Problem 2 (15 points) Consider an economy with five assets: 1) Cash 2) Checking
ID: 1203932 • Letter: P
Question
Problem 2 (15 points)
Consider an economy with five assets: 1) Cash 2) Checking Accounts 3) Savings and Money-Market Accounts 4) Bonds 5) Stocks. M1 includes asset classes 1 and 2, and M2 is the sum of M1 and asset class 3. All else being equal, how would each of the following changes affect demand for M1? And for M2? Explain.
(a) The stock market crashes, and investors who were previously excited about prospective gains now view it as too risky.
(b) Authorities intensify the fight against street crime, leading to more arrests and convictions for robbery. As crime rates fall, people feel safer holding cash.
(c) Banks introduce overdraft protection, under which funds are automatically transferred from savings to checking as needed to cover checks.
(d) Due to an increase in inflation expectations, the average interest rate on bonds rises from 3% to 6%.
(e) The government introduces deposit insurance, guaranteeing checking and savings deposits in the event that there are depositor runs and banks fails.
Hint: Each change in a-e makes one asset more (less) attractive by raising (lowering) its return, liquidity, safety, or another desirable characteristic of the asset. You need to identify which asset's attractiveness has increased (decreased) and will thus absorb more (less) funds. As agents change their portfolios, there may be several possibilities regarding where funds come from (flow to). Thus, different answers may be correct, as long as you write a sentence explaining the move you have in mind. The emphasis of the question is on demand. That is, you just need to think through how an individual would reallocate funds between different available assets. Do not try to guess further equilibrium effects, i.e., do not worry about what would happen to prices and other behaviors that might follow if everyone in the economy did this move. That is interesting, but beyond the scope of this problem. Also, assume that these are ceteris paribus changes, i.e., other factors do not change.
Explanation / Answer
(a) As investor perception about stocks gets a negative change, people decrease investing in stocks. So, investment in stock decreases, and Cash increases (since people hold their money less as stock, and more as cash/currency).
So, M1 and M2 both increase.
(b) As people feel safer holding cash, the holdings of cash and currency increase, therefore both M1 and M2 increase.
(c) This scheme will reduce the svaings account balances and raise the checking account balances by the same amount. So, M1 increases. While lower savings account will decrease M2, since M2 includes M1 also, the increase in M1 will be included within M2, and the decrease in saving account will be exactly offset by increase in checking account, and M2 will remain unchanged.
(d) This raises the demand for bonds, so people hold more bonds and less cash. Both M1 and M2 fall.
(e) This will make people hold less cash and put more into saving and checking accounts. As cash falls, both M1 and M2 falls. As checking account increases by same amount as decrease in cash, M1 becomes neutral (unchanged) with zero net effect. Next, M2 increases by the amount of increase in savings account.