Assume the following for a hypothetical economy in year 1: money supply=$400 bil

Question

Assume the following for a hypothetical economy in year 1: money supply=$400 billion; long-term annual growth of potential GDP=3%; velocity=4. assume that the banking system initially has no excess reserves and that the reserve requirement is 10%. also suppose that the velocity is constant and that the economy initially is operating at its full-employment real output.

A. What is the level of nominal GDP in year 1

B. Suppose the Fed adheres to a monetary rule through open-market operations. By how much must the Fed increase the money supply between years 1 + 2?

C. What amount of U.S. Securities will it have to sell to, or buy from, banks or the public between years 1 and 2 to achieve this increase in money supply.

Explanation / Answer

A. Nominal GDP = money supply * velocity of money = $400 bn * 4 = $1600 billion

B. % change in money supply = % change in nominal GDP

=> % change in money supply = 3%

Hence, New Money Supply = 1.03 * Old money supply = 1.03 * $400 bn = $412 billion

Increase the money supply = $412 bn - $400 bn = $12 bn

C. Change in money supply = (1/Required ratio)*Change in reserves

=> Change in reserves (amount of U.S. Securities bought) = Change in money supply * Required ratio

= $12 bn * 10% = $1.2 billion

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