Worksheet (Unit 13): Monetary Policy Actions By Central Bank
Situation: The central bank of the nation of Owenia is managed by people who are firmly of the Classical/Monetarist viewpoint. This means they believe the quantity theory of money (QTM) and the equation of exchange hold strictly true.
Here are the facts of the situation in Owenia presently (all dollar amounts are in billions):
- Unemployment rate: > 8.5%
- Velocity of money = 6
- Price Level = 1.5
- RealGDP = $3,200
- Total Bank Reserves in banking system: $ 80
- Amount of Total Bank Reserves that are “excess reserves”: $ 0
- Total checkable deposits in banking system: $ 400
- Estimate of RealGDP if full employment existed: $3,500
The issue: Owenia Central Bank has decided that it needs to take a policy action to help improve conditions in the economy. In particular, they want to affect the employment level towards full employment but they want to do it without taking any risk of inflation (they want to keep price level constant).
They have decided to change the discount rate and to target a change in the inter-bank lending rate for reserves (what is called Fed Funds rate in U.S.). To do this, they will commit to some open market operations involving buying/selling securities with the commercial banks via the public government bond market. They want to know what to do and how much or how large of an open market operation to conduct.
The following questions are intended to help you step through the logic involved in deciding how large and what type of open market operation.
What term (condition) best describes the Owenia economy?
What is nominal GDP for Owenia?
How much money (M1) is in circulation in Owenia?
What is the required reserve ratio that has been set by the central bank?
What is the theoretical maximum money multiplier (assuming that all excess reserves get loaned and new loans become new deposits)?
How big is the real GDP gap (the difference between actual and full employment)?
In nominal terms, how big is the GDP gap (using this price level)?
How much additional M1 is needed to close the GDP gap (assume no inflation and constant velocity)?
Given the additional M1 needed (previous question), if the central bank assumes the maximum money multiplier, how large of an initial change in bank reserves must the central bank trigger?
To achieve the initial change in bank reserves you calculated in the previous question, which action/announcements should the central bank make (multiple choice)?
- You will use the equation of exchange a lot.
- M1 includes both checkable deposits and currency/coin in circulation