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Solution
Solution
S-207
1. Go to the FOMC page of the Federal Reserve Board’s website (www.federal
reserve.gov/FOMC/) to find the statement issued after the most recent FOMC
meeting. (Click on “Meeting calendars and information” and then click on the
1. Answers will vary depending on when you look up the information. As of November 2014,
the latest statement was issued October 29, after the October 28–29 FOMC meeting.
a. On October 26, 2014, the Fed announced that it had kept the target range for the
federal funds rate unchanged at 0% to 0.25%.
b. No, the target rate remained the same. In fact, on October 26, 2014, the FOMC
2. How will the following events affect the demand for money? In each case, specify
whether there is a shift of the demand curve or a movement along the demand curve
and its direction.
a. There is a fall in the interest rate from 12% to 10%.
2. a. Any decrease in the interest rate will lead to an increase in the quantity of money
demanded (a movement down the money demand curve) but no shift in the
money demand curve.
Monetary Policy 15
CHAPTER
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Solution
Solution
S-208 CHAPTER 15 MONETARY POLICY
c. As McDonald’s and other fast - food restaurants begin to accept credit cards, it
3. a. Go to www.treasurydirect.gov. Under “Individuals,” go to “Treasury Securities &
Programs.” Click on “Treasury bills.” Under “at a glance,” click on “rates in
recent auctions.” What is the investment rate for the most recently issued
26-week T-bills?
3. a. Answers will vary. On December 2, 2014, the investment rate for the most
recently issued 26-week T-bills was 0.076%.
b. Answers will vary. At discoverbank.com, the interest rate for six-month CDs on
December 2, 2014, was 0.65%.
4. Go to www.treasurydirect.gov. Under “Individuals,” go to “Treasury Securities &
Programs.” Click on “Treasury notes.” Under “at a glance,” click on “rates in recent
auctions.” Use the list of Recent Note, Bond, and TIPS Auction Results to answer the
following questions.
4. a. Answers will vary. On December 2, 2014, the interest rate on the most recently
issued 2-year note was 0.5% and the interest rate on the most recently issued
10-year note was 2.25%.
b. The interest rate on the 10-year note is higher than the interest rate on the 2-year
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Solution
5. An economy is facing the recessionary gap shown in the accompanying diagram. To
eliminate the gap, should the central bank use expansionary or contractionary mone-
tary policy? How will the interest rate, investment spending, consumer spending, real
GDP, and the aggregate price level change as monetary policy closes the recessionary
gap?
Aggregate
price
LRAS
SRAS
5. The central bank can use expansionary monetary policy to eliminate the recession-
ary gap. The central bank could engage in an open - market purchase of U.S. Treasury
bills. This would increase the money supply, lower the interest rate, and encourage
Aggregate
price
level
P2
LRAS
E2
SRAS
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Solution
6. An economy is facing the inflationary gap shown in the accompanying diagram. To
eliminate the gap, should the central bank use expansionary or contractionary mone-
tary policy? How will the interest rate, investment spending, consumer spending, real
GDP, and the aggregate price level change as monetary policy closes the inflationary
gap?
SRAS
Aggregate
price
level
LRAS
6. The central bank can use contractionary monetary policy to eliminate the inflation-
ary gap. The central bank could engage in an open - market sale of U.S. Treasury bills.
This would reduce the supply of money, raise the interest rate, and reduce invest-
ment spending. The reduction in investment spending will lead consumers to reduce
their spending. The final situation is illustrated in the accompanying diagram by the
movement of the AD curve from its initial position, AD1, to its new location, AD2.
Real GDP and the aggregate price level will fall.
SRAS
Aggregate
price
level
LRAS
S-210 CHAPTER 15 MONETARY POLICY
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Solution
7. In the economy of Eastlandia, the money market is initially in equilibrium when the
economy begins to slide into a recession.
a. Using the accompanying diagram, explain what will happen to the interest rate if
the central bank of Eastlandia keeps the money supply constant at M
᎐᎐
1.
