Deck 10: Interest Rates and Monetary Policy

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 the money supply). Use your general knowledge of equilibrium prices to explain why the previous interest rate is no longer sustainable.

Answer 1

Transaction Demand for Money can be defined as the money which is positively affected by income and expenditure and negatively affected by the interest rate.
a)
The basic determinant of the strength of the transactions demand for money is the level of nominal gross domestic product because the amount of GDP in the economy is the amount of total amount of income in the economy which will determine the amount of required for doing the transactions for satisfying the demand. Hence, the transactions demand for money is directly proportional to the nominal GDP.
b)
The basic determinant of the amount of money demanded for assets is the rate of interest given a particular asset demand for money curve because as the rate of interest will increase, the demand for the money required for purchasing will decrease since the interest that would be required to pay for the loans will be higher. So, people will try to avoid borrowing loans when the interest rate will rise. Hence, the asset demand for money is inversely proportional to the interest rate.
The determination of the equilibrium rate of interest in the market is shown by the following diagram:
In the above graph, the rate of interest or the price of borrowing money is measured on the vertical axis and the quantity of money available is measured on the horizontal axis. Since the supply of money is autonomous, it shown by the vertical line S* and the two demand curves are shown by D0 and D1. The point of intersection of the demand curve and the supply curve is the equilibrium. Q* is the equilibrium quantity of money demanded and supplied in the market.
From the above figure, it can be seen that when the total demand for money increases in the economy, the earlier rate of interest r0 becomes unstable because now the quantity of money supplied is less than the quantity of money demanded. There occurs a dearth of money in the economy which pushes the interest rate to r1 up. In this way, the equilibrium rate of interest is determined in the economy.

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.

Answer 2

Given that, the money supply is $200 billion, quantity of money demanded for transactions is $150 billion, quantity of money demanded as an asset is $10 billion at 12% interest increasing by $10 billion for each 2% fall in the interest rate.
(a)
Below table shows the calculation of the interest rate:
Here, total quantity of money demanded is sum of the quantity of money demanded as an asset and transaction.
The equilibrium interest rate in country T is at the point where the quantity of money demanded is equal to the quantity of money supplied. Therefore, from the above table it can be observed that the equilibrium interest rate at country T is 4%.
(b)
At the equilibrium interest rate of 4% the total quantity of money demanded as well as the quantity of money supplied are $200 billion. The amount of money demanded for transactions is $150 billion , and the amount of money demanded as an asset is $50 billion.

Question 3

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.
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 3

(b) At the equilibrium interest rate the quantity of money supplied is 200 and the asset demand for money is 50, the transactions demand for money is 150 and the total quantity of money demanded is 200.

Question 4

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

Question 5

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.

Question 6

What is the impact of each of the following transactions on commercial bank reserves
b. Commercial banks borrow from the Federal Reserve Banks at the discount rate.

Question 7

What is the impact of each of the following transactions on commercial bank reserves
c. The Fed reduces the reserve ratio.

Question 8

What is the impact of each of the following transactions on commercial bank reserves
d. Commercial banks borrow from Federal Reserve Banks after winning an auction held as part of the term auction facility.

Question 9

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 10

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 11

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

Question 12

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

Question 13

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 14

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