Chapter 16 – Interest Rates and Monetary Policy
16-1
Chapter 16 Interest Rates and Monetary Policy
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.
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? LO2
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Answer: The basic objective of monetary policy is to assist the economy in achieving a
full-employment, non-inflationary level of total output.
3. Use commercial bank and Federal Reserve Bank balance sheets to demonstrate the impact of
each of the following transactions on commercial bank reserves: LO2
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 borrow from Federal Reserve Banks after winning an auction held as part of
the term auction facility.
Answer: In the tables below, 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
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CONSOLIDATED BALANCE SHEET: ALL COMMERCIAL BANKS
A
B
C
Assets:
Reserves
$ 40
$ 42
$ 41
$ 40
CONSOLIDATED BALANCE SHEET:
TWELVE FEDERAL RESERVE BANKS
A
B
C
Other liabilities and net worth
Assets:
Securities
$283
$285
$283
$283
4. 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? LO3
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.
5. Why is a decrease in the supply of Federal funds shown as an upshift of the supply curve in
Figure 33.3, whereas an increase in Federal funds is shown as a downshift of the supply curve?
LO3
Reserve Banks
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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
6. 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? LO3, LO4
Answer: To reduce inflation, the Federal funds rate should be raised. This would be
accomplished typically through open-market operations (selling bonds), but could also be
7. Explain the links between changes in the nation’s money supply, the interest rate, investment
spending, aggregate demand, real GDP, and the price level. LO4
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
8. 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? LO5
Answer: Cyclical asymmetry refers to the condition that a restrictive monetary policy is
relatively potent at contracting economic activity, while an expansionary monetary policy
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9. LAST WORD What are the three main aggregate supply factors that determine a nation’s
potential (or full employment) level of real output? What are the four main components of
aggregate demand? Explain: “Aggregate supply factors determine a nation’s potential GDP
whereas aggregate demand factors determine whether or not the nation achieves its full
employment GDP.” How does fiscal and monetary policy relate to aggregate demand?
Answer: From the Figure we see that the three main aggregate supply factors that
determine a nation’s potential (or full employment) level of real output are: (1) Inputs (2)
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?
Feedback: Consider the following example. 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.
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Part a:
What is the equilibrium interest rate in Trance?
To answer this part of the question we use the table below. The first column is the interest
Asset Demand
for Money
Transactions
Demand
Money Supply
10
150
200
40
150
200
60
150
200
Part b:
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?
It also follows from the answer above that the equilibrium quantity of money supplied is
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
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Feedback: Consider the following example. Suppose a bond with no expiration date has
a face value of $10,000 and annually pays a fixed amount of interest of $800. Compute
and enter in the spaces provided in the accompanying table 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. What generalization can be drawn from the completed
table?
To answer this question we use the formula for a perpetuity.
Bond Price = Fixed Payment Amount / Interest Yield
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. LO2
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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?
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Feedback: Consider the following example for the data and questions below. 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 figures provided. All accounts are in billions of dollars.
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To answer these questions we use the values immediately following the transaction. That
is, do not work through the monetary multiplier process (we will do this in part d).
Part a:
A decline in the discount rate prompts commercial banks to borrow an additional $1
Part 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.
Since the Reserve Banks sell $3 billion in securities to members of the public, who pay
for the bonds with checks, checkable deposits fall from $150 billion to $147 billion in
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Part c:
The Federal Reserve Banks buy $2 billion of securities from commercial banks. Show the
new balance-sheet figures in column 3 of each table.
CONSOLIDATED BALANCE SHEET: ALL COMMERCIAL BANKS
(1)
(2)
(3)
Assets:
Reserves
$ 33
$34
$30
$35
CONSOLIDATED BALANCE SHEET:
TWELVE FEDERAL RESERVE BANKS
(1)
(2)
(3)
Assets:
Securities
Loans to commercial banks
$60
3
$60
4
$57
3
$62
3
Part 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?
Transaction (a):
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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).
4. Refer to Table 33.2 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? LO2
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Feedback: Consider the following example. Refer to Table 33.2 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?
At the 10% reserve ratio the amount of excess reserves is $3000. If the Fed wants to
reduce a third of these excess reserves. eliminate $1000 of excess reserves, it should raise
5. Suppose that the demand for Federal funds curve is such that the quantity of funds demanded
changes by $120 billion for each 1 percent change in the Federal funds interest rate. Also, assume
that the current Federal funds rate is at the 3 percent rate that is targeted by the Fed. Now suppose
that the Fed retargets the rate to 3.5 percent. Assuming no change in demand, will the Fed need to
increase or decrease the supply of Federal funds? By how much will the quantity of Federal funds
have to change for the equilibrium to occur at the new target rate? LO3
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Feedback: Consider the following example. Suppose that the demand for Federal funds
curve is such that the quantity of funds demanded changes by $120 billion for each 1
percent change in the Federal funds interest rate. Also, assume that the current Federal
funds rate is at the 3 percent rate that is targeted by the Fed. Now suppose that the Fed
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? LO3
Feedback: Consider the following example. 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?
The Taylor rule assumes that the Fed has a 2 percent “target rate of inflation” that it is
willing to tolerate and that the FOMC follows three rules when setting its target for the
Federal funds rate:
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7. Refer to the accompanying table for Moola to answer the following questions. LO4
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? LO4
Feedback: Consider the following example. Refer to the accompanying table for Moola
to answer the following questions.
What is the equilibrium interest rate in Moola?
The equilibrium interest rate occurs at the interest rate where the quantity of money
What is level of investment at the equilibrium interest rate?
Investment at this interest rate is $20.
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