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36-705
CHAPTER 36
Interest Rates and Monetary Policy
A. Short-Answer, Essays, and Problems
1. What is the goal of monetary policy?
2. What are the two reasons that people want to hold money? In other words, what are the two types of demand for
money?
3. Explain how the GDP and the interest rate are related to the transactions demand and asset demand for money.
4. What are the two types of demand that make up total demand for money?
5. The total demand for money is equal to the transactions demand plus the asset demand for money.
(a) Assume that each dollar held for transactions purposes is spent on the average five times per year to buy final
goods and services. If the nominal GDP is $5000 billion ($5 trillion), what is the transaction demand?
(b) The table below shows the asset demand at certain rates of interest. Using your answer to part (a), complete
the table to show the total demand for money at various rates of interest.
Interest rate
(in %)
Asset demand
(billions)
Total demand
(billions)
10
$ 40
$_____
8
80
_____
6
120
_____
4
160
_____
(c) If the money supply is $1080 billion, what will be the equilibrium rate of interest?
(d) If the money supply rises, will the equilibrium rate of interest rise or fall?
(e) If GDP rises, will the equilibrium rate of interest rise or fall?
6. The total demand for money is equal to the transactions demand plus the asset demand for money.
(a) Assume that each dollar held for transactions purposes is spent on the average five times per year to buy final
goods and services. If the nominal GDP is $10,000 billion ($10 trillion), what is the transaction demand?
(b) The table below shows the asset demand at certain rates of interest. Using your answer to part (a), complete
the table to show the total demand for money at various rates of interest.
Interest rate
(in %)
Asset demand
(billions)
Total demand
(billions)
10
$ 30
$_____
8
60
_____
6
90
_____
4
120
_____
(c) If the money supply is $2060 billion, what will be the equilibrium rate of interest?
(d) If the money supply rises, will the equilibrium rate of interest rise or fall?
(e) If GDP rises, will the equilibrium rate of interest rise or fall?
36-706
7. Use the table below to answer the questions.
Interest rate
(in %)
Asset demand
(billions)
14
$200
13
300
12
400
11
500
(a) If the transactions demand for money equals 10% of nominal GDP, the nominal GDP is $6000 billion, and
the supply of money is $900 billion, what is the equilibrium interest rate?
(b) If nominal GDP remains constant, and the money supply is increased from $900 to $1000 billion, what will
the equilibrium rate of interest be?
8. Use the table below to answer the questions.
Interest rate
(in %)
Asset demand
(billions)
14
$200
13
300
12
400
11
500
(a) If the transactions demand for money equals 10% of nominal GDP, the nominal GDP is $5000 billion, and
the supply of money is $900 billion, what is the equilibrium interest rate?
(b) If nominal GDP remains constant, and the money supply is decreased from $900 to $800 billion, what will
the equilibrium rate of interest be?
9. Use the graph below to answer the following questions. Dt is the transactions demand for money, Dm is the total
demand for money, and Sm is the supply of money.
(a) What is the transactions demand for money in this market?
(b) What is the asset demand for money if the interest rate is 4%?
(c) If the money market is in equilibrium at 6%, describe the change that must occur for the equilibrium rate to
change to 4%.
(d) If the money market is in equilibrium at 6% and the money supply has increased to Sm3, by how much has
total demand for money changed?
10. Analyze what would happen to the equilibrium rate of interest in the money market if the supply of money were
36-707
12. Use the table below for the next set of questions. Column 1 shows the interest rate, column 2 shows the demand
for money, and columns 3–5 show the supply of money. All quantities are in millions ($).
(1)
Interest
rate
(2)
Dm
(3)
Sm1
(4)
Sm2
(5)
Sm3
10%
$1500
$2200
$2500
$1800
8
1800
2200
2500
1800
6
2200
2200
2500
1800
4
2500
2200
2500
1800
2
2800
2200
2500
1800
(a) Given the demand for money, what will the equilibrium interest rate be for each of the different supply of
money schedules?
