Chapter 26 The Money Market and Monetary Policy

Chapter 14 - THE MONEY MARKET AND MONETARY POLICY

PROBLEM SET

2.a.The money supply curve shifts to the right, the money supply increases by $196 million, and the nominal interest rate falls.

b.The money supply curve shifts to the left, the money supply decreases by $119 million, and the nominal interest rate rises.

4. a.

Price / Amount Paid in 1 Year / Interest Payment / Interest Rate / Quantity of Money Demanded
$18,000 / $20,000 / $2000 / 11.11% / $2,300 billion
$18,500 / $20,000 / $1500 / 8.11% / $2,600 billion
$19,000 / $20,000 / $1000 / 5.26% / $2,900 billion
$19,500 / $20,000 / $500 / 2.56% / $3,200 billion
$20,000 / $20,000 / $0 / 0% / $3,500 billion

b.

Since, in equilibrium, MS = MD, the money supply equals $2900 billion. The price of the bond is $19,000.

c.If the money supply increases to $3,200 billion, there will be a shortage of bonds, bond prices will rise, and the interest rate will fall until the quantity of money demanded once again equals the quantity supplied. This will happen when the interest rate falls to 2.56% and the price of a bond rises to $19,500.

6.a.The money demand curve will shift to the left; the Fed should decrease the money supply in order to keep the interest rate unchanged.

b.The money demand curve will shift to the right; the Fed should increase the money supply in order to keep the interest rate unchanged.

  1. The money demand curve will shift to the left; the Fed should decrease the money supply in order to keep the interest rate unchanged.

8.

Initially, the economy is at point E in the top diagram. To raise the interest rate, the Fed conducts an open-market sale of bonds. The money supply decreases to M2s and the interest rate rises. As the interest rate increases, investment and consumption spending decrease, causing the the aggregate expenditure line to shift downward in the bottom diagram. Consequently, the equilibrium GDP decreases from Y1 to Y2. In the new equilibrium, the interest rate is higher and GDP is lower.

10. The long-run/classical theory relies on flow variables (the flow of loanable funds), whereas the short-run theory of this chapter relies on stock variables (the total quantity of money in the money market).

MORE CHALLENGING QUESTIONS

12. Initially, the economy is at point E in the top diagram and point J in the bottom diagram. The Fed sets a target interest rate of rT and conducts an open market sale of bonds to raise the interest rate. The money supply decreases from Ms1 to Ms2. The higher interest rate leads to reduced aggregate spending shifting the aggregate expenditure line down from AE1 to AE2. Lower aggregate spending, in turn, affects the money market by reducing money demand from Md1 to Md2. The equilibrium interest rate after the feedback effects is now r2 instead of rT. Thus, the Fed must conduct a larger open market sale in order to reach its original target interest rate.