Imagine a monetary system with just two commercial banks. Their balance sheets are:
BANK A
R = 400 D = 6,200
L = 5,900 E = 100
BANK B
R = 800 D = 5,800
L = 5,100 E = 100
Where
R = reserves,
L = loans to the private sector,
D = deposits of the private sector and
E = equity.
i) If the private sector holds notes and coins (c) of 600, what is the money stock? What is the reserve ratio of the system as a whole? Calculate the money multiplier.
ii) Suppose that bank A is in need of liquidity and sells part of its loans to bank B. Briefly discuss what happens to the reserve ratio of the system and the money multiplier as a result.
b) Suppose that, as in Poole 1970, the economy is described by the following IS and LM curves.
IS y = a - bi
LM m = cy – i + 𝜀
Where 𝜀 = shock (with zero mean and variance σ2 ),
i = interest rate,
m = money supply, and
a, b, and c are positive fixed coefficients.
The goal of the policy maker is to stabilize output y. Calculate the variance of y under interest-rate target i0 and money supply target at M0.
Explain what the best instrument is.