(b) Assume the economy was in equilibrium at Dm and Sm1. If the FED decides to change the money supply to
Sm2 and the interest rate stays the same, how much of a shortage or surplus in the money supply will there be?
Describe what will happen in the money market and the bond market to eliminate the surplus or shortage and
restore a new equilibrium interest rate.
(c) Assume the economy was in equilibrium at Dm and Sm1. If the FED decides to change the money supply to
Sm3 and the interest rate stays the same, how much of a shortage or surplus in the money supply will there be?
Describe what will happen in this money market and the bond market to eliminate the surplus or shortage of
money and restore a new equilibrium interest rate.
13. Answer the next two questions using the following information: The price of a bond with no expiration date is
$1000 and its fixed annual interest payment is $50; bond annual rate of interest is 5%.
14. Suppose that a bond having no expiration date has a face value of $5000 and pays a fixed amount of interest of
$500 annually. Compute and enter in the spaces provided the effective interest rate (to one decimal place) that a
bond buyer could receive at the new bond price.
Bond price
Interest rate
(%)
$3750
_____
4250
_____
5750
_____
6500
_____
36-708
15. Suppose that a bond having no expiration date has a face value of $10,000 and pays a fixed amount of interest of
$1000 annually. Compute and enter in the spaces provided either the effective interest rate which a bond buyer
could receive at the new price or the bond price (rounded to the nearest $1000) required to receive the interest rate
shown.
Bond price
Interest rate
(%)
$ 8,000
_____
_____
11.1
10,000
_____
12,000
_____
_____
6.67
16. Suppose that a bond having no expiration date has a face value of $10,000 and pays a fixed amount of interest of
$1000 annually. Compute and enter in the spaces provided either the effective interest rate which a bond buyer
could receive at the new price or the bond price (rounded to the nearest $1000) required to receive the interest rate
shown.
Bond price
Interest rate
(%)
$_____
12.5
9,000
_____
_____
10.0
_____
8.3
15,000
_____
17. Why is the money demand curve downsloping?
18. Suppose an increase in aggregate demand raises the price level. What would be the effect on the total money
demand curve?
19. Suppose you have a $2000 bond that makes an annual interest payment of $75. Use this information to answer
the following questions.
20. Identify the major items in the consolidated balance sheet of the Federal Reserve Banks.
21. Identify the four major instruments of monetary policy.
22. What are the four principal tools of monetary policy? Explain how they can be used.
23. What is the difference between the Federal Reserve Banks’ purchases of securities from the commercial banking
24. Both Federal Reserve Banks and commercial banks buy and sell government securities, but for substantially
different reasons. Explain.
36-709
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
25. Explain the impact of each of the following upon commercial bank reserves: (a) the Federal Reserve sells
government bonds in the open market to private buyers; (b) the commercial banks reduce their indebtedness to the
Federal Reserve Banks; (c) the Treasury makes a number of large disbursements in accelerating space research.
26. Explain what is meant by a collateralized money loan. Provide an example.
27. Discuss how repos and reverse repos can be used to increase or decrease the money supply.
28. (Consider This) Explain what is meant by the Federal Reserve’s collateralized transactions known as repos and
30. What is the discount rate and how does changing it affect the money supply?
31. Explain how a change in the interest rate on reserves affects the money supply.
36-710
32. Following are the consolidated balance sheets of the commercial banks. Assume that the reserve ratio for banks is
10%. The figures in column 1 show the balance sheets’ condition prior to each of the following five transactions.
Place the new balance-sheet figures in the appropriate columns and complete A, B, C, D, and E for each column.
Start each part (2–6) with the figures in column 1. All figures are in billions of dollars.
(1)
(2)
(3)
(4)
(5)
(6)
Assets:
Reserves $ 50
Securities 70
Loans 90
Liabilities:
Checkable deposits 200
Loans from Federal Reserve 10
A. Required reserves
B. Excess reserves
C. Change in M1
D. How much more can M1 change?
E. C + D total
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
$____
_
_____
_____
_____
_____
_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
(a) Show in column 2 the initial results of the Federal Reserve selling $3 billion in securities to the public which
pays by checks.
