Prof.
Giovanna Vallanti TA: Diletta Topazio
LUISS dtopazio@[Link]
Macroeconomics
Academic Year 2023 − 2024
PROBLEM SET 2
Financial Markets
• Exercise 1
Suppose we have the following money demand:
d
M
= 1, 000 − 100i
P
M s
Where i is the interest rate in percentage. The money supply is P = 500.
a Draw the graph for the demand and supply of money.
b Determine the equilibrium interest rate.
c What happens to the equilibrium interest rate if money supply increases from 500 to 600?
d If the central bank wants to set the interest rate at 7%, at which level should it set the money
supply?
• Exercise 2
Suppose that the money demand function is given by
M
= 0.25Y − 62.5i
P
where i = 6 is the interest rate (in percentage term) and Y = 3500.
a Compute the money supply the central bank must create to ensure the equilibrium interest
rate equal to 6 (in percentage term)?
b If Y increases to 3700, and money supply does not change, what is the equilibrium interest
rate?
c If the central bank sets an interest rate target of 6%, what is the money supply the central
bank must create?
1
• Exercise 3
Suppose the following assumptions hold:
– the public holds no currency.
– the ratio of reserves to deposits is 0.1.
– the demand for money is given by:
M d = P Y (0.8 − 4i)
Initially, the monetary base is $100 billion and nominal income is $5 trillion.
a What is the money multiplier?
b What is the demand for high-powered money?
c Find the equilibrium interest rate by setting the demand for high-powered money equal to
the supply of high-powered money.
d What is the overall supply of money? Is it equal to the overall demand for money at the
interest rate you found in point (c)?
e What is the impact on the interest rate if high-powered money is increased to $300 billion?
f If the overall money supply increases to $3 trillion, what will be the impact on i?
• Exercise 4
During the Great Depression, the US economy experienced many bank runs, to the point where
people became unwilling to keep their money in banks, preferring to keep it in cash. How would
you expect such a shift away from deposit accounts toward currency to affect the size of the money
multiplier?
• Exercise 5
At the current interest rate, suppose the supply of money is less than the demand for money.
Given this information, we know that
(A) the interest rate will tend to decrease and the price of bonds will tend increase.
(B) the interest rate will tend to increase and the price of bonds will tend to fall.
(C) production equals demand.
(D) the goods market is also in equilibrium.
(E) the supply of bonds also equals the demand for bonds.
More than on answer can be correct. Explain your choice(s)
2
• Exercise 6
The overall money supply will tend to fall when which of the following occurs?
(A) a central bank sale of bonds
(B) a shift in public preferences away from currency to checkable deposits
(C) an increase in the ratio of reserves to deposits
(D) all of the above
(E) none of the above
More than on answer can be correct. Explain your choice(s)
• Exercise 7
Explain what is correct, mistaken, confused or incomplete in the following statement:
An increase in the interest rate will cause a reduction in the demand for currency and therefore a
leftward shift of the money demand curve.