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Chapter 16 - Interest Rates and Monetary Policy
Chapter 16 - Interest Rates and Monetary Policy
McConnell Brue Flynn 20e
DISCUSSION 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.
Qm
i1
i0
Dm 0 Dm1
Sm
Amount of money demanded and supplied
Rate of interest, i
(percent)
With an increase in total money demand, the previous interest rate (i0) is
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Chapter 16 - Interest Rates and Monetary Policy
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? LO3
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
3. 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? LO4
Answer: The Federal funds interest rate is the interest rate banks charge one
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
4. Why is a decrease in the supply of Federal funds shown as an upshift of the supply curve in
Figure 16.3, whereas an increase in Federal funds is shown as a downshift of the supply curve?
LO4
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
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Chapter 16 - Interest Rates and Monetary Policy
5. 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? LO5
Answer: To reduce inflation, the Federal funds rate should be raised. This would
be accomplished typically through open-market operations (selling bonds), but
6. Explain the links between changes in the nation’s money supply, the interest rate, investment
spending, aggregate demand, real GDP, and the price level. LO5
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
7. 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? LO6
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
Cyclical asymmetry, and the potential for a liquidity trap, is important to
policymakers because it suggests that while monetary policy can effectively fight
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Chapter 16 - Interest Rates and Monetary Policy
8. LAST WORD Did Operation Twist target long-term or short-term interest rates? How does
ZIRP cause problems for savers and pension funds? How might low interest rates lead to
problematic fiscal policy decisions?
Answer: Operation Twist targeted longer-term interest rates. ZIRP caused interest rates to
go to extremely low levels. This causes problems for savers and pension funds because
the yields on investments are extremely low. For example, low yields could force a retiree
Extremely low interest rates could also distort fiscal policy decisions because the interest
payments needed to finance deficit spending are low. This could cause policymakers to
REVIEW QUESTIONS
1. When bond prices go up, interest rates go_______ . LO1
a. Up.
b. Down.
c. Nowhere.
Feedback: When bond prices go up, interest rates go down. This happens because bond
prices and interest rates are inversely related. To see why they are inversely related, recall
that bonds are promises to repay particular amounts of money at particular points in the
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Chapter 16 - Interest Rates and Monetary Policy
2. A commercial bank sells a Treasury bond to the Federal Reserve for $100,000. The money
supply: LO3
a. Increases by $100,000.
b. Decreases by $100,000.
c. Is unaffected by the transaction.
Feedback: The money supply will increase by $100,000. This is true because when the
3. Use commercial bank and Federal Reserve Bank balance sheets to demonstrate the effect of
each of the following transactions on commercial bank reserves: LO3
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 increase their reserves after the Fed increases the interest rate that it pays on
reserves.
Consolidated Balance Sheet: All Commercial Banks
A B C
Assets:
Reserves $ 40 $ $ $
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42 41 40
Chapter 16 - Interest Rates and Monetary Policy
Consolidated Balance Sheet: 12 Federal Reserve Banks
A B C
Assets:
Securities $283 $ $ $
Feedback: In the tables above, 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 columns A, B, or C.
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. This is the
immediate effect to the consolidated balance sheet. 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 × 5) in the longer
term.
b. It is assumed the commercial banks borrow $1 billion from the Fed. The immediate
effect to the commercial banks' consolidated balance sheet is to increase reserves by $1
billion on the asset side and increase loans from the Federal Reserve banks by $1 billion
on the liabilities side. In the longer term, the commercial banks may now increase the
money supply (through making loans) by $5 billion (= $1 billion × 5).
c. Changing the reserve ratio in itself does not change the balance sheets. However, in the
longer term, 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.
d. Both columns A and B show an increase in commercial bank reserves. However,
column A is the better answer because it shows that the increase in reserves came from
selling securities, whereas the increase in reserves in column B came from loans from the
Federal Reserve Banks. It is unlikely that the Federal Reserve Banks would lend money
to commercial banks at an interest rate lower than the rate the Federal Reserve Banks pay
commercial banks on their reserves. The more likely scenario (which is not shown in the
balance sheets above) is that the commercial banks would increase their reserves by
decreasing loans to their customers.
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285 283 283
Chapter 16 - Interest Rates and Monetary Policy
4. A bank currently has $100,000 in checkable deposits and $15,000 in actual reserves. If the
reserve ratio is 20 percent, the bank has ___________ in money-creating potential. If the reserve
ratio is 14 percent, the bank has ___________ in money-creating potential. LO3
a. $20,000; $14,000.
b. $3,000; $2,100.
c. -$5,000; $1,000.
d. $5,000; $1,000.
Feedback: If the reserve ratio is 20 percent, the bank has – $5,000 in money-creating
potential. If the reserve ratio is 14 percent, the bank has $1,000 in money-creating
potential. To see why this is true, first consider the case where the bank has a reserve ratio
of 20 percent. Given that it has $100,000 in checkable deposits, the reserve ratio of 20
percent implies that the bank must keep $20,000 (= 0.20 × $100,000) worth of reserves.
5. A bank borrows $100,000 from the Fed, leaving a $100,000 Treasury bond on deposit with the
Fed to serve as collateral for the loan. The discount rate that applies to the loan is 4 percent and
the Fed is currently mandating a reserve ratio of 10 percent. How much of the $100,000 borrowed
by the bank must it keep as required reserves? LO3
a. $0.
b. $4,000.
c. $10,000.
d. $100,000.
Feedback: The bank must keep $0 as required reserves. This is true because the reserve
ratio does not apply to money that commercial banks borrow from the Fed. Thus, in this
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Chapter 16 - Interest Rates and Monetary Policy
6. Which of the following Fed actions will increase bank lending? LO3
Select one or more answers from the choices shown.
a. The Fed raises the discount rate from 5 percent to 6 percent.
b. The Fed raises the reserve ratio from 10 percent to 11 percent.
c. The Fed buys $400 million worth of Treasury bonds from commercial banks.
d. The Fed lowers the discount rate from 4 percent to 2 percent.
Answer: The two correct answers are: c. The Fed buys $400 million worth of Treasury
Feedback: These are correct because bank lending will rise when the Fed buys $400
million worth of Treasury bonds from commercial banks and when the Fed lowers the
discount rate from 4 percent to 2 percent. If the Fed buys $400 million worth of Treasury
bonds from commercial banks, the Fed will create $400 million worth of new money to
7. If the Federal Reserve wants to increase the federal funds rate using open-market operations, it
should _____________bonds. LO4
a. Buy.
b. Sell.
Feedback: If the Fed wants to increase the federal funds rate using open-market
operations, it should sell bonds. This is true because those who purchase bonds from the
Fed will have to pay for them with money. Thus, when the Fed sells bonds, money flows
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Chapter 16 - Interest Rates and Monetary Policy
8. True or False: A liquidity trap occurs when expansionary monetary policy fails to work because
an increase in bank reserves by the Fed does not lead to an increase in bank lending. LO6
Feedback: This statement is true because situations in which monetary policy fails
because increases in reserves do not lead to increases in lending are indeed referred to as
liquidity traps. Liquidity traps are very difficult for the Fed to deal with because they
9. True or False: In the United States, monetary policy has two key advantages over fiscal policy:
(1) isolation from political pressure and (2) speed and flexibility. LO6
Feedback: This statement is true because U.S. monetary policy is indeed isolated from
political pressure and does have notable advantages over U.S. fiscal policy in terms of
speed and flexibility. Monetary policy's political isolation is provided by the Federal
Reserve being a quasi-independent part of the government and by making sure that
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