Chapter12TheMoneyMarketandtheInterestRate.doc

Chapter 12 The Money Market and the Interest RateReview Questions2.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 firms 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 publics 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. Similarly, changes in output and changes in the publics preference for holding money and bondswhich are captured in our analysis of the money marketdo not last forever. Thus, it would not be appropriate to explain the long-run 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.Problems and Exercises 2.a.The money supply increases by $195 million and the money supply curve shifts rightward.b.The money supply decreases by $119 million and the money supply curve shifts leftward. 4.a.PriceAmount Paid in One YearInterest PaymentInterest RateQuantity of Money Demanded$18,000$20,000$200011.11%$2300 billion$18,500$20,000$15008.11%$2600 billion$19,000$20,000$10005.26%$2900 billion$19,500$20,000$5002.56%$3200 billion$20,000$20,000$00%$3500 billionb. 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 $3200 billion, there will be a shortage of bonds, bond prices will rise, and the interest rate will fall until money demand once again equals money supply. This will happen when the interest rate falls to 2.56% and the price of bonds rises to $19,500. 6.Initially, the economy is at point E in the top diagram and point J in the bottom diagram. To raise interest rates, the Fed conducts an open-market sale of bonds. The money supply de to M2s and interest rates begin to rise, heading towards r. As interest rates increase, investment and autonomous consumption spending decrease, and real GDP begins to decrease. As real GDP falls, M1d shifts to M2d. The economy comes to rest at an interest rate between r1 and r, such as r2, and the aggregate expenditure line falls. Equilibrium is reached at E and K in the top and bottom diagrams, respectively. The Feds action causes the money supply to decrease, the interest rate to increase, and GDP to decrease. 8.The students reasoning is incorrect. He is confusing a shift in the money demand curve with a movement along the money demand curve. An increase in the demand for money will shift the money demand curve to the right, from Md1 to Md2. At the current interest rate, r1, the quantity of money demanded increases from Q1 to Q2, creating an excess demand for money. The excess demand causes the interest rate to rise to r2, leading to a decrease in quantity demanded from Q2 back to Q1.10.Due to economic uncertainties after September 11, many people wanted to sell their bonds and shift their wealth to moneya 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. Challenge Questions 2.The net export effect makes fiscal policy less potent in changing GDP. To see why, cons