(b) Show in column 3 the initial results of the Federal Reserve buying $4 billion in securities from the
commercial banks.
(c) Show in column 4 the initial results of the Federal Reserve raising the reserve ratio to 20%.
(d) Show in column 5 the initial results when the U.S. Government buys $5 billion worth of goods from
American businesses with checks from the U.S. Treasury account at the Federal Reserve Banks and the
businesses immediately deposit these checks in their commercial banks.
(e) Show in column 6 the initial results when the Federal Reserve raises the discount rate which causes
commercial banks to repay $6 billion in loans owed to the Federal Reserve.
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33. The following are simplified balance sheets for the commercial banking system and the Federal Reserve system.
Perform each of the following three transactions, a, b, and c, making appropriate changes in columns (1) through
(3) in each balance sheet. Do not cumulate your answers. Also, answer these three questions for each part: (a)
What change, if any, took place in the money supply as a direct result of this transaction? (b) What change, if
any, occurred in commercial bank reserves? (c) What change occurred in the money-creating potential of the
commercial banking system if the reserve ratio is 20%? All figures are in billions of dollars.
Consolidated Balance Sheet: Commercial Banking System
(1)
(2)
(3)
Assets:
Reserves $ 45
Securities 80
Loans 80
Liabilities:
Checkable deposits 200
Loans from FRBs 5
$_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
$____
_
_____
_____
_____
_____
Consolidated Balance Sheet: Federal Reserve Banks
(1)
(2)
(3)
Assets:
Securities $80
Loans to CBs 5
Liabilities:
Reserves of CBs 45
Treasury deposits 5
Federal Reserve notes 35
$_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
$____
_
_____
_____
_____
_____
(a) Suppose a drop in the discount rate causes commercial banks to borrow an additional $2 billion from the Fed.
Show the new sheet figures in column 1.
(b) The Fed buys $3 billion of government bonds from the public. Show the new sheet figures in column 2.
(c) The Treasury spends $1 billion on research on new farm products. Show the new sheet figures in column 3.
36-712
34. The following are simplified balance sheets for the commercial banking system and the Federal Reserve System.
Perform each of the following three transactions, a, b, and c, making appropriate changes in columns (1) through
(3) in each balance sheet. Do not cumulate your answers. Also, answer these three questions for each part: (a)
What change, if any, took place in the money supply as a direct result of this transaction? (b) What change, if
any, occurred in commercial bank reserves? (c) What change occurred in the money-creating potential of the
commercial banking system if the reserve ratio is 20%? All figures are in billions of dollars.
Consolidated Balance Sheet: Commercial Banking System
(1)
(2)
(3)
Assets:
Reserves $ 50
Securities 75
Loans 75
Liabilities:
Checkable deposits 190
Loans from FRBs 10
$_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
$____
_
_____
_____
_____
_____
Consolidated Balance Sheet: Federal Reserve Banks
(1)
(2)
(3)
Assets:
Securities $90
Loans to CBs 10
Liabilities:
Reserves of CBs 50
Treasury deposits 10
Federal Reserve notes 10
$_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
$____
_
_____
_____
_____
_____
(a) Suppose a drop in the discount rate causes commercial banks to borrow an additional $3 billion from the Fed.
Show the new sheet figures in column 1.
(b) The Fed buys $2 billion of government bonds from the public. Show the new sheet figures in column 2.
(c) The Treasury spends $1 billion on research on new farm products. Show the new sheet figures in column 3.
35. Which tool of monetary policy is most important? Why?
36. What interest rate has been the focus of monetary policy?
37. What is the relationship between the Federal funds rate and the prime interest rate? Why doesn’t the Federal
Reserve target the prime interest rate?
