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Chapter 36 - Interest Rates and Monetary Policy
36-1
Chapter 36 - Interest Rates and Monetary Policy
McConnell Brue Flynn 21e
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
Chapter 36 - Interest Rates and Monetary Policy
36-2
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
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 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.
4. Distinguish between how the Fed would have to undertake restrictive monetary policy today
versus before the mortgage-debt crisis. What actions would it need to take in each case? LO4
Answer: Before 2008, short‐term interest rates were usually in the 3 to 10 percent range
and there was a lot of activity in the federal funds market. If the Fed wished to initiate a
Chapter 36 - Interest Rates and Monetary Policy
36-3
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
inflation.
5. Suppose that you are a member of the Board of Governors of the Federal Reserve System. The
post-2008 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
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
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
Chapter 36 - Interest Rates and Monetary Policy
36-4
8. LAST WORD By what chain of causation does the ECB think negative interest rates will
stimulate the economy? If the Fed manages to raise interest rates up to historical levels before the
next recession, will it have to consider negative interest rates as a first course of action in terms of
stimulating the economy? Explain.
Answer: Starting in 2014, the ECB had set negative interest rates. By March 2016, the
ECB had set its version of the federal funds rate at negative 0.4 percent for the Eurozone
REVIEW QUESTIONS
1. When bond prices go up, interest rates go_______ . LO1
a. Up.
b. Down.
c. Nowhere.
Chapter 36 - Interest Rates and Monetary Policy
36-5
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.
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.
Chapter 36 - Interest Rates and Monetary Policy
36-6
Consolidated Balance Sheet: 12 Federal Reserve Banks
A
B
C
Assets:
Securities
$283
$
285
$
283
$
283
Loans to commercial banks
2
2
3
2
Liabilities and net worth:
Reserves of commercial banks
40
42
41
40
Treasury deposits
5
5
5
5
Federal Reserve Notes
225
225
225
225
Other liabilities and net worth
15
15
15
15
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.
Chapter 36 - Interest Rates and Monetary Policy
36-7
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.
Answer: c. – $5,000, $1,000
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.
Chapter 36 - Interest Rates and Monetary Policy
36-8
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.
7. If the Federal Reserve wants to increase the federal funds rate using open-market operations, it
should _____________bonds. LO4
a. Buy.
b. Sell.
Chapter 36 - Interest Rates and Monetary Policy
36-9
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
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
Chapter 36 - Interest Rates and Monetary Policy
36-10
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?
Chapter 36 - Interest Rates and Monetary Policy
36-11
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
Chapter 36 - Interest Rates and Monetary Policy
36-12
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. LO3
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?
Chapter 36 - Interest Rates and Monetary Policy
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Chapter 36 - Interest Rates and Monetary Policy
CONSOLIDATED BALANCE SHEET: ALL COMMERCIAL BANKS
(1)
(2)
(3)
Assets:
Reserves
Securities
Loans
Liabilities and net worth:
Checkable deposits
Loans from the Federal
Reserve Banks
$ 33
60
60
150
3
$34
60
60
150
4
$30
60
60
147
3
$35
58
60
150
3
CONSOLIDATED BALANCE SHEET:
TWELVE FEDERAL RESERVE BANKS
(1)
(2)
(3)
Assets:
Securities
Loans to commercial banks
Liabilities and net worth:
Reserves of commercial banks
Treasury deposits
Federal Reserve Notes
$60
3
$33
3
27
$60
4
$34
3
27
$57
3
$30
3
27
$62
3
$35
3
27
Part d:
Transaction (b):
Chapter 36 - Interest Rates and Monetary Policy
36-15
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Assuming a 20% reserve ratio, the money-creating potential of the commercial banking
system has decreased by $12 billion. This one takes a little more thought. Reserves have
fallen by $3 billion. Given the monetary multiplier is 5 (=1/0.20) this results in a decrease
in money-creating potential of $15 billion (=5 x $3 billion). However, checkable deposits
have also fallen by $3 billion. This implies that the bank has additional excess reserves of
$0.6 billion (= .20 (required reserve ratio) x $3 billion (decrease in checkable deposits))
relative to reserves prior to the transaction. The bank can lend out these additional excess
reserves. Again, given the monetary multiplier is 5 (=1/0.20) this results in an increase in
money-creating potential of $3 billion (=5 x $.06 billion).
Combining these two effects the money-creating potential of the commercial banking
system has decreased by $12 billion as stated above (= decrease of $15 billion due to the
direct fall in reserves minus the $3 billion increase resulting from the decrease of
checkable deposits and reduced need for required reserves.)
Transaction (c):
There is no immediate effect on the money supply because the banks checkable deposits
(and loans) have not changed immediately after the transaction.
Reserves increased from $33 to $35 billion.
Assuming a 20% reserve ratio, the money-creating potential of the commercial banking
system has increased by $10 billion. The monetary multiplier here is 5 (=1/0.20) and the
increase in reserves is $2 billion.
4. Refer to Table 36.2 and assume that the Fed’s reserve ratio is 10 percent and the economy is in
a severe recession. Also suppose that the commercial banks are hoarding all excess reserves (not
lending them out) because of their fear of loan defaults. Finally, suppose that the Fed is highly
concerned that the banks will suddenly lend out these excess reserves and possibly contribute to
inflation once the economy begins to recover and confidence is restored. By how many
percentage points would the Fed need to increase the reserve ratio to eliminate one-third of the
excess reserves? What would be the size of the monetary multiplier before and after the change in
the reserve ratio? By how much would the lending potential of the banks decline as a result of the
increase in the reserve ratio? LO3
Chapter 36 - Interest Rates and Monetary Policy
36-16
5. Suppose that the target range for the federal funds rate is 1.5 to 2.0 percent but that the
equilibrium federal funds rate is currently 1.70 percent. Assume that the equilibrium federal funds
rate falls (rises) by 1 percent for each $120 billion in repo (reverse repo) bond transactions the
Fed undertakes. If the Fed wishes to raise the equilibrium federal funds rate up to the top end of
the target range, will it initiate repos or reverse repos of bonds to nonbank financial firms? How
much will it have to repo or reverse repo? LO4
6. Suppose that inflation is 2 percent, the Federal funds rate is 4 percent, and real GDP falls 2
percent below potential GDP. According to the Taylor rule, in what direction and by how much
should the Fed change the real Federal funds rate? LO4
Chapter 36 - Interest Rates and Monetary Policy
36-17
7. Refer to the accompanying table for Moola to answer the following questions. LO5
What is the equilibrium interest rate in Moola? What is the level of investment at the equilibrium
interest rate? Is there either a recessionary output gap (negative GDP gap) or an inflationary
output gap (positive GDP gap) at the equilibrium interest rate, and, if either, what is the amount?
Given money demand, by how much would the Moola central bank need to change the money
supply to close the output gap? What is the expenditure multiplier in Moola?
