Key Questions

Chapter 33: Interest Rates and Monetary Policy

Key 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.

2. Assume that the following data characterize a hypothetical economy: 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.

What is the equilibrium interest rate? Explain.

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?

3. 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?

4. 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.

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 figures in column 1 of each table.

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 figures in column 2 of each table.

The Federal Reserve Banks buy $2 billion of securities from commercial banks. Show the new balance sheet figures in column 3 of each table.

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 commercial banks' reserves took place in each transaction? (3) Assuming a reserve ratio of

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20 percent, what change in the money-creating potential of the commercial banking system occurred as a result of each transaction?

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?

Chapter 33 Key Question Solutions (72.0K)