Deck 17: Wage Determination

Question 1

What is the basic determinant of (a) the strength of the transactions demand for money (the location of the transactions demand for money curve) and (b) the amount of money demanded for assets, given a particular asset demand for money curve How is the equilibrium interest rate in the market for money determined Use a graph to show the impact of an increase in the total demand for money on the equilibrium interest rate (no change in money supply). Use your general knowledge of equilibrium prices to explain why the previous interest rate is no longer sustainable.

Answer 1

The basic determinant of (a) the transaction demand for money is the level of nominal GDP and (b) the asset demand for money is the rate of interest. The demand curve for the former is a vertical line since it is assumed to be independent of the rate of interest. The demand curve for the asset demand is a downward sloping demand curve since there is an inverse relationship between the asset demand for money and the rate of interest. The horizontal summation of the two demand curves will give us the aggregate demand curve for money. Since the transaction demand for money is drawn for a given Nominal GDP so the aggregate demand curve is also based on the same assumption. Any increase in the nominal GDP increases the transaction demand for money hence the aggregate demand curve for money shifts upwards.
Rate of
Rate of Rate of
Interest Interest Interest
(percent) (percent) (percent)
D m
D t
D a
0 100 0 100 200 0 100 200 300
Amounts of Money Amounts of Money Amounts of Money
Demanded demanded demanded and supplied
An increase in money supply decreases the equilibrium rate of interest but
an increase in the demand for money increases the equilibrium rate of interest. The equilibrium rate of interest is determined with the help of the demand and the supply of money.
Rate of
Rate of
Interest S m Interest S m
(percent) (percent) i e 2 c
i e e i e 1 a b
Dm D m 1 D m 2
0 M s /P 0 M s /P
Amounts of Money Amounts of Money
demanded and supplied demanded and supplied
An increase in the total demand for money, with given money supply, creates excess demand for money (i.e. ab) which requires the equilibrium rate of interest to increase to re-established the equilibrium in the money market. The previous rate of interest is not sustainable because there is excess demand for money equal to ab at the same.

Question 2

Assume that the following data characterize a hypothetical economy: money supply = $200 billion; quantity of money demanded for transactions = $150 billion; quantity of money demanded as an asset = $10 billion at 12 percent interest, increasing by $10 billion for each 2-percentage- point fall in the interest rate.
a. What is the equilibrium interest rate Explain.
b. At the equilibrium interest rate, what are the quantity of money supplied, the total quantity of money demanded, the amount of money demanded for transactions, and the amount of money demanded as an asset

Answer 2

Interest rate can be defined as the amount that is charged by a lender to borrower for the use of assets.
a)
The equilibrium interest rate is determined by the equilibrium point of the quantity of money demanded and the quantity of money supplied.
Here, the supply of money = $200 billion which must be equal to the total demand for money. At present, the transaction demand for money is $150 billion and the asset demand for money is $10 billion at 12 % interest rate. Hence the total demand for money at present is $160 billion. To reach the equilibrium of $200 billion, the asset demand for money must be equal to $50 billion.
When the asset demand for money is $10 billion, then the rate of interest is 12 %. So when the asset demand for money will be $50 billion, the interest rate will be 4 % as there will be an increase in the asset demand for money by $10 billion for each 2 percentage point fall in the interest rate.
Hence, the equilibrium interest rate is 4 %.
b)
At the equilibrium rate of interest, the amount of money is $200 billions that are supplied, the total amount of money that is demanded is $200 billions, the amount of money demanded for transactions is $150 billion and the amount of money demanded as an asset is $ 50 billion. All these are derived from the above section (a).

Question 3

What is the basic objective of monetary policy State the cause-effect chain through which monetary policy is made effective. What are the major strengths of monetary policy

Answer 3

The policy which is taken up by the monetary authority of any economy is known as the monetary policy.
The basic objective of monetary policy is to ensure price stability, bring in full employment and achieve economic growth.
The cause and effect chain through which monetary policy can be made effective is as follows: through its various tools like selling bonds, increasing reserve ratio, increasing discount rate, or auctioning fewer resources, the Fed ensures to reduce the excess reserves that the commercial banks hold with themselves. This brings a decline in money supply, which raises the interest rates. With the increase in rate of interest, the investment spending takes a backseat and eventually declines. Thus finally reduces the aggregate demand. Thus the decline in money supply through various tools brings an effect of controlling the inflationary situation. This is known as tight monetary policy.
The strength of the monetary policy is its effectiveness in controlling the expansionary phase in the economy. Such expansionary phase which is an inflationary type is very effectively and successfully controlled by the monetary policy. This is the strength of monetary policy. Its speed and flexibility in tackling an inflationary spiral in the economy is checked by reducing the money supply, raising the interest rates and then reducing the investment spending which in its turn reduces the aggregate demand.

Question 4

What is the impact of each of the following transactions on commercial bank reserves
a. The New York Federal Reserve Bank purchases government securities from private businesses and consumers.
b. Commercial banks borrow from Federal Reserve Banks at the discount rate.
c. The Fed reduces the reserve ratio
d. Commercial banks borrow from Federal Reserve Banks after winning an auction held as part of the term auction facility.

Question 5

Why do changes in bank reserves resulting from open-market operations by the Fed produce multiple changes in checkable deposits (and therefore money) in the economy

Question 6

Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp and prolonged inflationary trend. What changes in (a) the reserve ratio, (b) the discount rate, (c) open-market operations, and (d) the amount of reserves offered at the term auction facility would you recommend Explain in each case how the change you advocate would affect commercial bank reserves, the money supply, interest rates, and aggregate demand.

Question 7

Why is monetary policy easier to undertake than fiscal policy in a highly divided national political environment

Question 8

What do economists mean when they say that monetary policy can exhibit cyclical asymmetry Why is this possibility significant to policymakers

Question 9

Distinguish between the Federal funds rate and the prime interest rate. Which of these two rates does the Fed explicitly target in undertaking its monetary policy In 2004 and 2005 the Fed used open-market operations to significantly increase the Federal funds rate. What was the logic of those actions What was the effect on the prime interest rate

Question 10

What actions did the Fed take in the second half of 2007 and early 2008 What motivated these actions