ECON1002 Introductory Macroeconomics, Semester 2, 2023 1
Tutorial Tasks
READING GUIDE: REVIEW WEEK 6 LECTURE AND TEXTBOOK CHS 9 AND 10.
Key Concepts: Bank creation of money; the Quantity Theory; Open market operations; The
Reserve bank and interest rate targeting, Policy reaction function, Monetary policy in the
Keynesian model.
REVIEW OF CONCEPTUAL UNDERSTANDING
These are to be attempted before the tutorial. They will not normally be covered in the tutorial,
maybe, except for a quick review, time permitting. The answers are typically found in the
textbook and lecture notes.
1. What is money? Why is the cryptocurrency not considered a money?
2. Why is it important for the Quantity Theory that the velocity of circulation be constant? Is it
likely that the velocity of circulation is constant? Explain.
3. What do you understand by the open market operations?
4. How is monetary policy conducted though setting interest rates?
5. Define policy reaction function. Sketch a policy reaction function relating to the Reserve
Bank’s setting of the real interest rate.
6. What is the mechanism by which monetary policy affects the economy?
PRACTICE PROBLEMS (FOR IN-CLASS DISCUSSION)
N.B. THERE ARE 2 PROBLEMS WITH * FOR A TEAM BASED PRESENTATION.
*1. During World War II an Allied soldier named Robert Radford spent several years in
a large German prisoner-of-war camp. At times more than 50 000 prisoners were
held in the camp, with some freedom to move about within the compound. Radford
later wrote an account of his experiences. He described how an economy developed
in the camp, in which prisoners traded food, clothing and other items. Services, such
as barbering, were also exchanged. Lacking paper money, the prisoners began to use
cigarettes (provided monthly by the Red Cross) as money. Prices were quoted, and
payments made, using cigarettes.
a. In Radford’s POW camp, how did cigarettes fulfil the three functions of money?
b. Why do you think the prisoners used cigarettes as money, as opposed to other
items of value such as squares of chocolate or pairs of boots?
c. Do you think a non-smoking prisoner would have been willing to accept
cigarettes in exchange for a good or service in Radford’s camp? Why or why
not?
2. Real GDP is $8 trillion, nominal GDP is $10 trillion, M1 is $2 trillion, and M3 is
$5 trillion.
a. Find velocity for M1 and for M3.
TUTORIAL 7
(Week beginning September 18)
ECON1002 Introductory Macroeconomics, Semester 2, 2023 2
Tutorial Tasks
b. Show that the quantity equation holds for both M1 and M3.
*3. When a central bank increases bank reserves by $1, the money supply rises by more
than $1. The amount of extra money created when the central bank increases bank
reserves by $1 is called the money multiplier.
a. Explain why the money multiplier is generally greater than 1. In what special
case would it equal 1?
b. The initial money supply is $1000, of which $500 is currently held by the public.
The desired reserve-deposit ratio is 0.2. Find the increase in money supply
associated with increases in bank reserves of $1, $5 and $10. What is the money
multiplier in this economy?
c. Find a general rule for calculating the money multiplier.
d. Suppose the Reserve Bank wanted to reduce the money multiplier, perhaps
because it believes that change would give it more precise control over the
money supply. What action could the Reserve Bank take to achieve its goal?
4. An economy is described by the following equations:
C = 2,600 + 0.8(Y – T) – 10,000r
IP = 2,000 – 10,000r
G = 1,800
NX = 0
T = 3,000.
The real interest rate, expressed as a decimal, is 0.10 (that is, 10 percent).
a. Find a numerical equation relating planned aggregate expenditure to output.
b. Solve for short run equilibrium output. Show your results graphically using the
Keynesian cross diagram.
5. Consider the economy as described in terms of the equations in Question 4
above.
a. Potential output Y* equals 12,000. What real interest rate should the Reserve
Bank set to bring the economy to full employment? You may take as given that
the multiplier for this economy is 5.
b. Repeat part (a) for the case in which potential output Y* = 9,000.
ECON1002 Introductory Macroeconomics, Semester 2, 2023 3
Tutorial Tasks
c. Show that the real interest rate you found in part a sets national saving at
potential output, defined as Y* – C – G, equal to planned investment, IP. What
does this result show about the real interest rate and the market for saving?
6. Suppose the Reserve Bank follows the following policy reaction function.
Rate of inflation, π Real interest rate set by Reserve Bank, r
0.00 0.02 (= 2%)
0.01 (=1%) 0.03
0.02 0.04
0.03 0.05
0.04 0.06
For this economy, the relationship between short-run equilibrium output Y and the real
interest rate r set by the Reserve Bank is given by
Y = 1,000 – 1,000r.
Potential output is Y* = 960. What can you infer about the Reserve Bank’s objective for
the inflation rate in the long-term?