Monetary Policy and Required Reserve Ratio Essay

MIDDLESEX UNIVERSITY ECS 1260-65 ECONOMICS FOR (BUSINESS AND) MANAGEMENT Final COURSEWORK April 2012 Submission Deadline: 23rd April 2012 Student Name: Ali Abbas Muhammad Saeed ID: M00384206 1) This coursework has ten questions. Each question is in the combined form of multiple choice and narrative answer. You must answer all questions. 2) The multiple choice part is assigned 50% weight. The other 50% is assigned to the narrative part of the question. 3) The narrative part is to be used to Justify your answer in the multiple choice part.

If you answer the multiple choice part wrong, no oints will be assigned to the narrative part of the question. 4) This coursework is to be done individually only. 5) The narrative part of the question should be answered within the space provided. Thus, answers should be very short. The whole assignment must have no more than six pages (including the front page and page of instructions). Additional sheets are not accepted. 6) The deadline for submission is 23rd April 2012, at the Students Office, Williams Building (ground floor).

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ECS 1260-65 Final coursework 2011-2012 1) If nominal GNP increases at a rate of 10 per cent per year while the eflator increases at 8 per cent per year, then A. real GNP remains constant B. real GNP rises by 10 per cent C. real GNP falls by 8 per cent D. real GNP rises by 2 per cent Explain. GNP Real GNP refers to the market value of goods and services produced within a year, at constant prices. 2) Suppose that national income is initially at its equilibrium level investment falls. We would expect when desired A. fall in national income, but not by as much as the fall in desired investment B. increase in national income by an amount equal to the reduction in investment spending D. fall in national income by some multiple of the fall in desired investment spending Investment curve is a straight line curve parallel to x axis. At equilibrium level savings = investment. When investment falls, national income does not change, but savings > investment, which leads to excess demand. So prices increase, economy is in full employment and supply is constant.

If the MPC for the economy is 0. 8, then 3) A. MPS 1/0. 8 B. the multiplier is 4 C. the multiplier is undefined D. the MPS 0. 2 Why? It is because of multiplier effect. E. g. : Assume an initial EIOO million of autonomous investment. This money will return to the households in terms of income earned from the factors of production (land, labor and capital) hired by the firms. It is assumed that the MPC = 0. 8, and so the MPS = 0. 2. Hence, households save 20% of this income. E20 million is saved and the rest is spent on the goods and services produced by the firms.

This E80 million again returns to the households in terms of factor incomes. 20% of this is saved (E16 million) leaving E64 million to be spent on goods and services. This process keeps going. The initial EIOO million will multiply to give a final increase in total national ncome of much more than EIOO million. In fact, there is a formula that can be used to find the multiplier: Multiplier (m) = 1/1-MPC = 1 IMPS to simplify, MPC+MPS=I. 4) The prevention of major swings in economic activity can be handled most easily by the A. ousehold sector B. business sector C. financial sector Explain how. Keynes argued that the business cycle was due to extreme swings in the total demand for goods and services. The total demand in an economy from households, business, and government is called aggregate demand. Contra cyclical policy is increasing aggregate demand in recessions and decreasing aggregate demand in verheated expansions. In a market economy the government has two types of economic policies to control aggregate demand fiscal policy and monetary policy.

When these policies are used to stimulate the economy during a recession, it is said that the government is pursuing expansionary economic policies. Monetary policy is under the control of the Federal Reserve System and is completely discretionary. It is the changes in interest rates and money supply to expand or contract aggregate demand. In a recession, the FED will lower interest rates and increase the money supply. In an overheated expansion, the FED will raise interest rates and decrease the money supply. 5) Expansionary fiscal policy A. decreases aggregate demand B. ccurs when the government takes actions to stimulate the economy C. occurs when the government cuts spending D. occurs when the government reforms the public sector through privatisation How? Expansionary fiscal policy is when an increase in government purchases, a decrease in taxes, and/or an increase in transfer payments are used to correct the problems of a business-cycle contraction. The goal of this is to close a recessionary gap, stimulate he economy, and decrease the unemployment rate. Expansionary fiscal policy is often supported by expansionary monetary policy. An alternative is contractionary fiscal policy.

This is accomplished by increasing aggregate expenditures and aggregate demand through an increase in government spending (both government purchases and transfer payments) or a decrease in taxes. Expansionary fiscal policy leads to a larger government budget deficit or a smaller budget surplus. 6) Commercial banks create money by A. loaning out pounds they receive as deposits B. printing currency C. collecting bad debts D. arning profits Commercial banks raise funds by accepting deposits from individuals and businesses. These could include checking, savings and certificates of deposits.

The banks then turn around and lend the money to other individuals and businesses as business loans, personal loans, student loans, auto loans, mortgages and credit cards. The banks charge and earn interest on all these loans. They also purchase instruments is another way commercial banks make money. An example of them loaning out pounds that they received as deposit would be: Andy deposits $100 at the bank. The bank then loans out $80 to Bill. The amount of the $100 that the bank received as a deposit that can be loaned out depends on the required reserve ratio as set by the Fed.

At this point, Andy has $100 and Bill has $80 in purchasing power. So the money supply has essentially increased from $100 to $180, thus “creating” money. Further money creation can be achieved if Bill went to a bank and deposited his $80, then that bank could (assuming the required reserve ratio is 20%) loan out $64 to Carl, etc etc. 7) Suppose Mr. Robinson deposits pounds 600 in currency ata bank. Later that day Ms. Volker borrows pounds 1200 from the same bank. The money supply will have A. increased by pounds 1200 B. increased by pounds 600 C. decreased by pounds 600 D. tayed the same Money supply implies when a certain amount of money exists at any given time, even though the quantity may be unknown depending on its demand. E. g. : When someone uses a credit card in a purchase, he automatically expands the money supply. The seller receives a new deposit in his account, which increases the total of demand deposits in the banking system-until the buyer pays off the loan. The result is that consumers who roll over their credit card loans rather than paying them off have ncreased the money supply on their own initiative by hundreds of billions of dollars. ) Suppose that the per capita income in Alfaland (with initial high per capita income) is growing faster than it is in Betaland (with initial low per capita income). Then: A. the real value of the output produced by Alfaland exceeds that of Betaland B. the difference in the living standards between Alfaland and Betaland remain constant over time C. the gap in the standard of living between the two countries decrease over time D. the gap in the standard of living between the two countries widens over time Explain.

Countries with low per capita income have lower income inequality than a high per capita income country. Hence the gap in standard of living widens over time. 9) If the Bank of England wanted to discourage investment spending and reduce aggregate demand, it could B. sell securities on the open market C. lower the discount rate D. buy securities on the open market E. g. :ln an open market operation, the Central bank can also tighten monetary policy by restricting the supply of money. To do this they can print less money or sell long dated government securities (bonds) to the banking sector.

By selling bonds, banks ee a reduction in liquidity and therefore reduce lending which in turn reduces aggregate demand due to less spending. 10) Suppose the marginal propensity to consume (MPC) is 0. 9. Beginning from equilibrium, investment demand increases by 50. How much does equilibrium income increase? A. 50 B. 100 c. 250 D. 500 Show the calculation and explain the mechanism. MPC = 0. 9 Multiplier (K) = 1 I-MPC 1-0. 9 Increase in Investment Demand( l) – – 50 Therefore, increase in income = K x ( We know MPC+MPS = 1, and increased investment has higher multiplier effect (because of higher MPC). Hence income rises by 50.


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