42. How does monetary policy affect equilibrium GDP? How can it address the problem of recession or slow
growth? Inflation.
36-713
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
43. Other things being equal, what effect will each of the following have on the equilibrium rate of interest? (a) an
increase in the supply of money; (b) an increase in the equilibrium level of national income; (c) a decrease in the
supply of money; (d) a leftward shift of the asset demand for money.
44. Use the below graphs to answer the following questions assuming the nominal GDP in the economy is given.
48. Suppose the economy is experiencing a recession and high unemployment. What would be the interpretation of
how an expansionary monetary policy would address this problem?
49. Suppose the economy is experiencing inflation. What would be the interpretation of how a restrictive monetary
policy would address this problem?
52. What are the political and economic limitations upon (a) fiscal policy and (b) monetary policy?
53. How did the Fed use the Federal funds rate to respond to the mortgage default crisis?
54. One of the advantages of monetary policy is its speed and flexibility, but there are limitations. Explain.
56. What are the implications of a liquidity trap for the Federal Reserve?
57. Discuss the various monetary policy actions taken by the Federal Reserve to deal with the problems occurring in
58. Explain the “big picture” of macroeconomics based on the components of aggregate supply and
36-715
B. Answers to Short-Answer, Essays, and Problems
1. What is the goal of monetary policy?
2. What are the two reasons that people want to hold money? In other words, what are the two types of demand for
money?
3. Explain how the GDP and the interest rate are related to the transactions demand and asset demand for money.
The transactions demand for money is believed to have a direct relationship with GDP and the level of income,
but is thought to be largely independent of interest-rate fluctuations. The asset demand for money is believed to
4. What are the two types of demand that make up total demand for money?
The first type of demand for money is transaction demand or demand for money as a medium of exchange.
Households in part demand money because it is convenient for purchasing goods and services and valuable to
5. The total demand for money is equal to the transactions demand plus the asset demand for money.
(a) Assume that each dollar held for transactions purposes is spent on the average five times per year to buy final
goods and services. If the nominal GDP is $5000 billion ($5 trillion), what is the transaction demand?
(b) The table below shows the asset demand at certain rates of interest. Using your answer to part (a), complete
the table to show the total demand for money at various rates of interest.
Interest rate
(in %)
Asset demand
(billions)
Total demand
(billions)
10
$ 40
$_____
8
80
_____
6
120
_____
4
160
_____
(c) If the money supply is $1080 billion, what will be the equilibrium rate of interest?
(d) If the money supply rises, will the equilibrium rate of interest rise or fall?
(e) If GDP rises, will the equilibrium rate of interest rise or fall?
36-717
6. The total demand for money is equal to the transactions demand plus the asset demand for money.
(a) Assume that each dollar held for transactions purposes is spent on the average five times per year to buy final
goods and services. If the nominal GDP is $10,000 billion ($10 trillion), what is the transaction demand?
(b) The table below shows the asset demand at certain rates of interest. Using your answer to part (a), complete
the table to show the total demand for money at various rates of interest.
Interest rate
(in %)
Asset demand
(billions)
Total demand
(billions)
10
$ 30
$_____
8
60
_____
6
90
_____
4
120
_____
(c) If the money supply is $2060 billion, what will be the equilibrium rate of interest?
(d) If the money supply rises, will the equilibrium rate of interest rise or fall?
(e) If GDP rises, will the equilibrium rate of interest rise or fall?
Interest rate
(in %)
Asset demand
(billions)
Total demand
(billions)
10
$ 30
$2030
8
60
2060
6
90
2090
4
120
2120
(c) Where money supply is equal to total demand at 8%.
(d) If the money supply increases, the rate will fall.
(e) The rate will rise because transactions demand, hence total demand, will rise and intersect supply at a new
higher rate of interest.
7. Use the table below to answer the questions.
Interest rate
(in %)
Asset demand
(billions)
14
$200
13
300
12
400
11
500
(a) If the transactions demand for money equals 10% of nominal GDP, the nominal GDP is $6000 billion, and
the supply of money is $900 billion, what is the equilibrium interest rate?
