates will increase savings, decrease consumption, and decrease investment.
10. If the Fed lowers the real interest rate, what will happen to short-run equilibrium output?
Lowering the interest rate will increase consumption and investment, shifting the aggregate
demand curve rightward. The new equilibrium will be at a higher level of output.
11. If potential output equals 4,000 and short-run equilibrium output equals 3,500, there is a
recessionary gap and the Federal Reserve must lower interest rates in order to close the gap.
12. How does the Fed reduce inflation, and what are the likely consequences of the Fed trying to
reduce inflation to AD, AS, and unemployment?
In order to reduce inflation, the Fed will increase interest rates, which will shift AD to the left,
which will reduce output (and increase unemployment) in the short run.
13. How does the Fed reduce unemployment, what are the likely consequences of the Fed trying
to reduce unemployment to AD, AS, and inflation?
In order to reduce unemployment, the Fed will decrease interest rates, which will shift AD to the
right, which will increase inflation.
14. Explain the moral hazard problem associated with the Fed protecting large financial
institutions.
The moral hazard problem is based on the idea that people or firms act riskier when insured
against losses than they would otherwise. So by protecting these financial institutions against
losses, these institutions may be more willing to take risks (make risky loans or risky
investments).
15. What is the demand for money?
The demand for money represents how much of one’s assets are held in the form of money (cash
+ checking in the case of a narrow definition of money)
16. What is the opportunity cost of holding money?
The nominal interest rate
17. Refer to the figure above. If the Federal Reserve wants to raise the interest rate to 7%, it must
decrease the money supply to 300.
18. Refer to the figure above. If the Federal Reserve wants to set the nominal interest rate at 1%,
it must conduct open market purchases to set the money supply at 900.
19. An increase in the nominal interest rate will decrease the quantity of money demanded, and is
represented with a movement upward along the money demand curve.
20. How would a decrease in output affect the Money Demand Curve?
A decrease in output (which is equivalent to income) would decrease the amount of money that is
held at any given interest rate. Therefore, the Money Demand Curves shifts to the left.
21. If there is an expansionary gap in the economy, the FED will decrease money supply, which
will increase interest rates, which will decrease investment and decrease AD, which will decrease
inflation.
22. If there is a recessionary gap in the economy, the Federal Reserve will likely (circle
the correct answer) to the following:
Interest rates:
Increase
Decrease
Not change
Money Supply:
Increase
Decrease
Not change
Which will cause (circle the correct answer) to:
Savings:
Increase
Decrease
Not change
Investment:
Increase
Decrease
Not change
Aggregate Demand:
Increase
Decrease
Not change
Aggregate Supply:
Increase
Decrease
Not change
Inflation:
Increase
Decrease
Not change
Unemployment:
Increase
Decrease
Not change
23. Suppose inflation is 2% and there is an expansionary gap of 5%. According to the Taylor
rule, the Federal Funds rate should equal 4 + (5*.5) = 6.5%.
24. Suppose inflation is 1% and there is a recessionary gap of 4%. According to the Taylor rule,
the Federal Funds rate should equal 4 - 4*0.5– (2-1)*1.5 = 0.5%.
25. What is the relationship between prevailing interest rates and bond prices?
There is an inverse relationship, in that when interest rates rise, bond prices fall.
26. The Phillips Curve shows that in the short run there is tradeoff between inflation and
unemployment. What is this relationship in the long-run and why? There is no tradeoff
in the long run. The reason is as inflation increases, eventually wages adjust, and
employment moves back to its natural full employment level.
27. Suppose real GDP = $5,000 billion, the price level is 1.10, and M1 is $2,500 billion, what is
the velocity of M1?
V=P*Y/M = (1.10*$5,000)/$2,500 = 2.2
28. According to the quantity equation, if the velocity of money and real GDP are constant, how
would an increase in the money supply of 10% affect the price level and nominal GDP?
It would increase the price level by 10%. MV=PY. Solving for P, P=MV/Y. If V and Y are held
constant, an increase in M will increase P (the price level).
29. If a company’s stock trades for $12, and there are 10 million shares, what is their market cap?
The market cap = price/share * number of shares, which in this case equals $12*10 million =
$120 million.
30. What are the two ways investors in stocks can earn money?
Through dividends (regular payments based on profits) and capital gains (the price of the stock
increases).
31. Suppose investment A is riskier than investment B. Which is likely to have a higher
rate of return? What does the risk premium between these two investments equal?
