Addy G Pieter
1.- In the Republic of Ragu, the currency is the rag. During 2009, the Treasury of Ragu sold bonds to finance the Ragu budget deficit. In all, the Treasury sold 50,000 10-year bonds with a face value of 100 rags each. The total deficit was 5 million rags. Further, assume that Ragu Central Bank reserve requirement was 20 percent and that in the same year, the bank bought 500,000 rags worth of outstanding bonds on the open market. Finally, assume that all of the Ragu debt is held by either the private sector (the public) or the central bank.
a) What is the combined effect of the Treasury sale and the central bank purchase on the total Ragu debt outstanding? On debt held by the private sector?
1.- The treasury sale of bonds means that total debt outstanding has increased by 5 million; the Ragu Central Bank (RCB) purchase means that private debt outstanding went up by 4.5 million.
b) What is the effect of the Treasury sale on the money supply in Ragu?
2.- The treasury sale of bonds has no effect whatever on the money supply-the Treasury receives money in payment for the bonds, then spends the money on roads or aircraft and returns it to circulation. If the Treasury had simply buried the money it received for bonds in the ground, then banks would have lost reserves and the money supply would have contracted, but they are no more likely to do that than you are when you take out a loan.
c) Assuming no leakage of reserves out of the banking system, what is the effect of the central bank purchase of bonds on the money supply.
3.- The RCB purchase bonds on the open market will expand the money supply. If the RCB boughs the bonds from banks, its would directly credit their reserves with the RCB and the money multiplier of 1/.20=5 would mean that the money supply would expand by 2,500,000 as a result of the 500,000. If the RCB bought the bonds from the republic, the public would deposit the...
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