CHAPTER 26
THE MONEY MARKET AND MONETARY POLICY
EVEN NUMBER ANSWERS, SOLUTIONS, AND EXERCISES
ANSWERS TO 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.
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 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.
PROBLEM SET
2.
a. The money supply curve shifts to the right, and the money supply increases by $196
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.
6.
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
s
M2
s
M1
E′
r′
E
r
d
M
Money
Real
Aggregate
Expenditure
AEr
E
AEr′
E′
Z
Z
45
°
Y2
Y1
Real
GDP
Initially, the economy is at point E in the top 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 consumption spending
decrease, causing the the aggregate expenditure line to shift downward in the bottom
diagram. Consequently, the equilibrium GDP decreases from Y1 to Y2. In the new
equilibrium, the interest rate is higher and GDP is lower.
10. The long-run/classical theory relies on flow variables (the flow of loanable funds), whereas
the short-run theory of this chapter relies on stock variables (the total quantity of money
in the money market).
MORE CHALLENGING
12. 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 r2. 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
14. a. A negative interest rate on reserves would likely increase the money supply and cause
interest rates to fall.
b. The nominal federal funds rate could not be negative (because the banks could simply
choose not to lend out money). If inflation ends up being higher than the nominal interest
rate, it is, in general, possible to have a negative real interest rate.