Solutions Manual Ch33 - macroeconomic Tutorial exercise questions principle macroeconomic PDF

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Chapter 33 - Interest Rates and Monetary Policy

Chapter 33 Interest Rates and Monetary Policy QUESTIONS 1. What is the basic determinant of (a) the transactions demand and (b) the asset demand for money? Explain how these two demands can be combined graphically to determine total money demand. How is the equilibrium interest rate in the money market 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. LO1 Answer: (a) The level of nominal GDP. The higher this level, the greater the amount of money demanded for transactions. (b) The interest rate. The higher the interest rate, the smaller the amount of money demanded as an asset. On a graph measuring the interest rate vertically and the amount of money demanded horizontally, the two demands for the money curves can be summed horizontally to get the total demand for money. This total demand shows the total amount of money demanded at each interest rate. The equilibrium interest rate is determined at the intersection of the total demand for money curve and the supply of money curve.

Rate of interest, i (percent)

Sm

i1

i0

Dm 0

D m1

Qm Amount of money demanded and supplied

With an increase in total money demand, the previous interest rate (i0) is unsustainable because with the new demand for money (Dm1), the quantity of money demanded will exceed the quantity of money supplied. There would be a shortage of funds and upward pressure on the interest rate. 2. What is the basic objective of monetary policy? What are the major strengths of monetary policy? Why is monetary policy easier to conduct than fiscal policy? LO2

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Chapter 33 - Interest Rates and Monetary Policy

Answer: The basic objective of monetary policy is to assist the economy in achieving a full-employment, non-inflationary level of total output. The major strengths of monetary policy are its speed and flexibility compared to fiscal policy, the Board of Governors is somewhat removed from political pressure, and its successful record in preventing inflation and keeping prices stable. The Fed is given some credit for prosperity in the 1990s and early 2000s. Monetary policy is formed by the 7 members of the Board of Governors. Fiscal policy requires the consent of both houses in Congress, plus the President. One of the implications is that monetary policy has a much shorter administrative lag than fiscal policy. 3. Use commercial bank and Federal Reserve Bank balance sheets to demonstrate the impact of each of the following transactions on commercial bank reserves: LO2 a. Federal Reserve Banks purchase securities from banks. 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. Answer: In the tables below, columns “a” through “c” show the changes caused by the answers to the questions. It is assumed the initial reserve ratio is 20 percent. Thus, as the first column shows, the commercial banks are initially completely loaned up. The answers are not cumulated: We return to the first column each time to show the resulting change in column a, b, or c. If you would rather not use numbers, it would be acceptable to substitute with + or - signs, using symbols to represent numbers. For example, part (a) could read “the Fed purchases ‘x dollars’ worth of securities,” and instead of the $2 billion changes on the balance sheet, you would indicate + x. Note: Any numbers could demonstrate this if direction is same. The answer to part (d) is similar to that of part (b) conditional on winning the auction. (a) It is assumed the Fed buys $2 billion worth of securities. This should increase commercial bank reserves by $2 billion, and reduce securities by $2 billion. With demand deposits of $200 billion, required reserves are $40 billion, (= 20 percent of $200 billion). Therefore, excess reserves are $2 billion (= $42 billion - $40 billion) and the banking system can increase the money supply (by making loans) by $10 billion more (= $2 billion x 5). (b) It is assumed the commercial banks borrow $1 billion from the Fed. The commercial banks may now increase the money supply (through making loans) by $5 billion (= $1 billion x 5). (c) Changing the reserve ratio in itself does not change the balance sheets. However, if we assume the reserve ratio has been decreased from 20 percent to 19 percent, required reserves are now $38 billion (= 19 percent of $200 billion) and the commercial banks can now increase the money supply (through making loans) by $10.53 billion [= $2 billion (1/0.19)]. Proof: 19 percent of $210.53 billion is $40 billion.