Interest
rate, r
MS1
7. a. Beginning at equilibrium point E1 in the accompanying money market diagram,
when the economy of Eastlandia goes into recession, aggregate spending will fall
and the money demand curve will shift to the left, from MD1 to MD2, moving the
CHAPTER 15 MONETARY POLICY S-211
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Solution
b. If the central bank is committed to maintaining an interest rate target of r1, then
the central bank will reduce the money supply as the economy goes into recession,
from MS1 to MS2 in the accompanying diagram, eliminating the potential for
interest rates to fall. The new equilibrium in the money market is at E3, with the
interest rate at its target rate, r1.
MS1
MS2
Interest
rate, r
8. Suppose that the money market in Westlandia is initially in equilibrium and the cen-
tral bank decides to decrease the money supply.
8. a. In the short run, the money supply curve will shift to the left, to MS2, and the
interest rate will rise from r1 to r2.
MS2MS1
Interest
rate
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Solution
b. Over time, the aggregate price level will fall. This will reduce money demand,
shifting the money demand curve left from MD1 to MD2, which causes the equi-
librium interest rate to fall again.
MS2MS1
Interest
rate
E2
9. An economy is in long - run macroeconomic equilibrium with an unemployment rate
of 5% when the government passes a law requiring the central bank to use monetary
9. If the economy is in long - run macroeconomic equilibrium with an unemployment
rate of 5%, then the long - run aggregate supply curve must be vertical at a real GDP
that is associated with a 5% unemployment rate. This long - run macroeconomic
equilibrium is E1 in the accompanying diagram. In the short run, the central bank
can engage in expansionary monetary policy to shift the aggregate demand curve to
CHAPTER 15 MONETARY POLICY S-213
Solution
10. According to the European Central Bank website, the treaty establishing the
European Community “makes clear that ensuring price stability is the most impor-
10. If price stability is the only goal of monetary policy, then during recessions resulting
from a leftward shift of the aggregate demand curve, as the aggregate price level falls,
the central bank would engage in expansionary monetary policy. This would lower
11. The effectiveness of monetary policy depends on how easy it is for changes in the
money supply to change interest rates. By changing interest rates, monetary policy
affects investment spending and the aggregate demand curve. The economies of
Albernia and Brittania have very different money demand curves, as shown in the
accompanying diagram. In which economy will changes in the money supply be a
more effective policy tool? Why?
Interest
rate, r
MS1
r1
(a) Albernia
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Solution
Solution
11. According to the accompanying diagram, monetary policy will be more effective in
Albernia and less effective in Brittania. In Albernia a relatively small change in the
money supply will lead to a large change in the interest rate, but in Brittania a rela-
tively large change in the money supply will lead to only a small change in the inter-
est rate.
MS2MS2
MS1MS1
Interest
rate, r
Interest
rate, r
(a) Albernia (b) Brittania
12. During the Great Depression, businesspeople in the United States were very pes-
simistic about the future of economic growth and reluctant to increase investment
spending even when interest rates fell. How did this limit the potential for monetary
policy to help alleviate the Depression?
12. Monetary policy is effective when changes in the money supply change the interest
rate and, in turn, the change in the interest rate changes investment spending. If
13. Because of the economic slowdown associated with the 2007–2009 recession, the
Federal Open Market Committee of the Federal Reserve, between September 18,
2007, and December 16, 2008, lowered the federal funds rate in a series of steps
from a high of 5.25% to a rate between zero and 0.25%. The idea was to provide a
boost to the economy by increasing aggregate demand.
a. Use the liquidity preference model to explain how the Federal Open Market
Committee lowers the interest rate in the short run. Draw a typical graph that
CHAPTER 15 MONETARY POLICY S-215
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Solution
13. a. The Federal Reserve Open Market Committee increases the money supply, which
shifts the money supply curve to the right, from MS1 to MS2. An increase in the
money supply drives the interest rate down, from r1 to r2.
MS1MS2
r1
Interest
rate
E1
c. Although in the short run a rise in the interest rate leads to an increase in the
quantity of goods and services demanded, in the long run nominal wages will rise.
This will cause the economy to end up at E2, at a higher price level.
LRAS
Aggregate
price level
E2
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