Deck 11: Money Demand and the Equilibrium Interest Rate

Question 1

Using the graph above what would happen to the interest rate if the money supply decreased.

Answer 1

If the money supply decreased this would shift the money supply curve to the left and would have the effect of raising the equilibrium interest rate.

Question 2

Illustrate with the use of a graph what would happen to the demand for money as output in the economy expands.

Answer 2

The demand for money would shift to the right.

Question 3

What are the two major forces that determine the demand for money?

Answer 3

The two major forces that determine the demand for money are the interest rate and the dollar volume of transactions. The latter is a function of aggregate output and the price level.

Question 4

Assume that the interest rate paid on bonds rises from 4% to 6%. Explain what would happen to the level of optimal (money) balances.

Question 5

Assume that Joe earns $2400 a month, deposits it in a checking account and draws down his income evenly throughout the course of the month with an average money holding of $1200. What are the costs of this money strategy?

Question 6

Assume that Sally has a chance to purchase a magazine subscription for $240 for a year or choose to be billed on a monthly basis for $21. Why might choosing the $240 option not be the rational choice even though it appears to be $12 cheaper?

Question 7

In broad terms what is monetary policy?

Question 8

Draw the demand curve for money balances and explain how the interest rate affects the number of switches that an individual would make between money balances and bonds.

Question 9

Explain why money management is costly.

Question 10

Define what economists mean by the term interest rate.

Question 11

What is meant by the nonsynchronization of income and spending?

Question 12

Draw a graph illustrating the idea behind the non-synchronization of income and spending.

Question 13

How do changes in interest rates affect the composition of bonds and money that people will want to hold?

Question 14

Explain why the theory of money demanded presented in the book may be more complicated in real life.

Question 15

Critically evaluate the following statement. "A decrease in the interest rate will not increase the demand for money."

Question 16

Assume that Kelly could decide to deposit his entire paycheck ($1,200) into her checking account at the start of the month and run her balance down to zero by the end of the month. Illustrate this with the use of a graph and determine her average monthly holdings. What is the economic cost of this money management strategy?

Question 17

One rationale for holding money is the transaction motive. Explain what this means.

Question 18

Using the graph above explain what would happen if the interest rate were currently at r_o.What would happen in the market if the interest rate were at r₁ instead?

Question 19

Explain briefly what the optimal balance of money strategy is.

Question 20

Using the graph above what would happen to the interest rate if the money supply increased.

Question 21

Explain the speculative motive for holding money.

Question 22

Explain how the demand for money might change even if interest rates remain unchanged.

Question 23

What do economists mean when they say that bond prices and interest rates are really "two sides of the same coin?"

Question 24

Assume that the current interest rate is 9% . Assume that investors know that normally interest rates are 7%. How would this affect investors' decisions with regard to how much money and bold holdings to keep?

Question 25

What is the nonsynchronization of income and spending?

Question 26

Explain why money demand is not a flow measure.

Question 27

Suppose that you own a $1000 bond which earns 5% interest. Furthermore, assume that interest rates on newly issued bonds rise to 10%. Explain why no one would be willing to buy your bond for a $1000. In addition, calculate the price that you could reasonably expect to receive for your bond.

Question 28

Critically evaluate the following statement. "Higher bond prices are what causes lower interest rates."

Question 29

Assume that the current interest rate is 8%. Let's say that investors know that normally interest rates are 10%. How would this affect investors' decisions with regard to how much money and bond holdings to keep?

Question 30

What is the federal funds rate? What is the commercial paper rate? What is the prime rate of interest?

Question 31

Why are money demand and saving not really the same thing for the household?

Question 32

Summarize the determinants of the demand for money.
(a) aggregate output
(b) the prices of goods and services

Question 33

Why don't people simply keep all of their assets in forms that are easiest to use for making transactions?

Question 34

What is the relationship between interest rates or yields on bonds and their price or market value?

Question 35

If interest rates are currently at zero percent how might this inhibit the ability of the Feederal Reserve to conduct monetary policy to stimulate investment?

Question 36

Explain the demand for money in relation to interest rates.

Question 37

Explain how and why the demand for money might change even if the number of transactions in the economy does not.

Question 38

Keynes argued that people hold money for speculative reason. He stressed the choice between money and bonds. If agents expect the future nominal interest rate (the return on bonds) to be lower than the current rate they will then reduce their holdings of money and increase their holdings of bonds. If the future interest rate does fall, then the price of bonds will increase and the agents will have realized a capital gain on the bonds they purchased. This means that the demand for money in any period will depend on both the current nominal interest rate and the expected future interest rate. What implications does this have with respect to the volatility of money?

Question 39

By the middle of 2008 the Fed had driven the short-term interest rate close to zero, and it remained at essentially zero through the middle of 2010. How do you think this affected people's decision of whether to hold on to money or hold bonds instead?

Question 40

Suppose that you own a $1000 bond which earns 20% interest. Now assume that interest rates on newly issued bonds fall to 10%. How much could you reasonably expect to receive for your bond if you were to sell it?

Question 41

Assume that Joe chooses to deposit half his paycheck of $1200 and invests the remaining $600 in an interst-bearing account and runs his balance down evenly throughout the course of the month. Show with the use of a graph what his average monthly holdings would look like.

Question 42

Draw the demand and the supply for money and identify the equilibrium interest rate. Make sure to draw a money supply curve that is independent of the interest rate. Draw the curves so that the equilibrium interest rate is 8%. Explain why interest rates above or below 8% are not stable.

Question 43

Explain all of the determinants of money demand. Also include a brief explanation of how a change in each of these determinants would cause a reduction in money demand.