Investment A is likely to have a higher rate of return because risks (or potential losses) are
capitalized in the form of higher returns.
The risk premium is given by the returns on A – returns on B.
32. Suppose you invest $5,000 and earn a 6% rate of return for 45 years. How much will your
investment be worth? How much will it be worth if you start 10 years earlier and withdraw it in
35 years?
5,000*(1.06)45=$68,823
5,000*(1.06)35=$38,430
33. If 1.00 U.S. dollar is worth 0.75 euro, how much does 1.00 euro worth in terms of dollars?
If 1 U.S. dollar = .75 euro then, 1 euro = 1/.75 U.S dollar = $1.33
34. Use the following exchange rate table to answer the following questions
Country
Foreign Currency/Dollar
Dollar/Foreign Currency
Swedish (Krona)
6.00
Australian (Dollar)
1.09
a. What is the number of U.S. dollars per Swedish kronar?
1/6.00 = 0.167
b. What is the number of Australian dollars per U.S. dollars?
1/1.09 = 0.92
c. What is the number of Swedish Krona per Australian dollar?
6 = 0.92 ; 6/0.92 = 0.92 / 0.92 = 6.52
35. What groups benefit from and what groups are hurt by a depreciating currency?
Domestic producers of exported goods and foreign consumers of domestic goods (e.g. foreign
travelers in the U.S.) benefit from a depreciating currency.
Foreign producers of imported goods and domestic consumers of foreign goods (e.g. U.S.
travelers abroad) are hurt by a depreciating currency.
36. A new mp3 player costs 200 U.S dollars. If the exchange rate is $1.50 per euro, how much
will the mp3 player cost in Euros?
$200/($1.50/Euro) = 133.33 euros
37. If the exchange rate expressed in euros per dollar increases, what will happen to the price of
U.S. goods and services for Europeans?
As the exchange rate increases, the dollar is appreciating against the euro. This makes U.S. goods
and services more expensive for Europeans.
38. How will a decrease in the exchange rate for U.S. dollars (expressed in foreign currency per
dollar) affect quantities of dollars demanded?
As the exchange rate falls, U.S. goods and services become relatively cheaper. Foreigners will
purchase more U.S. goods and services, increasing the quantity of dollars demanded.
39. If the exchange rate moves from 10 Mexican pesos per U.S. dollar to 8 Mexican pesos per
U.S. dollar, then the Mexican peso has appreciated and the U.S. dollar has depreciated.
40. How would a decrease in U.S. interest rates relative to Japan interest rates affect the supply
for dollars curve, other things constant? How would it affect the value of U.S. dollars?
Japanese assets would become more appealing, and there would be an increase in the supply of
dollars at every exchange rate. This will decrease the value of U.S. dollars.
41. What will happen to a country’s imports and exports if the country maintains an undervalued
exchange rate?
That country’s exports will become relatively cheap, and their imports will become relatively
expensive. Therefore, we should see imports decrease and exports increase.
42a. Refer to the figure above. Based on the figure, if the krone exchange rate is fixed at $0.15
dollars per krone, the krone is overvalued.
42b. If the krone exchange rate is fixed at $0.15 dollars per krone, there will be an excess supply
equal to 5,500 krone?
42c. In order to maintain an exchange rate of $0.15 krones/dollar, what will the Polish
government will have to do on foreign exchange markets?
They will have to purchase the excess supply of krone (5,500) in foreign exchange markets to
maintain this overvalued exchange rate.
43. Suppose a country exports $50,000 and imports $75,000. What is the country’s trade
balance?
Trade balances = Exports – Imports = $50,000 - $75,000 = -$25,000
44. What was the balance of trade in the U.S. in 2013? What is the top deficit nation and what is
the top surplus nation?
The 2013 balance of trade deficit was approximately $690 billion. The top deficit nation was
China and the top surplus nation was Hong Kong.
45. What are the major determinants of a country’s trade balance?
One important determinant is its national savings rate. As a country saves more, their balance of
trade improves, as they save less, it worsens. Also the value of their currency is a major
determinant (as it depreciates, their net exports improve).
46. What groups benefit from free trade and what groups are hurt by free trade?
Domestic producers of imported goods are hurt. Domestic producers of exported goods benefit
and domestic consumers of imported goods benefit.
47. What is a tariff and what is a quota?
A tariff is a tax imposed on an imported good. A quota is a legal limit on the quantity of a good
that may be imported.