Question

1. The current rate of unemployment in Maxistan is 4% and the natural rate of unemployment is believed to be 2%.

a. If the Central Bank of Maxistan has all of the same policy tools available to it as the Federal Reserve, what is the appropriate open market operation to correct the current state of the economy? Explain. (NOTE: Your explanation must include the role of excess reserves).

b. Show the effect of the open market operation you described in part (a) on a correctly labeled graph of the money market.

c. What is the difference between the money market and the market for loanable funds (not just the labels... what does each really represent)?

d. What happens to the real rate of interest based on the change in the nominal rate of interest you showed in part b in the long run? Explain (hint: use Fischer equation in your explanation)

Answer 1

The answer to the question is as follows-

a) The appropriate open market operation that the Central Bank of Maxistan should use is the purchasing of securities from commercial banks. In this way, the commercial banks will have more excess reserves for credit creation because now they will have money which they earned from selling the securities to the Central bank. The commercial banks can use these increased excess reserves for lending purposes. The more the credit creation in the economy the more will be the investments. Further, these investments will get converted into production and more employment opportunities will be developed in the economy bringing the unemployment rate down. So, the purchasing of securities by the central bank is the apt solution.

b)

c) The money market refers to the money supply in the economy which includes money with the banks, public, post offices, etc. While the loanable funds market represents the money in commercial banks and lending institutions that are available to lend out to firms and households to finance expenditures.