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CHAPTER 12
THE MONEY MARKET AND MONETARY POLICY
ANSWERS TO EVEN-NUMBERED ONLINE REVIEW QUESTIONS
2.
The money demand curve gives the total quantity of money demanded in the
economy at each interest rate. As the interest rate rises, the opportunity cost of
holding money increases. Individuals want to take advantage of the rising interest
rate and choose to hold more bonds, and thus they demand less money. This
inverse relationship explains why the curve slopes downward. A change in the
interest rate involves a movement along the money demand curve. In part (a),
there is a rightward movement along the money demand curve, and in part (b),
there is a leftward movement along the curve. As the price level or real income
decreases [parts (c) and (f)], money demand decreases, and the curve shifts
leftward. As the price level or real income increases [parts (d) and (e)], money
demand increases, and the curve shifts rightward.
4.
An excess supply of money implies an excess demand for bonds. As the public
buys bonds, the price of bonds increases. An increase in the price of bonds results
in a lower interest rate. At a lower interest rate, people are willing to hold more
money. The excess supply of money disappears, and the market returns to
equilibrium.
In the case of an excess demand for money, there is an excess supply of bonds. As
people sell their bonds, the price of bonds falls. Falling bond prices means a
higher interest rate. As the interest rate increases, the opportunity cost of holding
money rises, and money demand decreases. The money market returns to
equilibrium.
6.
a. An increase in the interest rate discourages business spending on plant and
equipment. If the firm must borrow funds to invest, then a higher interest rate
means that the firm will have to pay back more to the lender. If instead the
firm finances its project out of its own funds, a higher interest rate implies a
higher opportunity cost of using the firm’s funds on plant and equipment
instead of lending them out.
b. New housing purchases are inversely related to interest rates since an increase
in the interest rate raises the total cost of a house for families that need to
borrow money to make the purchase.
c. Since people often borrow money to purchase consumer durables, an increase
in the interest rate raises the monthly payments on these items. Consequently,
consumers purchase fewer durables when interest rates rise.
8.
The classical model is a long-run framework. It uses the loanable funds market to
explain how the interest rate is determined. But the classical theory of the interest
rate does not take into account short-run changes in output, such as recessions and
booms, and it ignores changes in the public’s preference for holding its wealth in
money versus bonds. Thus, we could not explain the short-run determination of
the interest rate in the classical, loanable funds framework.
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Even-Numbered Answers for Economics: Principles and Applications, 4e
Similarly, changes in output and changes in the public’s preference for
holding money and bonds—which are captured in our analysis of the money
market—do not last forever. Thus, it would not be appropriate to explain the longrun determination of the interest rate using the money market and the short-run
macro framework.
10. The federal funds rate is the interest rate that banks with excess reserves charge for
lending reserves to other banks.
EVEN-NUMBERED PROBLEM SET
2.
a. The money supply curve shifts to the right, and the money supply increases by
$195 million.
b. The money supply curve shifts to the left, and the money supply decreases by
$119 million.
4. a.
Price
$18,000
$18,500
$19,000
$19,500
$20,000
Amount Paid in
1 Year
$20,000
$20,000
$20,000
$20,000
$20,000
Interest
Payment
$2000
$1500
$1000
$500
$0
Interest Rate
11.11%
8.11%
5.26%
2.56%
0%
Quantity of
Money
Demanded
$2,300 billion
$2,600 billion
$2,900 billion
$3,200 billion
$3,500 billion
b.
Since, in equilibrium, MS = MD, the money supply equals $2900 billion. The
price of the bond is $19,000.
c. If the money supply increases to $3,200 billion, there will be a shortage of
bonds, bond prices will rise, and the interest rate will fall until the quantity of
money demanded once again equals the quantity supplied. This will happen
when the interest rate falls to 2.56% and the price of a bond rises to $19,500.
Chapter 25
6.
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a. The money demand curve will shift to the left; the Fed should decrease the
money supply in order to keep the interest rate unchanged.
b. The money demand curve will shift to the right; the Fed should increase the
money supply in order to keep the interest rate unchanged.
c. The money demand curve will shift to the left; the Fed should decrease the
money supply in order to keep the interest rate unchanged.
8.
Interest
Rate
r′
r
Ms2
E′
Ms
1
E
1
M dY Y1
Money
Initially, the economy is at point E in the top diagram and point J in the bottom
diagram. To raise the interest rate, the Fed conducts an open-market sale of bonds.
The money supply decreases to M2s and the interest rate rises. As the interest rate
increases, investment and autonomous consumption spending decrease, the
aggregate expenditure line shifts downward, and real GDP decreases to Y2. The
economy reaches a new equilibrium at interest r. The new equilibrium is at E
and K in the top and bottom diagrams, respectively. The Fed’s action causes the
money supply to decrease, the interest rate to increase, and GDP to decrease.
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Even-Numbered Answers for Economics: Principles and Applications, 4e
MORE CHALLENGING QUESTIONS
10. Initially, suppose that the economy is at point E in the top diagram and point J in
the bottom diagram. To raise the interest rate, the Fed conducts an open-market
sale of bonds. The money supply decreases to M2s and the interest rate begins to
rise, heading towards r. As the interest rate increases, investment and
autonomous consumption spending decrease, the aggregate expenditure line shifts
downward and real GDP begins to decrease. As real GDP falls, the money
demand curve shifts leftward from M1d to M2d. The economy comes to rest at an
interest rate between r1 and r, such as r. Equilibrium is reached at E and K in the
top and bottom diagrams, respectively. The Fed’s action causes the money supply
to decrease, the interest rate to increase, and GDP to decrease.
Interest
Rate
s
M2
s
M1
r'
r2
E
E
r1
d
M
Y=Y
1
d
M
Y=Y
2
Money
Real
Aggregate
Expenditure
AEr =
r1
AE r =
r2
J
K
45°
Y2
Y1
Real
GDP
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12. Due to economic uncertainties after September 11, many people wanted to sell
their bonds and shift their wealth to money—a rightward shift in the money
demand curve. This would have led to higher interest rates, which could have
triggered a recession by reducing planned investment spending and autonomous
consumption spending. The Fed increased the money supply rapidly to prevent the
rise in interest rates.