Chapter 28 Economics
The Fed's $2.2 trillion fire hose The Fed threw a lot of money at the financial crisis in 2008 to unfreeze credit markets and encourage economic activity. As part of its effort to keep the interest rate low, the Fed purchased government bonds worth $300 billion between March and September 2009. By October, the Fed held $770 billion in government securities, nearly double its pre-crisis total. Before the crisis, the Fed held mainly government securities, which it used to control the quantity of money in the economy. Now government securities make up just 35% of the Fed's balance sheet. Source: CNN Money, October 9, 2009 If the Fed purchased the government securities on the open market, explain why the purchase of $300 billion of government securities would influence the interest rate.
If the Fed purchases the government securities on the open market, the quantity of money ______ because _______. increases; bank reserves increase The nominal interest rate _______. falls
What is the opportunity cost of holding money?
The opportunity cost of holding money is the nominal interest rate. The nominal interest rate equals the real interest rate plus the inflation rate. When the inflation-adjusted rate of interest on bonds is 0 percent, the real interest rate on bonds is 0 percent and the opportunity cost of holding a bond is equal to the nominal interest rate. So the returns on bonds and money are equal. But when the inflation rate rises and the real interest rate on bonds is guaranteed to be 0.1 percent, the nominal interest rate exceeds the real interest rate received on bonds. So the return on bonds is greater than the return on holding money.
In the long run with a constant velocity of circulation, the inflation rate _______.
equals the money growth rate minus the growth rate of real GDP Money growth + Velocity growth = Inflation rate + Real GDP growth Rearranging Inflation rate = Money growth + Velocity growth−Real GDP growth With a constant velocity of circulation Inflation rate = Money growth−Real GDP growth
Sara has $500 in currency and $4,000 in a bank account on which the bank pays no interest. The inflation rate is 4 percent a year. Calculate the amount of inflation tax that Sara pays in a year.
(4,500*(1 - inflation rate [4 %]) = 4320. 4500 - 4320 = 180$ of "inflation tax." Sara is holding $500 in currency and $4,000 in her bank account, and she receives no interest on either her currency holding or her bank account. At the end of the year, her purchasing power is 4 percent less than at the beginning of the year because of the effects of inflation. The inflation tax that she pays is equal to the decrease in her purchasing power, which is 4 percent of her currency holding plus 4 percent of her bank account. So Sara pays an inflation tax of $180.
Why does an increase in real GDP increase the demand for money and changes in financial technology can increase the demand for money or decrease the demand for money
An increase in real GDP increases the demand for money and financial technology can increase the demand for money or decrease the demand for money. For example, daily interest checking deposits and automatic transfers between checkable deposits and saving deposits lower the opportunity cost of holding money and increase the demand for money. Credit cards that have made it easier for people to buy goods and services on credit and pay for them later have decreased the demand for money.
In 2000, the Canadian economy was at full employment. Real GDP was $940 billion. The nominal interest rate was 7.0 percent a year, the inflation rate was 4.0 percent a year, the price level was 1.10, and the velocity of circulation was 11.00. What was the quantity of money in Canada?
In 2000, the quantity of money in Canada is $94.0 billion.
Choose the correct statement.
Inflation is a tax on holding money.
What are some costs of inflation?
The costs of inflation include the tax on money held by individuals and businesses, the increased opportunity cost of holding money, and the cost of running around to compare prices at different outlets.
Sally has a credit card balance of $2,000. The credit card company charges a nominal interest rate of 18 percent a year on unpaid balances. The inflation rate is 7 percent a year. Calculate the real interest rate that Sally pays the credit card company.
The real interest rate is equal to the nominal interest rate minus the inflation rate. The real interest rate is 18 percent a year minus 7 percent a year, which is 11 percent a year.
In 2007, the United States was at full employment. The quantity of money was growing at 6.4 percent a year, the nominal interest rate was 4.4 percent a year, real GDP grew at 1.9 percent a year, and the inflation rate was 2.9 percent a year. Was the velocity of circulation constant? [Hint: Use the quantity theory of money.] If the velocity of circulation was not constant, how did it change and why might it have changed?
The velocity of circulation decreased and its change was −1.6 percent a year. The change in the velocity of circulation occurred because the_______. growth rate of the quantity of money was greater than the growth rate of nominal GDP
Explain why, other things remaining the same, interest rates will rise the economy recovers from recession.
