Problem Set 5 Complete all questions listed below. Clearly label your answers. 1

Question

Problem Set 5

Complete all questions listed below. Clearly label your answers.

1. What impact will an unanticipated increase in the money supply have on the real interest rate, real output, and employment in the short run? How will expansionary monetary policy affect these factors in the long run? Explain.

2. How rapidly has the money supply (M1) grown during the past twelve months? State the rate of growth (use http://www.federalreserve.gov/releases/h6/) and the most recent release, use the seasonally adjusted figures. Calculate the rate of growth across the year by taking the (new amount of M1- old amount of M1)/old amount of M1). Given the state of the economy, should monetary authorities increase or decrease the growth rate of money? Explain why.

3. Is stability in the general level of prices through time important? Why or why not? Should price stability be the goal of monetary policy? Explain your responses.

4. Compare and contrast the impact of an unexpected shift to a more expansionary monetary policy under rational and adaptive expectations. Are the implications of the two theories different in the short run? Are the long-run implications different? Explain.

Explanation / Answer

Ultimately, an interest rate is merely the price in a market for loans or loanable

funds, which we unimaginatively call the loanable funds market. We discussed this in

chapter 9. By the way, the picture is not really much different if the interest rate we are

talking about is a real

interest rate or a nominal

interest rate.

Since supply and

demand for loans are

really doing the heavy

interest rate making, the

Fed does not set interest

rates, but rather

influences them. The Fed

can set one sort of interest

rate, the discount rate, but

it is ultimately the

willingness of lenders to

make loans, as well as the

demand for those loans,

that determine the interest rate. Also, the Fed generally changes the reserves available

to banks through open market operations, not by changing the discount rate.

Supply in the loanable funds market can be influenced by things that the Fed

does. As we discussed in chapter 9, most of the loanable funds supply comes from

people who save and deposit their savings in banks. Banks then create loans, using the

deposits as the source of reserves, as we discussed in chapter 10. The Fed can act to

augment the "raw materials" the banks have to work with, by increasing bank reserves.

We also discussed this in chapter 10. The increased reserves of banks allow them to

make more loans. As banks increase their loaning activity, the supply of loanable funds

increases. As the supply of loanable funds increases, the real interest rate will most Options and Outcomes - Chapter 13

138 How Does Money Affect the Economy? Copyright 2006 by Ray Bromley

PRICE

interest rate

original

interest rate

Original SUPPLY

DEMAND for

loanable funds

QUANTITY of

loanable funds

original

loans

SUPPLY with

increased bank

reserves

new

interest rate

increased

loans

likely start to fall, to induce borrowers to take out the increased amount of loans available. As the banks increase

their lending, and as more

loans are taken out by

borrowers at the lower

interest rates, the amount

of money increases. The

process that creates new

money (bank expansion)

also lowers interest rates.

Of course, the

opposite happens when

the Fed reduces the money

supply, or its growth rate.

We can also view

the link between money

supply growth and interest rates in another way. People have a demand for money212

itself. People desire to hold some portion of their incomes and wealth as money to meet

their everyday expenses, either as cash or as checking account deposits. However,

holding money in forms that don't pay interest, or pay very little interest, has an opportunity cost. That opportunity cost is the (higher) interest rate that could be earned by

making some other investment, such as buying an interest-paying bond, rather than

keeping cash or large checking account deposits. If we think of the interest rate as the

price of holding money, then the demand for money is the relationship between the

interest rate and the

quantity of money that

people desire to hold. The

higher the interest rate

paid by non-money investments, the less money

people will be willing to

hold. The supply of

money213

in this view is

independent of the interest rate, and is just the

amount of money that is

around. So, we get a

"market" as pictured to the

left.

At a higher supply of money, people will find themselves with more money than

they desire to hold at the current interest rate (the original interest rate on the diagram),

so they will invest in bonds and other investments. When more bonds are purchased,

the prices of bonds rise, thus lowering their return or implicit interest rate. Similarly,

when other investments are made, the prices of those other investments will be driven

up. At a higher price to buy into any investment, the return (rate of interest implicitly

paid by the investment) will start to decline.

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