Bank of America’s (BoA’s) Balance Sheet (6 points)Assume that the legal reserve requirement is 10 percent on all deposits.

3. Bank of America’s (BoA’s) Balance Sheet (6 points)Assume that the legal reserve requirement is 10 percent on all deposits. SupposeBoA has $200 million in checkable deposits, $30 million in reserves, $50 millionin securities, and $150 million in loans.A. (1 point) What is BoA’s bank capital? Draw a balance sheet (T-account)for BoA.B. (1 point) How much does BoA hold in excess reserves? How is thisrelated to liquidity risk? Explain.C. (2 points) Assume that Sac of Money Bank (a small local bank inSacramento) has the following balance sheet information: $25 million incheckable deposits, $22 million in loans, $1 million in bank capital, andno excess reserves. How much is Sac of Money Bank holding insecurities and reserves?D. (2 points) Assume that both banks have the same return on assets (perdollar). Which bank has a higher return on equity? Which bank is lesslikely to become insolvent? Explain.

4. The Volcker Disinflation and the 1981-1982 Recession (4 points)When Paul Volcker was appointed Chair of the Federal Reserve in 1979, the U.S.was experiencing accelerating inflation. By 1980, the inflation rate in the UnitedStates was well over 10 percent. In order to reduce the inflation rate, Volcker and 3the Federal Reserve dramatically raised nominal and real interest rates. The resultwas the recession of 1981-1982, but by 1984 the inflation rate was down to 4percent and the economy was close to potential output. This question uses thedynamic AD/AS model to simulate this historical episode.Assume that in Period 0, the economy is at potential output ( = 0) and that thecurrent and target rate of inflation are 12 percent ( = = 0.12). In Period 1,assume that the Fed permanently reduces the target rate of inflation to 4 percent( = 0.04).Assume that the economy is described by the basic, dynamic AD/AS model: = − − ̅ IS curve − ̅ = − MPR curve = + ̅ + ̅ AS curveAlso, assume the following parameter values: = 0, ̅ = 0, = 2, = 0.5, ̅ = 1.A. (2 points) Starting in a steady-state equilibrium in Period 0,mathematically solve for the output gap () and the inflation rate () inPeriods 1 and 2, as a result of the change in the target rate of inflation inPeriod 1.B. (2 points) Graphically illustrate using an AD/AS diagram for Periods 0, 1,and 2 using the numerical calculations from above. Explain andgraphically illustrate, on the same diagram, how the economy converges toits new steady-state equilibrium. What will be the inflation rate andoutput gap in this new steady-state equilibrium?

5. Oil Price Shocks, Inflation, and the Failure to Follow the Taylor Principle(6 points)While Question 4 above illustrated how Paul Volcker and the Federal Reserveended the Great Inflation of the 1970s. This question examines how the GreatInflation started and accelerated over the 1970s as a result of two OPEC oil priceshocks and poor Federal Reserve policy.Assume that an economy is characterized by the following IS, MPR, and SRAScurves: = − − ̅ IS curve − ̅ = − + MPR curve = + ̅ + ̅ SRAS curve 4A. (1 point) Derive a general mathematical expression for the solution to theoutput gap in any period t:B. (1 point) Suppose that the Federal Reserve increases the nominal interestrate by 0.5 percentage points for every 1 percentage-point increase in theinflation rate. What is the value of ? Briefly explain.C. (2 points) Assume the following parameter values in Period 0, along withthe value of you computed in Part B above: = 0, ̅ = 0, = 1, ̅ = 0.022!”#”$, = 0.5, = 0.033!”#”$, ̅ = 1.Prior to the shock, the economy is at potential output and inflation is equalto the inflation target. Starting from potential output ( = 0, assumethat there an oil price shock that only lasts for one period, Period 1(̅ = 0.02). In all periods after Period 1, the value of ̅ = 0 and there areno spending shocks in any period ( = 0). Calculate numerically andshow on an AD/SRAS diagram the initial eqilibrium, the shock in Period1, and two periods following the shock. That is, calculate , &, ‘ aswell as , &, ‘ and graphically illustrate using an AD/SRASdiagram.D. (2 points) What is the Taylor Principle and why does it lead to instability?Intuitively explain.

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