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It is observed that the velocity of money is constant in the Barbados economy and that real GDP is growing at 3.6 percent.

a.      It is observed that the velocity of money is constant in the Barbados economy and that real GDP is growing at 3.6 percent. If the central bank increases the money supply by 12 percent, while the real interest rate is estimated at 6 percent, use your understanding of the quantity theory of money to answer the following questions:

                                                        i.           What is the current inflation rate and nominal interest rate?

                                                      ii.           Are the answers in part (i) reliable?

                                                    iii.           If the money supply growth rate increases to 18 percent, how will the answers in part (i) change?

                                                    iv.           Why would the central bank be willing to increase the money supply in the Barbados economy?

                                                      v.           How would the change in money supply growth effect an investor's real profitability, assuming that they now receive the new nominal

interest rate?

                                                    vi.           Based on your previous answers, would a fixed or a floating interest rate be preferred on investments? Which would be preferred if it was thought that money supply growth was going to be reduced?

b.      The quantity theory of money helps in explaining the economy's overall level of prices. Identify the three building blocks upon which the theory is built.

c.      Suppose that the T-account for Black Rock National Bank (BRNB) is as follows:

Assets Liabilities

Reserves                   $200,000 Deposits          $1,000,000

Loans                         $800,000

                             i.           What is the reserve-deposit ratio of BRNB?

                           ii.           What is the ratio's significance to the bank's operation?

                         iii.           If the central bank requires banks to hold 10% of deposits as reserves, how much in excess reserves does BRNB hold?

                         iv.           Is it in the bank's interest to hold more or less reserves?

                           v.           Suppose that households' liquidity preference is 5%, if BRNB decides to reduce its reserves to only the required amount, by how much would the economy's money supply increase?

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