Chapter 12 The Money Market and the Interest Rate
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.
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.
Price
Amount Paid in
One Year
Interest Payment
Interest Rate
Quantity of
Money
Demanded
$18,000
$18,500
$19,000
$19,500
$20,000
$20,000
$20,000
$20,000
$20,000
$20,000
$2000
$1500
$1000
$500
$0
11.11%
8.11%
5.26%
2.56%
0%
$2300 billion
$2600 billion
$2900 billion
$3200 billion
$3500 billion
b.
c.
Since, in equilibrium, MS = MD, the money supply equals $2900 billion. The price
of the bond is $19,000.
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.
Interest
Rate
s
M2
s
M1
r'
r2
E
E
r1
d
M
d
M
Y = Y1
Y = Y2
Money
Real
Aggregate
Expenditure
AEr =
r1
AE r =
r2
J
K
45°
Y2
Y1
Real
GDP
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 Fed’s action causes
the money supply to decrease, the interest rate to increase, and GDP to decrease.
8.
The student’s 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 r 2, 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 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.
Challenge Questions
2. The net export effect makes fiscal policy less potent in changing GDP. To see why,
consider expansionary fiscal policy. In an open economy there will be an initial effect:
G
Multiplier
Real GDP
Effect
and a net export effect:
M
d
Interest
Rate
Dollar
Appreciates
NX
Multiplier
Effect
The net export effect works in the opposite direction of the initial effect and leads to a
smaller overall change in real GDP than if it did not occur.
Real GDP
4.
Initially, assume the economy is in equilibrium at point A. Then the Fed decreases the money
supply from MS1 to MS2. If this were the only change to occur, then the interest rate would rise
from r1 to r2. However, if the demand for money were to simultaneously decrease, by more than
the money supply increased, as seen by the shift from MD1 to MD2, then the interest rate would
fall to r3.