Doubt - please explain :)

[Homer Simpson]

1) Suppose the Fed wants to keep output fixed at its current level. What, if anything, should the Fed do to the monetary base in response to this desire of households and firms to hold a larger fractions of their money in the form of currency?

a) Fed should sell bonds
b) Fed should purchase bonds
c) Either a or b
d) None of the above

2) Consider a country whose Central Bank issued 100$ of High-Powered Money (H). Citizens' cash holdings (dollar bills) amount to 10% of their deposits while each commercial bank has to have reserves for 15% of the volume of deposits.

What is the level of deposits?

a) 200
b) 300
c) 400
d) 500

[Arushi1]

The Fed should purchase the bonds?

[Anjali]

But wouldn't that ultimately affect output ?

[Arushi1]

Ah crap! I missed out on that part. Let me introspect more.

Thanks :)

[econ14]

d

[Homer Simpson]

Can you elaborate? Not clear about the logic.

[econ14]

well i am not too sure but i think selling and buying of bonds will have  effect on interest rate which will change investment

[Anjali]

I will go with Sandeep's logic !

[econ14]

tuski for second is it 400???

[Anjali]

Ques 2 - C !!

[Homer Simpson]

Yeah its 400 :) can you explain how to solve? Investment logic seems on track but i am not completely clear yet.

[Dreyfus]

The high powered money or monetary base = Currency + Reserves held by banks
Currency = 0.1deposits & reserves = .15deposits

[Anjali]

Vaibhav's approach is absolutely correct !

[Dreyfus]

In the question it is given that Y has to be remain constant.
Now when central bank purchases bonds there are two effects:
Money supply increases leading to increase in Y
The demand for bonds increases leading rise in price of bonds which in turn lowers the rate of interest. Lower interest have two effects:
One investment ie it increases leading to increase in Y
One on citizens as they will earn lower interest on their deposits so they will instead hold money in the form currency.
So ans should be d as Y has to be remain constant

[Homer Simpson]

Thanks, i understood 1 but i am still confused about 2 :(

[Dreyfus]

Hmmm....

[Anjali]

Tsuki high powered money has two components :
1. Currency
2. Reserves
H=C+R
Here both C and R are given in terms of deposits.
And value of H is also given .
Just substitute the values !

[mrittik]

Eta FED ke bond purchase korte hobe.....r congrats tomake CDS er jonno...by the way tomar nam ki? tsuki asha kori nam noy

[Anjali]

Mrittik her name is jaysmita !
But for us she is tsuki - Congo tsuki ! :-D

[Granpa Simpson]

Congrats jayasmita aka Tsuki...