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Chapter 33 - Interest Rates and Monetary Policy

CONSOLIDATED BALANCE SHEET: ALL COMMERCIAL BANKS A B C Assets: Reserves Securities Loans Liabilities and net worth: Checkable deposits Loans from the Federal Reserve Banks

$ 40 60 102

$ 42 58 102

$ 41 60 102

$ 40 60 102

200

200

200

200

2

2

3

2

CONSOLIDATED BALANCE SHEET: TWELVE FEDERAL RESERVE BANKS A Assets: Securities Loans to commercial banks Liabilities and net worth: Reserves of commercial banks Treasury deposits Federal Reserve Notes Other liabilities and net worth

B

C

$283 2

$285 2

$283 3

$283 2

40 5 225 15

42 5 225 15

41 5 225 15

40 5 225 15

4. Distinguish between the Federal funds rate and the prime interest rate. Why is one higher than the other? Why do changes in the two rates closely track one another? LO3 Answer: The Federal funds interest rate is the interest rate banks charge one another on overnight loans needed to meet the reserve requirement. The prime interest rate is the interest rate banks charge on loans to their most creditworthy customers. The Federal funds rate is lower than the prime interest rate for a number of reasons. Federal funds are loaned overnight, so lenders don’t have to wait long for repayment. The reserves loaned would otherwise generate no interest, so even loaning at the lower Federal funds rate is beneficial to lenders. Interest rates also depend on risk. It is less risky to lend overnight to other banks than it is to lend for longer periods to non-bank businesses and households. Both rates are related to the relative scarcity or availability of reserves. If there are less reserves available for lending, the price to borrow those reserves (the interest rate) will rise whether the customers are banks, businesses, or households. 5. Why is a decrease in the supply of Federal funds shown as an upshift of the supply curve in Figure 33.3, whereas an increase in Federal funds is shown as a downshift of the supply curve? LO3

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Chapter 33 - Interest Rates and Monetary Policy

Answer: The decrease in the supply of Federal funds is shown as an upshift in the supply curve because the FED will ensure that the quantity of funds supplied equals the quantity of funds demanded at the targeted rate of 4.5%. In effect, the FED creates a perfectly elastic (horizontal) supply curve to target the rate of 4.5%. This logic applies to an increase in Federal funds where we observe a downshift in the supply curve. Here the FED targets the rate of 3.5%, so the amount of funds in the market are constantly adjusted to match demand at this targeted rate. Again, in effect the supply curve is perfectly elastic(horizontal). 6. Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp rise in the inflation rate. What change in the Federal funds rate would you recommend? How would your recommended change get accomplished? What impact would the actions have on the lending ability of the banking system, the real interest rate, investment spending, aggregate demand, and inflation? LO3, LO4 Answer: To reduce inflation, the Federal funds rate should be raised. This would be accomplished typically through open-market operations (selling bonds), but could also be achieved with an increase in the reserve ratio or discount rate. The restrictive monetary policy would reduce the lending ability of the banking system, increase the real interest rate, reduce investment spending, reduce aggregate demand, and reduce inflation. 7. Explain the links between changes in the nation’s money supply, the interest rate, investment spending, aggregate demand, real GDP, and the price level. LO4 Answer: A change in the nation’s money supply (achieved by changing reserves in the banking system) will cause an opposite change in the interest rate. A reduction in the money supply will make funds increasingly scarce and drive up their price (interest rate). The interest rate and investment spending are also inversely related. A rising interest rate will make some investments (capital spending projects) unprofitable, so spending on those will decline. Investment spending is part of aggregate demand, so they will move together, as will real GDP. A decline in spending (AD) will reduce inflationary pressure (and will reduce prices if they are downwardly flexible). 8. What do economists mean when they say that monetary policy can exhibit cyclical asymmetry? How does the idea of a liquidity trap relate to cyclical asymmetry? Why is this possibility of a liquidity trap significant to policymakers? LO5 Answer: Cyclical asymmetry refers to the condition that a restrictive monetary policy is relatively potent at contracting economic activity, while an expansionary monetary policy is relatively weak at stimulating an economy. The weakness in expansionary monetary policy results when, even though the Fed increases liquidity (reserves) in the system, potential borrowers are unwilling to spend (often because of uncertainty over general weakness in the economy). This is often referred to as a liquidity trap.

