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AK Macroeconomics – Chapter 8 CHAPTER EIGHT Answers to Self Test Questions 1. a) total demand for money: $140 (If GDP = $800 then transactions demand = 10% x $800 = $80; and if r = 10%, asset demand is $60, so total demand = $140.) b) Surplus of $10. (The money supply of 150 is 10 more than the demand of 140) 2. See the table below: Interest Rate % 12 11 10 9 8 7 6 Asset Demand Transactions Demand 80 80 80 80 80 80 80 50 55 60 65 70 75 80 Total Demand 130 135 140 145 150 155 160 a) equilibrium interest rate: 8% (This is where the money demand of 150 is equal to the money supply.) b) equilibrium interest rate: 10% (This is where the money demand of 140 is equal to the money supply.) c) Surplus of money of $15 (At 11 percent interest, the money supply of 150 exceeds the money demand of 135). 3. If prices increase, so too will money demand, which will push up interest rates and cause a drop in investment and real GDP. The aggregate demand curve, however, will not shift, but the aggregate quantity demanded will decrease, i.e., the price change causes a movement along the AD curve, not a shift in it. 4. A reduction in the money supply will cause interest rates to rise and this will cause a decrease in investment and real income. 5. a) velocity of money: 10 b) P = $2.40 © 2009 McGraw-Hill Ryerson Limited (2 x 500 ÷ 100) (120 x 10 ÷ 500) 54 AK Macroeconomics – Chapter 8 Answers to Study Guide Questions 1. 2. 3. 4. 5. False: it is determined by their nominal GDP True False: it is determined by the demand and supply of money True False: the Bank of Canada does not automatically adjust the money supply to ensure that it always equals the demand. 6. True 7. False: it refers to the way changes in interest rates cause changes in investment and real GDP. 8. True 9. False: refers to the number of times money changes hands in a year. 10. True 11. 12. 13. 14. 15. 36A. a b a b c 16. 17. 18. 19. 20. a c c a a 21. 22. 23. 24. 25. d d a a a 26. 27. 28. 29. 30. a a c d a 31. 32. 33. 34. 35. d c c d e Key Problem a) Surplus of 20 billion. Figure 8.13 shows that at 7% interest rate, the quantity demanded is 40. Since the money supply is 60, there is a surplus of $20. b) 5%. This is the rate of interest that the quantity of money demanded equals the quantity supplied. In Figure 8.13 this is where the two curves intersect. © 2009 McGraw-Hill Ryerson Limited 55 AK Macroeconomics – Chapter 8 c) See the following figure: Figure 8.13 (completed) d) 3%. This is where the new money supply curve intersects the money demand curve in Figure 8.13 (completed). e) Increase of $20 billion. Figure 8.14 shows that at the previous interest rate of 5%, the quantity of investment was $40. At the new interest rate of 3%, the quantity of investment is $60. The difference is $20 billion higher. f) See the following figure: Figure 8.15 (completed) 150 140 AS 130 Price level 120 AD2 110 AD1 100 90 400 increased 500 by $20 600billion, 700 800 demand 900will increase 1000 Since investment aggregate by $100 billion. This means graphically that the AD curve will shift by 2 Real GDP squares to the right. © 2009 McGraw-Hill Ryerson Limited 56 AK Macroeconomics – Chapter 8 g) Price level of 125 and real GDP of $750. This is where the new AD curve, AD2, intersects the AS curve. 37A. a) b) 77 million drams (nominal GDP is real GDP x price level (70 x 1.1 = 77) 12.1 million drams. (the money supply must rise by the same 10% that GDP has increased: 11 million + 10% = 12.1) 38A. V = 10.7 (nominal GDP is 873 X 108.7 ÷ 100 = 948.95 and this figure ÷ 88.4 = 10.7) 39A. a) price level = 2; nominal GDP = 200 b) price level = 2.4; nominal GDP = 240 c) Since a 20% increase in the price level leads to the same percentage increase in nominal GDP, we can conclude that there is a direct and proportional relationship between the two. 40A. 2.9% interest. Using the formula: Rate of return (rate of interest) = coupon interest +/- change in the bond price x100 Price paid for bond gives us: $350 - $200 x 100 = 2.9% $5200 41A. a) Interest rate: 10%; b) Interest rate: 6%; c) Interest rate: 12%; 42A The two major determinants of the transactions demand for money are the price level and the real GDP of the economy (together, they make up the nominal GDP). An increase in either will increase the transactions demand for money. (The transactions demand is also affected by institutional factors like the efficiency of the payments system, the use of electronic money and so on.) 43A. Equilibrium in the money market means that the total demand for money (the total of the transactions and asset demands) is equal to the total supply of money (as determined by the central bank). 44A. investment: $160. investment: $200. investment: $140. a) Surplus of money of $20b (Ms = 100; Md = 80). b) Surplus of goods and services of $30b. (At 10%, investment = $70; at GDP = $500, savings = $100 so consumption = $400. Therefore aggregate expenditures (C + I) = $470. So supply of goods and services of $500 exceeds the demand of $470.) c) GDP: $400; interest rate: 8%. d) GDP: $350; interest rate: 10%. e) Money supply: $140. © 2009 McGraw-Hill Ryerson Limited 57 AK Macroeconomics – Chapter 8 45A. a) b) c) d) e) rate of interest: 7%; investment: $600. decrease of 3% (from 7% to 4%). increase by 40 (from $40 to $80). an increase of $100B (from $80 to $180). no 46A. a) Surplus of $20. At 10% interest rate, Figure 8.18A shows that the quantity of money demanded would be $80. Since the money supply is $100, the difference of $20 represents the surplus. b) Surplus of $30 At 10% interest, Figure 8.18B shows that investment will be $70. If