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Chapter 16 - Interest Rates and Monetary Policy
16-1
CHAPTER 16
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?
Chapter 16 - Interest Rates and Monetary Policy
16-2
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 $800 billion, what
will the equilibrium rate of interest be?
9. Use the graph below to answer the following questions. Dt is the transactions demand for money, Dm is the
total demand for money, and Sm is the supply of money.
(a) What is the transactions demand for money in this market?
(b) What is the asset demand for money if the interest rate is 4%?
(c) If the money market is in equilibrium at 6%, describe the change that must occur for the equilibrium
rate to change to 4%.
(d) If the money market is in equilibrium at 6% and the money supply has increased to Sm3, by how much
has total demand for money changed?
10. Analyze what would happen to the equilibrium rate of interest in the money market if the supply of money
were increased while the demand schedule remained the same.
11. Explain how the money market responds to a shortage of money or to a surplus of money.
Chapter 16 - Interest Rates and Monetary Policy
16-3
12. Use the table below for the next set of questions. Column 1 shows the interest rate, column 2 shows the
demand for money, and columns 3–5 show the supply of money. All quantities are in millions ($).
Chapter 16 - Interest Rates and Monetary Policy
16-4
(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?
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 _____
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
Chapter 16 - Interest Rates and Monetary Policy
16-5
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.
(a) Suppose the current interest rate is 6%. What would be the market price of the bond?
(b) Suppose the interest rate lowered to 3.75%. What would be the market price of the bond?
(c) Suppose the interest rate lowered even further to 2%. What would be the market price of the bond?
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 system and those from the public? Give an example.
24. Both Federal Reserve Banks and commercial banks buy and sell government securities, but for
substantially different reasons. Explain.
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 how a change in the reserve ratio affects the money supply.
27. What is the discount rate and how does changing it affect the money supply?
28. What is the term auction facility and how does it affect the excess reserves and the monetary multiplier of
the banking system?
Chapter 16 - Interest Rates and Monetary Policy
16-6
29. 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?
Chapter 16 - Interest Rates and Monetary Policy
16-7
E. C + D total
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
Chapter 16 - Interest Rates and Monetary Policy
16-8
(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.
30. 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
$_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
Chapter 16 - Interest Rates and Monetary Policy
16-9
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.
31. 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
Chapter 16 - Interest Rates and Monetary Policy
16-10
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.
32. Which tool of monetary policy is most important? Why?
33. What interest rate has been the focus of monetary policy?
34. 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?
35. How is the Federal funds rate established? What role does the Federal Reserve play?
Chapter 16 - Interest Rates and Monetary Policy
16-11
36. What is the Federal funds rate and how does the Fed target it?
37. Describe how changes in the Fed’s major policy tool leads to expansionary and restrictive monetary
policies.
38. Define the Taylor rule.
39. How does monetary policy affect equilibrium GDP? How can it address the problem of recession or slow
growth? Inflation?
40. 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.
41. Use the below graphs to answer the following questions assuming the nominal GDP in the economy is
given.
(a) Look at graph A and suppose the supply of money increases from 100 to 200. What will be the
equilibrium rate of interest?
(b) Look at graph B which shows an investment-demand curve for this economy. Given the answer to part
(a) above, how much will investors plan to spend on capital goods?
(c) What will happen to aggregate demand?
(d) Now trace what will happen in parts (a)–(c) if the money supply increases to $300.
42. Trace the cause-effect chain that results from an expansionary monetary policy.
43. Trace the cause-effect chain that results from a restrictive monetary policy.
44. Differentiate between expansionary and restrictive monetary policies.
45. 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?
Chapter 16 - Interest Rates and Monetary Policy
16-12
46. Suppose the economy is experiencing inflation. What would be the interpretation of how a restrictive
monetary policy would address this problem?
47. Discuss the relative merits of monetary policy under conditions of demand-pull inflation or recession.
48. Explain two strengths of monetary policy for achieving economic stability.
49. What are the political and economic limitations upon (a) fiscal policy and (b) monetary policy?
50. Describe how the Federal Reserve handled the monetary policy from 2000–2006. What type of economic
events did it face and how did it use monetary policy to address them?
51. How did the Fed use the Federal funds rate to respond to the mortgage default crisis?
52. One of the advantages of monetary policy is its speed and flexibility, but there are limitations. Explain.
53. Explain what is meant by cyclical asymmetry with regard to monetary policy effects.
54. What are the implications of a liquidity trap for the Federal Reserve?
55. (Consider This) How did the consolidated balance sheet of the 12 Federal Reserve banks change during the
severe recession of 2007–2009?
56. (Last Word) Explain the “big picture” of macroeconomics based on the components of aggregate supply
and aggregate demand.
Chapter 16 - Interest Rates and Monetary Policy
16-13
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.
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?
Chapter 16 - Interest Rates and Monetary Policy
16-14
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?
Chapter 16 - Interest Rates and Monetary Policy
16-15
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 $800 billion, what
will the equilibrium rate of interest be?
9. Use the graph below to answer the following questions. Dt is the transactions demand for money, Dm is the
total demand for money, and Sm is the supply of money.
(a) What is the transactions demand for money in this market?
(b) What is the asset demand for money if the interest rate is 4%?
(c) If the money market is in equilibrium at 6%, describe the change that must occur for the equilibrium
rate to change to 4%.
Chapter 16 - Interest Rates and Monetary Policy
16-16
(d) If the money market is in equilibrium at 6% and the money supply has increased to Sm3, by how much
has total demand for money changed?
10. Analyze what would happen to the equilibrium rate of interest in the money market if the supply of money
were increased while the demand schedule remained the same.
11. Explain how the money market responds to a shortage of money or to a surplus of money.
12. Use the table below for the next set of questions. Column 1 shows the interest rate, column 2 shows the
demand for money, and columns 3–5 show the supply of money. All quantities are in millions ($).
Chapter 16 - Interest Rates and Monetary Policy
16-17
(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?
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 _____
Chapter 16 - Interest Rates and Monetary Policy
16-18
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
[text: E p. 673; MA p. 317]
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.
Chapter 16 - Interest Rates and Monetary Policy
16-19
(a) Suppose the current interest rate is 6%. What would be the market price of the bond?
(b) Suppose the current interest rate fell to 3.75%. What would be the market price of the bond?
(c) Suppose the current interest rate fell even further to 2%. What would be the market price of the bond?
