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 fail.
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.