GDP is $500, Figure 8.18C shows that saving equals $100. Since there are no taxes, then consumption must be $400. Aggregate expenditures will therefore total 70 (I) and 400 (C), equals $470. Since GDP is $500, there will be a surplus of $30 in goods and services. (This represents the difference between GDP and aggregate expenditures. c) Interest rate equals 8% and GDP equals $400. Given the money demand shown in Figure 8.18A, if the money supply is set at $100, then the equilibrium rate must be 8%. If the interest rate is 8%, then Figure 8.18B shows that investment spending will be $80. If the product market is in equilibrium, then saving must also be $80. To produce saving of $80, Figure 8.18C shows that GDP must be $400. d) Interest rate equals 10% and GDP equals $350. Given the money demand shown in Figure 8.18A, if the money supply is set at $80, then the equilibrium rate must be 10%. If the interest rate is 10%, then Figure 8.18B shows that investment spending will be $70. If the product market is in equilibrium, then saving must also be $70. To produce saving of $70, Figure 8.18C shows that GDP must be $350. e) Money supply of $140. At a GDP of $500, saving equals $100. If the product market is in equilibrium Figure 8.18C shows that investment also equals $100. For investment to be $100, Figure 8.18B shows that the interest rate must be 4%. If the interest rate is 4%, then Table 8.18C shows that the quantity of money demanded will be $140. If the money market is to be in equilibrium, then the money supply must also be $140. © 2009 McGraw-Hill Ryerson Limited 58 AK Macroeconomics – Chapter 8 47A. a) See the following figure: Figure 8.19 (completed) A rightward shift of 1 square of the MS curve in graph A will reduce the interest rate by 1% and this will cause a movement along the Id curve in graph B, which will increase investment spending by $50 (from $50 to $100). b) investment spending: $100 c) See Figure 8.19 (completed) The AD will increase by $200. (The AD curve in graph C shifts to the right by 2 squares.) d) GDP: $700 48A. a) The transactions demand for money will increase because an increase in the price level will increase nominal income. b) The transactions demand for money will increase because an increase real income will increase nominal income. c) The transactions demand for money will increase because nominal income has increased. d) The transactions demand for money will increase because; nominal income has increased. © 2009 McGraw-Hill Ryerson Limited 59 AK Macroeconomics – Chapter 8 49A. To begin re-arrange the equation of exchange, to get V = P x Q 100M Using this formula, we get: 1993: V = 15 (101.2/100 x 716/48.3); 1994: V = 14.1 (102.4/100 x 744/54.2) ; 1995: V = 14 (105.1/100 x 760/57.1); 1996: V = 13 (106.6/100 x 770/63.1); 1997: V = 11.6 (107.1/100 x 798/73.5). 50A. $10 285. Whoever is holding the bond when it is redeemed in one year will receive $10 800, (principal of $10 000 plus the coupon interest of $800). Alternatively a prospective investor could invest that money ($X) at the market rate of 5% for one year. So we ask the question: What sum of money ($X) invested at 5% will equal $10 800 in one year? Or algebraically, $X x (1.05) = $10 800. X therefore equals $10 800/1.05 = $10 285. So a person paying $10 285 for the bond will earn $800 in coupon interest but lose $285 on the depreciation of the bond, totaling $515. This works out to an interest rate of $515/$10 285 = 5%. 51A. A surplus of money would lead people to get rid of the excess by buying bonds. This would increase the demand for bonds, so pushing up their prices, which implies a lower interest rate. As the interest rate drops, people’s desire to hold money will increase; this process continues to the point that at a lower interest rate people’s desire to hold money is equal to the supply of money; in other words, until the surplus has disappeared. 52A. An increase in the supply of money causes a surplus of money. People react by buying bonds, causing the price of bonds to increase and the interest rate to drop. The lower interest rate will lead to an increase in investment and in income. The process is more direct, according to Monetarists, since the surplus of money will lead to an increase in spending (not just on bonds) which will lead to an increase in aggregate demand and in nominal income. 53A. $21 200. Whoever buys the bond expects to receive a return equal to that on other investments, i.e. $2000 over two years ($20 000 @ 5% x 2). Since the holder will receive $3200 ($1600 x 2) in interest from the bond, that investor would be prepared to lose $1200 on the sale of the bond, i.e. they would be prepared to pay $21 200. 54A. a) b) c) d) Keynesian view: graph A; Monetarist view: graph B. Keynesian view: graph B; Monetarist view: graph A. increase by $10. (interest rate changes by 1%). increase by $160. (interest rate changes by 4%). 55A. Keynesians would expect the asset demand for money to be very high. Monetarists assume that there is no asset demand for money. © 2009 McGraw-Hill Ryerson Limited 60 AK Macroeconomics – Chapter 8 56A. Since economic growth means an increase in the output of real goods and services, an increase in the money supply is needed to prevent higher interest rates (as a result of a higher transactions demand for money) which would reduce investment and economic growth. 57A. They do not believe that there is an asset demand because they feel that people would not hold idle balances of cash. This is because, according to Monetarists, there are many financial instruments available which are as safe and as liquid as cash. © 2009 McGraw-Hill Ryerson Limited 61