Chapter 15 Answers will vary depending on when you look

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Solution

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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

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Solution

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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

LRAS

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

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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

᎐᎐

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

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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

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

(a) Albernia

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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

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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

Interest

rate

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

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