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Chapter 33 - Interest Rates and Monetary Policy

Cyclical asymmetry, and the potential for a liquidity trap, is important to policymakers because it suggests that while monetary policy can effectively fight inflation, it may not be as successful in bringing an economy out of a recession. As Japan learned in the 1990s, expansionary monetary policy may be inadequate, and an expansionary fiscal policy may be necessary to stimulate recovery. 9. LAST WORD What are the three main aggregate supply factors that determine a nation’s potential (or full employment) level of real output? What are the four main components of aggregate demand? Explain: “Aggregate supply factors determine a nation’s potential GDP whereas aggregate demand factors determine whether or not the nation achieves its full employment GDP.” How does fiscal and monetary policy relate to aggregate demand? Answer: From the Figure we see that the three main aggregate supply factors that determine a nation’s potential (or full employment) level of real output are: (1) Inputs (2) Productivity and (3) the legal-institutional environment. Also from the figure we see that the four main components of aggregate demand are: (1) Consumption (2) Investment (3) Net Export spending and (4) Government spending. The reason that aggregate supply factors determine a nation’s potential GDP is because it is this set of factors that determines what, and how much, an economy can produce. However, aggregate demand factors determine whether or not the nation achieves its full employment GDP. For example, the economy may be able to produce goods, but if no one is willing to purchase the goods they will not be produced. Fiscal and Monetary policy can potentially guide aggregate demand to the appropriate level to achieve full-employment. PROBLEMS 1. Assume that the following data characterize the hypothetical economy of Trance: 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. LO1 a. What is the equilibrium interest rate in Trance? 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 in Trance? Answer: (a) 4% (b) $200; $200; $150; $50 Feedback: Consider the following example. Assume that the following data characterize the hypothetical economy of Trance: 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. LO1

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Chapter 33 - Interest Rates and Monetary Policy

Part a: What is the equilibrium interest rate in Trance? To answer this part of the question we use the table below. The first column is the interest rate and the second column is the quantity of money demanded as an asset at each rate. The third column us the quantity of money demanded for transactions, which is independent of the interest rate. The fourth column is actual (total) quantity of money demanded at each interest rate, which is the sum of the columns 1 and 2. The fifth column is the quantity of money supplied at each interest rate.

Interest Rate

Asset Demand for Money

Transactions Demand

12% 10% 8% 6% 4% 2%

10 20 30 40 50 60

150 150 150 150 150 150

Combined Demand for Money 160 170 180 190 200 210

Money Supply

200 200 200 200 200 200

We find the equilibrium interest rate by equating the quantity supplied with the quantity demanded, which occurs at the interest rate of 4%. Part b: 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 in Trance? It also follows from the answer above that the equilibrium quantity of money supplied is $200 and the equilibrium quantity demanded is $200. We can decompose the quantity demanded into its separate components, where the amount of money demanded for transactions is $150 and the amount of money demanded as an asset is $50. 2. Suppose a bond with no expiration date has a face value of $10,000 and annually pays a fixed amount of interest of $800. In the table provided, calculate and enter either the interest rate that the bond would yield to a bond buyer at each of the bond prices listed or the bond price at each of the interest yields shown. Round your answer to the nearest thousandth. What generalization can be drawn from the completed table? LO1

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Chapter 33 - Interest Rates and Monetary Policy

Answer: The generalization is that Bond price and interest rate are inversely related. Feedback: Consider the following example. Suppose a bond with no expiration date has a face value of $10,000 and annually pays a fixed amount of interest of $800. Compute and enter in the spaces provided in the accompanying table either the interest rate that the bond would yield to a bond buyer at each of the bond prices listed or the bond price at each of the interest yields shown. What generalization can be drawn from the completed table?

