Chapter 16

What is the basic determinant of the transactions demand and the asset demand for money? Explain how to combine these two demands graphically to determine tottal money dsemanded. How is the equilibrium interest rate in the money market determed? Use a graph to show how an increase in teh total demand for money affects the equilibrium interest rate (no change in money supply). Use your general knowledeg of equilibrium prices to explain why the previous interst rate is no lnger sustainable.

(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. On a graph

Explain the links between changes in the nation's money supply, the interest rate, investment spending, aggreagate demand, real GDP, and the price level.

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 money supply will make funds increasingly scarce and drive up their price (interest rate). The interest rate and investment spending are also inversely related. A rising interest rate will make some investments (capital spending projects) unprofitable, so spending on those will decline. Investment spending is part of aggregate demand, so they will move together, as will real GDP. A decline in spending (AD) will reduce inflationary pressure (and will reduce prices if they are downwardly flexible).

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 the possibility of a liquidity trap significant to policymakers?

Cyclical asymmetry refers to the condition that a restrictive monetary policy is relatively potent at contracting economic activity, while an expansionary monetary policy is relatively weak at stimulating an economy. The weakness in expansionary monetary policy results when, even though the Fed increases liquidity (reserves) in the system, potential borrowers are unwilling to spend (often because of uncertainty over general weakness in the economy). This is often referred to as a liquidity trap. Cyclical asymmetry, and the potential for a liquidity trap, is important to policymakers because it suggests that while monetary policy can effectively fight inflation, it may not be as successful in bringing an economy out of a recession. As Japan learned in the 1990s, expansionary monetary policy may be inadequate, and an expansionary fiscal policy may be necessary to stimulate recovery.

A commercial bank sells a treasury bond to the federal reserve for $100,000. The money supply:

Increases by $100,000. Feedback: The money supply will increase by $100,000. This is true because when the commercial bank sells the Treasury bond to the Fed for $100,000, the Fed creates $100,000 of new money to pay for the bond. That $100,000 will increase the bank's excess reserves and thereby lead the bank to lend more, thus pushing money into the economy.

Which of the following will increase lending?

Lower discount rate from 4 to 2 percent

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?

The basic objective of monetary policy is to assist the economy in achieving a full-employment, non-inflationary level of total output. The major strengths of monetary policy are its speed and flexibility compared to fiscal policy, the Board of Governors is somewhat removed from political pressure, and its successful record in preventing inflation and keeping prices stable. The Fed is given some credit for prosperity in the 1990s and early 2000s. Monetary policy is formed by the 7 members of the Board of Governors. Fiscal policy requires the consent of both houses in Congress, plus the President. One of the implications is that monetary policy has a much shorter administrative lag than fiscal policy.

Suppose that you are a member of the board of governers of the federal reserve system and the economy is experiencing an 8 percent inflation rate. Unemployment is at the full-employment level and the target interest rate is currently 4 percent. What change in the target interest rate would you want to make? How would this change get implemented? What impact would implementation actions have on the lending ability of the banking system, the real interest rate, investment spenidng, aggregate demand, and inflation?

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 achieved with an increase in the reserve ratio or discount rate.The restrictive monetary policy would reduce the lending ability of the banking system, increase the real interest rate, reduce investment spending, reduce aggregate demand, and reduce inflation.