Questions:
1) Bilbo receives a $100 payment from the Middle Earth Insurance company located in Gondor (outside the Shire where he lives) for his destroyed ring. He deposits all of the money in the Hobbiton Bank in the Shire.
a) If the reserve rate in the Shire is set at 25%, how much of Bilbo's deposit must the bank keep? What type of reserves are these called?
b) How much can the bank loan out to Sam Gamgee? What type of reserves are these called?
2) What would be the maximum change to the money supply from 1)? Where does the change come from and by what formula? Show deposit, required reserves, and loan amounts for the first 6 levels in the fractional banking system.
3) What assumptions are included in calculating the maximum change in the money supply?
4) If the money supply in the Shire is $20,000, velocity of money is a constant 3, the price level is 4.0, and output is constant at 15,000, what is nominal GDP? How did you get your answer?
5) The Thain of the Shire increases the money supply by $5,000. Using the simple quantity theory of money above, what is the net effect of the increase in the money supply in this case? Use the actual numbers.
6) Explain and draw how the change in 5) affects the money market in the short run. Explain what happens in the long run. (don't use numbers-answer in general terms)
7) Now suppose that real GDP increases. Graph the change in the money market and explain how the change comes about. (don't use numbers-answer in general terms)