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Monetary and Fiscal Policy Solutions and Practice Exam with Solutions

Name: Monetary and Fiscal Policy Solutions and Practice Exam with Solutions
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Author: Drooghoofd

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Monetary and Fiscal Policy

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Universiteit Van Amsterdam (UvA)

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Monetary and Fiscal Policy - Tutorial 1

1. Imagine a system with just two commercial banks. Their simplified balance sheets are
shown below:

Bank A Bank B
Assets Liabilities Assets Liabilities
Cb 50 D 2000 Cb 150 D 5000
Db 30 Db 50
L 1920 L 4800

In addition, the non-bank sector holds notes and coins (C) for 140.
a. What are the total amounts of monetary base and money? What is the total reserve ratio
(that is required reserve ratio r plus excess reserve ratio e) of each individual bank and
of the monetary system? Calculate the money multiplier.

Suppose that Bank A makes additional loans of 50 to a subset of its customers and that
some of these customers use 20 to make payments to other depositors of the same bank and
30 to make payments to clients of Bank B.

b. Draw up new balance sheets for each bank.
c. What are the total amounts of monetary base and money now? And the total reserve
ratios? Calculate the new money multiplier.
d. Can the banking system increase the lending to its clients without limits?

2. Within the MM model, explain what happens to the money supply as a result of (ceteris paribus):
a. Development of a new type of deposits with zero minimum reserve requirements;
b. “Quantitative easing” policy with banks depositing most of the excess reserves at
the central bank;
c. A decrease of the lending rate on lending facilities at the central bank;
d. A decrease of the deposit rate on reserves held at the central bank.

3. Suppose that, as in Poole’s model, the economy is described by the following IS and LM
curves (Hint: first get familiar with the graphical analysis of this model in the lecture notes):

(IS) y = c – ai + εIS
(LM) m = hy – ki + εLM

Where y is the output, m is the money supply, i is the interest rate, and εIS and εLM are
independent, mean-zero shocks with variance σ2IS and σ2LM. Moreover, c, a, h, and k are
constant positive coefficients. The goal of the central bank is to stabilize output y. Suppose
that the central bank cannot observe the two shocks εIS and εLM, but based on historical
evidence, knows their mean and variance.
a. Calculate and compare the variance of y assuming that the policy maker
fixes either i at a the level i0 or m at level m0;
b. If there are only IS shocks (that is σ2LM =0), what is the best policy
instruments in lowering the variance of y?
c. If there are only LM shocks (that is, σ2IS =0), what is the best policy
instruments in lowering the variance of y?

, 4. After reading the boxes of Chapter 15 on the unconventional measures implemented by the
Bank of England, the ECB and the Fed over the last few years, answer the following
questions:
a. The BoE is the central bank which more closely (and officially) adopted
QE as in Japan in the 2000s. However, there are quite significant differences. In what
respect?
b. What are the most important non-standard measures implemented by the
ECB? What is the SMP? How does it differ from QE?
c. Bernanke, the chairman of the Fed, argues that the Fed’s approach is
conceptually different from QE? Why? What is meant by the unconventional tool
“management of expectations”?

5. After reading Chapter 16 and Kahn and Benolkin (2007), answer the following questions:
a. Why has monetary targeting been abandoned by many central banks?
b. What is a fan chart? What does the latest fun chart of the Bank of
England look like?
a. The ECB and the Fed seem to have a different opinion on the role of money in their
monetary policy strategies. Why?
c. Why are Taylor rules so popular? Why don’t central banks officially
adopt a Taylor rule?
d. What is the Taylor Principle? How should a central bank react to a
negative supply shock such as an increase of oil prices according to the Taylor rule?
e. Should a Taylor rule be augmented with asset prices? In general, how
should a central bank react to asset price bubbles?

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