Review Questions for Midterm 2

Economics 470/570

Fall 2008

**Definitions**

Money multiplier

Corridor or Tunnel System

Quantity equation

Velocity of money

Equation of exchange

Consumption, disposable income, MPC and MPS

Investment

Government spending

Aggregate demand or expenditures

Expenditure multiplier

IS curve

LM curve

Policy effectiveness

Crowding out

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**Essay**

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1. Suppose that a bank has $100,000 in excess reserves that it loans out.
Assuming that the required reserve ratio is 20%, use t-accounts to illustrate
the multiple deposit creation process. Use this to obtain the simple deposit
multiplier.

Chapter 14

2. Explain why the multiplier falls when people hold currency or when banks
hold excess reserves.

3. Suppose that the required reserve ratio is 20%, the currency to deposit
ratio is .25, the excess reserve to deposit ratio is .05, and the monetary base
is 1,000. (a) Find the money supply. (b) Let open market operations increase the
monetary base by 200. Use the money multiplier to find the new value of the
money supply.

4. Explain how and why the money multiplier changes when (a) the required
reserve ratio increases, (b) the currency to demand deposit ratio increases, and
(c) the excess reserve to demand deposit ratio increases. Who determines each of
these quantities?

Chapter 15

5. (a) Explain why the demand curve for reserves slopes downward. (b) Explain
the shape of the supply curve for reserves.

6. Use the supply and demand model for bank reserves to explain and
illustrate the effects of (a) an open market operation to buy bonds, (b) a
decrease in the discount rate, and (c) an increase in required reserves.

7. Describe the three traditional tools available to the Fed for controlling the money
supply.

8. What is meant by the phrase lender of last resort? Why is this important?
Explain and show graphically how the Fed uses discount rate policy to act as a
lender of last resort and how this limits the amount the federal funds rate can
rise.

9. Explain the quantity theory of money. Explain the Cambridge approach and
illustrate that it leads to the same identity as the quantity theory. What
assumptions are imposed to arrive at a theoretical statement?

10. What is the money demand function in the classical model?

11. Discuss the transactions, precautionary, and speculative motives for
holding money in Keynes liquidity preference theory. When all three motives are
put together, what theory of money demand emerges?

12. Show the money demand curve graphically and explain why it slopes
downward. Show how the money demand curve shifts when income increases.

13. According to Baumol, the transactions demand for money depends upon the
interest rate as well as nominal income. Explain why the transactions demand for
money depends upon the interest rate. Why is this important?

14. What did Tobin add to Keynes theory of the speculative demand for money?
Why was this development important?

15. Explain Friedman's Modern Quantity Theory of the Demand for Money.

16. Derive the IS curve. Explain intuitively why it slopes downward. What
factors cause the IS curve to shift? In what direction do they shift the IS
curve?

17. Derive the LM curve. Explain intuitively why it slopes upward. What
factors cause the LM curve to shift? In what direction do they shift the LM
curve?

18. Show graphically and explain intuitively how an increase in government
spending affects income and the interest rate in the IS-LM model.

19. Show graphically and explain intuitively how an increase in the money
supply affects income and the interest rate in the IS-LM model.

20. Explain why the LM curve is vertical when money demand is unaffected by
changes in the interest rate (as in the classical model). Explain and show graphically why the LM curve is horizontal in a liquidity trap.

21. Use the IS-LM model to show that monetary policy becomes more effective
relative to fiscal policy as money demand becomes less sensitive to the interest
rate (examine the cases where the LM curve is either vertical or horizontal). Explain the result intuitively. What does this imply about the use of
monetary and fiscal policy over the business cycle?

22. Explain why investment is less sensitive to interest rate changes in
recessions as compared to when the economy is operating closer to full
employment. Explain why the IS curve is vertical when investment is completely
insensitive to changes in the interest rate.

23. Use the IS-LM model to show that fiscal policy becomes more effective
relative to monetary policy as investment becomes less sensitive to the interest
rate (examine the cases where the IS curve is either vertical or horizontal). Explain the result intuitively. What does this imply about the use of
monetary and fiscal policy over the business cycle?

[Many of these are also homework problems]