To answer this question we use the formula for a perpetuity. Bond Price = Fixed Payment Amount / Interest Yield or Interest Yield = Fixed Payment Amount / Bond Price Bond Price $8,000: Interest Yield = $800/$8000 = 0.10 (or 10%) Interest Yield 8.9%: Bond Price = $800/.089 = $9000 (rounded to nearest thousandth) Bond Price $10,000: Interest Yield = $800/$10,000 = 0.08 (or 8%) Bond Price $11,000: Interest Yield = $800/$11,000 = 0.07272 (or 7.272%) Interest Yield 6.2%: Bond Price = $800/.062 = $13,000 (rounded to nearest thousandth) Note here that the Face Value does not enter the equation because it has no expiration date (you could actually drop this part of the question). The generalization is that bond price and interest rate are inversely related. 3. In the accompanying tables you will find consolidated balance sheets for the commercial banking system and the 12 Federal Reserve Banks. Use columns 1 through 3 to indicate how the balance sheets would read after each of transactions a to c is completed. Do not cumulate your answers; that is, analyze each transaction separately, starting in each case from the numbers provided. All accounts are in billions of dollars. LO2

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Chapter 33 - Interest Rates and Monetary Policy

a. A decline in the discount rate prompts commercial banks to borrow an additional $1 billion from the Federal Reserve Banks. Show the new balance-sheet numbers in column 1 of each table. b. The Federal Reserve Banks sell $3 billion in securities to members of the public, who pay for the bonds with checks. Show the new balance-sheet numbers in column 2 of each table. c. The Federal Reserve Banks buy $2 billion of securities from commercial banks. Show the new balance-sheet numbers in column 3 of each table. d. Now review each of the above three transactions, asking yourself these three questions: (1) What change, if any, took place in the money supply as a direct and immediate result of each transaction? (2) What increase or decrease in the commercial banks’ reserves took place in each transaction? (3) Assuming a reserve ratio of 20 percent, what change in the money-creating potential of the commercial banking system occurred as a result of each transaction? Answer: (a) Commercial Bank Balance Sheet (Column 1): Reserves = $34, Securities = $60, Loans = $60, Checkable deposits = $150, Loans from the Federal Reserve Banks = $4; The 12 Federal Reserve Banks Balance Sheet (Column 1): Securities = $60, Loans to commercial banks = $4, Reserves of commercial banks = $34, Treasury deposits = $3, Federal Reserve Notes = $27

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Chapter 33 - Interest Rates and Monetary Policy

(b) Commercial Bank Balance Sheet (Column 2): Reserves = $30, Securities = $60, Loans = $60, Checkable deposits = $147, Loans from the Federal Reserve Banks = $3; The 12 Federal Reserve Banks Balance Sheet (Column 2): Securities = $57, Loans to commercial banks = $3, Reserves of commercial banks = $30, Treasury deposits = $3, Federal Reserve Notes = $27 (c) Commercial Bank Balance Sheet (Column 3): Reserves = $35, Securities = $58, Loans = $60, Checkable deposits = $150, Loans from the Federal Reserve Banks = $3; The 12 Federal Reserve Banks Balance Sheet (Column 3): Securities = $62, Loans to commercial banks = $3, Reserves of commercial banks = $35, Treasury deposits = $3, Federal Reserve Notes = $27 (d) Transaction (a) – 1: No immediate effect on the money supply; 2: Reserves increased from $33 to $34 billion; 3: Money-creating potential increased by $5 billion Transaction (b) – 1: Immediate decrease in the money supply by $3 billion; 2: Reserves fall from $33 to $30 billion; 3: Money-creating potential decreased by $12 billion Transaction (c) – 1: No immediate effect on the money supply; 2: Reserves increased from $33 to $35 billion; 3: money-creating potential increased by $10 billion Feedback: Consider the following example for the data and questions below. In the accompanying tables you will find consolidated balance sheets for the commercial banking system and the 12 Federal Reserve Banks. Use columns 1 through 3 to indicate how the balance sheets would read after each of transactions a to c is completed. Do not cumulate your answers; that is, analyze each transaction separately, starting in ...