ECO 473 – Money & Banking
Dr. D. Foster – Spring 2016
Monetary Transmission Mechanism Problems
Where we have the following information: The money multiplier is 3.25, or is derived from the formula. Interest rates will change by 1.5% for each $65 billion change in the money
supply. Investment will change by $122 billion for each 2% change in interest rates. Income will change by $7 for each $2 change in investment. The unemployment rate will change by .46% for each $150 billion change in
income,
up to a maximum short run change of +1.84%. If the change in income exceeds +$600 billion, the effects will be strictly
inflationary (if income rises) or deflationary (if income falls). For each
additional $150 billion in income, the inflation rate will change by 2.1%.
1. What will be the impact on income, unemployment and inflation if the Fed buys
$15 billion worth of bonds? 2. What will be the impact on income, unemployment and inflation if the Fed sells
$25 billion worth of bonds? 3. If the Fed wants to raise income by $350 billion, how much should it buy/sell in
Treasury bonds? 4. If the Fed wants to lower the unemployment rate by 1%, how much should it
buy/sell in Treasury bonds? 5. Recalculate problem #1 where the required reserve ratio is 15%, the desired
excess reserve ratio is 5% and the currency ratio is 75%. Let your calculated
impact on income and unemployment be the Fed’s targets.
a. Let’s begin this problem again, except that there has been increased
pessimism in the market and the following changes have occurred that the Fed
didn’t count on, as follows: the desired excess reserve ratio rises to 50%. the desired currency ratio rises to 100% interest only changes by .75% for each $65 billion change in the MS investment only changes by $66 billion for each 2% change in interest
Calculate the effect of the Fed’s policy. b. Clearly the Fed didn’t reach its target, so they try again, but with an increase
amount of bond purchases of $85 billion. But, once again there has been
increased pessimism in the market and the following changes have occurred that
the Fed didn’t count on: the desired excess reserve ratio rises to 95%. the desired currency ratio rises to 125% interest only changes by .4% for each $65 billion change in the MS investment only changes by $36 billion for each 2% change in interest
Calculate the effect of the Fed’s policy. c. That still didn’t work, so the Fed tries once again. This time they buy even
more bonds: $250 billion! Well, that should do the trick. Except now, there have
been further changes, representing a wave of optimism, as follows: the desired excess reserve ratio falls to 15%. the desired currency ratio falls to 60% interest only changes by 1.5 % for each $65 billion change in the MS investment only changes by $122 billion for each 2% change in interest
Calculate the effect of the Fed’s policy.

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