When real GDP increases, expenditures and incomes increase. To make the increased expenditures and income payments, households and firms must hold larger average amounts of money. The demand for money increases. The demand for money curve shifts rightward and the interest rate rises. In the figure, the demand for curve for money shifts rightward from MD0 to MD1 and the equilibrium nominal interest rate rises from 5 percent a year to 6 percent a year
The costs of inflation do not include _______.
an increase in saving and investment
The Fed decreases the quantity of money. In the short run, the quantity of money demanded ______ and the nominal interest rate ______.
decreases; rises
Inflation-adjusted savings bonds purchased from May through October 2009 will earn 0% for the first six months. The fixed interest rate on these bonds is 0.1% and over the previous 6 months, inflation fell at an annual rate of 5.56%. The minimum interest rate on savings bonds is set at 0%. Source: USA Today, May 5, 2009 Are these savings bonds a better deal than cash under the mattress? At an interest rate of 0 percent, the return on the bonds ______ the return on money. If inflation starts to rise, and bonds receive a fixed interest rate of 0.1 percent, the return on the bonds ______ the return on money.
equals; is greater than
The graph shows the demand for money curve. Draw the supply of money curve if the equilibrium interest rate is 8 percent a year. Label it MS. Draw a point at the equilibrium quantity of money and nominal interest rate.
https://i.imgur.com/qlc1oCV.png demand for money decreases and the nominal interest rate falls
The spread of ATMs and the increased use of debit cards ______ money. Everything else remaining the same, the nominal interest rate ______.
increase the demand for; rises
The Fed threw a lot of money at the financial crisis in 2008 to unfreeze credit markets and encourage economic activity. As part of its effort to keep the interest rate low, the Fed purchased government bonds worth $300 billion between March and September 2009. By October, the Fed held $770 billion in government securities, nearly double its pre-crisis total. Before the crisis, the Fed held mainly government securities, which it used to control the quantity of money in the economy. Now government securities make up just 35% of the Fed's balance sheet. If government securities make up just 35 percent of the Fed's assets, calculate the Fed's total assets. What effect did the Fed's purchase of $300 billion of government bonds have on the Fed's total liabilities?
$2200; increased; 300
Peter Howitt of Brown University has estimated that if inflation is lowered from 3 percent a year to zero, then after 30 years, real GDP would be ______ percent higher.
Peter Howitt of Brown University has estimated that if inflation is lowered from 3 percent a year to zero, then after 30 years, real GDP would be 2.3 percent higher.
The Federal Reserve Chairman Ben Bernanke said Thursday that while interest rates will stay low for some time, interest rates will rise as the recovery picks up, in order to fight off the threat of inflation. Source: CNNMoney, October 9, 2009 Explain why, other things remaining the same, interest rates will rise the economy recovers from recession. Other things remaining the same, interest rates will rise as the economy recovers from recession because ______.
the increase in real GDP increases the demand for money
Explain why businesses paid workers twice a day during the hyperinflation in Germany after World War I and why workers spent their incomes as soon as they were paid. Choose the correct statement.
(The longest one) Businesses paid workers twice a day so that employees would not leave their jobs and search for employment elsewhere. Workers spent their incomes as soon as they were paid to minimize the loss in value of their income.
In 1999, the United Kingdom economy was at full employment. Nominal GDP was £770 billion, the real interest rate was 4 percent per year, the inflation rate was 3 percent a year, and the price level was 110. Calculate the nominal interest rate.
The nominal interest rate is 7 percent a year. (Nominal equals real interest rate + inflation rate) In the long run, if the real interest rate remains the same but the inflation rate increases to 4 percent a year, then the nominal interest rate increases to 8 percent a year.
Sally has a credit card balance of $5,000. The credit card company charges a nominal interest rate of 19 percent a year on unpaid balances. The inflation rate is 10 percent a year. Calculate the real interest rate that Sally pays the credit card company.
The real interest rate is equal to the nominal interest rate minus the inflation rate. The real interest rate is 19 percent a year minus 10 percent a year, which is 9 percent a year.
Sally has a credit card balance of $10,000. The credit card company charges a nominal interest rate of 17 percent a year on unpaid balances. The inflation rate is 9 percent a year. Calculate the real interest rate that Sally pays the credit card company.
The real interest rate that Sally pays the credit card company is 8 percent a year.
An increase in real GDP ______ the demand for money and changes in financial technology ______.
increases; can increase the demand for money or decrease the demand for money