Question 44

Draw a demand curve for money. Explain the two factors that could cause an increase in the demand for money.

Question 45

Related to the Economics in Practice on p. 209 [521]: What were the two conclusions of the study concerning ATMs, interest rates, and money holdings?

Question 46

Explain how people will switch between bonds and money if the interest rate is initially above the market-clearing level. Explain your answer in terms of opportunity costs.

Question 47

Explain the transaction and speculation motives for holding money.

Question 48

Explain what is meant by the "speculation motive" for holding money.

Question 49

Assume that Joe chooses to deposit his entire paycheck of $1200 and runs his balance down evenly throughout the course of the month. Show with the use of a graph what his average monthly holdings would look like.

Question 50

Explain the trade-off between holding bonds and holding money. Why don't people keep all their assets in the forms that are the easiest to use for making transactions?

Question 51

Mary earns a monthly income of $3,000. She spends the entire amount each month at the rate of $100 a day. (Assume there are 30 days in the month.) The interest rate paid on bonds is 5% per month. It costs $10 every time Mary sells a bond.
(a) Describe briefly how Mary should go about deciding how much money to hold.
(b) Mary can switch from bonds to cash up to a maximum of three times. How many times should Mary switch from bonds to cash?
(c) What is Mary's optimal balance?

Question 52

Explain how people will switch between bonds and money if the interest rate is initially below the market-clearing level. Explain your answer in terms of opportunity costs.

Question 53

In simple terms how is the interest rate determined in the economy and explain why?

Question 54

What is meant by the term "excess demand for money?" How does the money market resolve this disequilibrium?

Question 55

Explain what demands make up the total demand for money.

Question 56

Show on a graph what the effect on the demand for money would be after an increase in income.

Question 57

Label each of the following events as either leading to an increase or a decrease in the equilibrium interest rate?

Question 58

Using the graph above, answer the following questions.
a. Which interest rate would result in an excess demand for money? What would eventually happen to the interest rate?
b. Which interest rate would result in an excess supply for money? What would eventually happen to the interest rate?

Question 59

Why is the money supply curve discussed in the book a vertical line?

Question 60

What is meant by the term "excess supply of money?" How does the money market resolve this disequilibrium?

Question 61

Assume the money market is initially in equilibrium. Now suppose there is an increase in income. Explain what effect this increase in income will have on the equilibrium interest rate. Also explain what the Fed would have to do if it wants to prevent this change in Y from affecting the interest rate.

Question 62

What do economists mean when they say that there is an "excess supply of money" in the economy? Illustrate this situation graphically. If there is an excess supply of money, what happens to the interest rate? How does the change in the interest rate influence the trade-off between holding money and holding bonds?

Question 63

Explain what is meant by the "transactions motive" for holding money.

Question 64

Answer the following three questions dealing with monetary policy.
(a) Explain how the Federal Reserve might carry out a "tight" monetary policy.
(b) Explain how the Federal Reserve might carry out an "easy" monetary policy.
(c) How would each of the policies affect the equilibrium interest rate?

Question 65

Use a graph to illustrate the effect an expansionary fiscal policy will have on the money market. What happens to the interest rate? What impact will this have on the effectiveness of fiscal policy?

Question 66

What is meant by the term structure of interest rates?

Question 67

Graphically demonstrate the effect on the interest rate of a decrease of the money supply by the Fed.

Question 68

Graphically demonstrate how an increase in the level of aggregate output can have an impact on the money market and ultimately on the equilibrium interest rate.

Question 69

Assume the money market is initially in equilibrium. Now, suppose the Fed sells bonds. Graphically illustrate and explain what effect this Fed open-market sale of bonds will have on the money market.

Question 70

Assume for some reason that the demand for money has risen. In addition, the Fed has responded to this development by increasing the money supply. Explain why the movement of the interest rate is largely indeterminate. In other words, what information are we lacking in order to make a definitive statement about the direction of the interest rate?

Question 71

Explain what is meant by a "tight monetary policy?"

Question 72

Draw a graph of a money demand curve and a money supply curve. On the graph, indicate the equilibrium interest rate. Also indicate the new equilibrium interest rate if the Fed increases the money supply.

Question 73

Explain what effect an increase in the brokerage fees associated with the purchase and sale of bonds will have on money demand and on the equilibrium interest rate.

Question 74

Joe has two investment opportunities. He can buy a two-year security today, hold onto it for two years, and then cash it in. The interest rate on the two-year security is 8%. Or Joe can buy a one-year security today. At the end of the year he can cash in the one-year security and buy another one-year security. The interest rate on the first one-year security is 7%. Explain under what circumstances it would be preferable for Joe to:
(a) buy the two-year security;
(b) buy the two one-year securities.
(c) Under what circumstance would Joe be indifferent between the two-year security and the two one-year securities?

Question 75

Explain with the use of a graph why the shape of the money demand curve makes a difference in terms of the effectiveness of monetary policy. (Hint: draw one money demand curve very steep and another very flat)

Question 76

Explain the effect of a reduction in the price level on the demand for money and the interest rate.

Question 77

Assume the money market is initially in equilibrium. Now, suppose that the aggregate price level falls. Graphically illustrate and explain what effect this reduction in the aggregate price level will have on the money market.

Question 78

Suppose there is an excess demand for money. Explain what will happen in the money market as a result of this.

Question 79

Graphically demonstrate the effect on the equilibrium interest rate of an increase in the money supply by the Fed.

Question 80

Suppose there is an excess supply for money. Explain what will happen in the money market as a result of this.