(b) If nominal GDP remains constant, and the money supply is increased from $900 to $1000 billion, what will
the equilibrium rate of interest be?
36-718
8. Use the table below to answer the questions.
Interest rate
(in %)
Asset demand
(billions)
14
$200
13
300
12
400
11
500
(a) If the transactions demand for money equals 10% of nominal GDP, the nominal GDP is $5000 billion, and
the supply of money is $900 billion, what is the equilibrium interest rate?
(b) If nominal GDP remains constant, and the money supply is decreased from $900 to $800 billion, what will
the equilibrium rate of interest be?
9. Use the graph below to answer the following questions. Dt is the transactions demand for money, Dm is the total
demand for money, and Sm is the supply of money.
(a) What is the transactions demand for money in this market?
(b) What is the asset demand for money if the interest rate is 4%?
(c) If the money market is in equilibrium at 6%, describe the change that must occur for the equilibrium rate to
change to 4%.
(d) If the money market is in equilibrium at 6% and the money supply has increased to Sm3, by how much has
total demand for money changed?
10. Analyze what would happen to the equilibrium rate of interest in the money market if the supply of money were
increased while the demand schedule remained the same.
36-719
11. Explain how the money market responds to a shortage of money or to a surplus of money.
12. Use the table below for the next set of questions. Column 1 shows the interest rate, column 2 shows the demand
for money, and columns 3–5 show the supply of money. All quantities are in millions ($).
(1)
Interest
rate
(2)
Dm
(3)
Sm1
(4)
Sm2
(5)
Sm3
10%
$1500
$2200
$2500
$1800
8
1800
2200
2500
1800
6
2200
2200
2500
1800
4
2500
2200
2500
1800
2
2800
2200
2500
1800
(a) Given the demand for money, what will the equilibrium interest rate be for each of the different supply of
money schedules?
(b) Assume the economy was in equilibrium at Dm and Sm1. If the FED decides to change the money supply to
Sm2 and the interest rate stays the same, how much of a shortage or surplus in the money supply will there be?
Describe what will happen in the money market and the bond market to eliminate the surplus or shortage and
restore a new equilibrium interest rate.
(c) Assume the economy was in equilibrium at Dm and Sm1. If the FED decides to change the money supply to
Sm3 and the interest rate stays the same, how much of a shortage or surplus in the money supply will there be?
Describe what will happen in this money market and the bond market to eliminate the surplus or shortage of
money and restore a new equilibrium interest rate.
13. Answer the next two questions using the following information: The price of a bond with no expiration date is
$1000 and its fixed annual interest payment is $50; bond annual rate of interest is 5%.
(a) If the price of this bond decreases by $250 to $750, what will its effective interest rate be for the new buyer?
(b) If the price of this bond increases to $1200, what will its effective interest rate be for the new buyer?
36-720
14. Suppose that a bond having no expiration date has a face value of $5000 and pays a fixed amount of interest of
$500 annually. Compute and enter in the spaces provided the effective interest rate (to one decimal place) that a
bond buyer could receive at the new bond price.
Bond price
Interest rate
(%)
$3750
_____
4250
_____
5750
_____
6500
_____
Bond price
Interest rate
(%)
$3750
13.3
4250
11.8
5750
8.7
6500
7.7
15. Suppose that a bond having no expiration date has a face value of $10,000 and pays a fixed amount of interest of
$1000 annually. Compute and enter in the spaces provided either the effective interest rate which a bond buyer
could receive at the new price or the bond price (rounded to the nearest $1000) required to receive the interest rate
shown.
Bond price
Interest rate
(%)
$ 8,000
_____
_____
11.1
10,000
_____
12,000
_____
_____
6.67
Bond price
Interest rate
(%)
$ 8,000
12.5
9,000
11.1
10,000
10.0
12,000
8.3
15,000
6.67
