Government Bonds

Explain why each of the following statements is True, False, or Uncertain according to economic
principles. Use diagrams where appropriate and show your calculations. Unsupported answers will
receive no marks. It is the explanation that is important.
A2-1. Suppose the consolidated balance sheet of an economy where the public holds all its money in the form of
bank deposits is shown in the following table. If the banking system is originally in equilibrium and
then the economy’s central bank sells 50 worth of government bonds to the banking system,
immediately after the transaction there is no change in the money supply, but after the banking system
has returned to equilibrium, the money supply is reduced by 1000. [Hint: Use two additional balance
sheets in your answer.]
Assets: Liabilities:
Reserves 100 Deposits 2000
Government Bonds 300
Loans Outstanding 1800 Capital 200
Total 2200 Total 2200
A2-2. The credit card in your wallet is part of your money holdings.
A2-3. The yield of a bond that promises to pay 110 in one year’s time is equal to 5% if the equilibrium price of
that bond is 104.76.
A2-4. Suppose price index that is used to guide central bank policy increases from 120 to 126. If the central
bank has an inflation target of 2%, it should pursue an expansionary monetary policy. [Hint: Use an
AD-AS diagram in your answer.]
Problem [20 marks – marks for each part as shown]
A2-5. Suppose a central bank decides to decrease its policy interest rate in an effort to decrease interest rates
throughout the economy.
(a) Using a diagram for the money market, explain the effects of the decision on interest rates and how
the central bank must respond to support this policy decision. [Hint: make sure to discuss the
adjustment to the new equilibrium in the money market.] [5]
(b) Suppose the economy is a closed one. What effect will the policy change have on investment, on
aggregate expenditure? Include diagrams in your answer. [5]
(c) What additional effect will there be on aggregate expenditure if the economy was an open one? [5]
(d) How will aggregate demand be affected, whether we treat the economy as closed or open?
(Illustrate in a diagram.) Under what circumstances would this policy be appropriate for a central
bank that was trying to stabilize the economy? (Illustrate in your diagram.) [5]

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