Chapter 15-Monetary Policy

(Figure 15.5) The liquidity trap illustrated could be the result of a

(Figure 15.5) The liquidity trap illustrated could be the result of a ✓ low opportunity cost of money. A liquidity trap represents the portion of the money demand curve that is horizontal: people are willing to hold unlimited amounts of money at some interest rate. Thereby, with such a low opportunity cost of holding money, individuals will hold onto a large amount of funds.

If a lender desires to earn a real return of 3 percent on a loan and the anticipated rate of inflation is 2 percent, the lender should charge a

✓ nominal interest rate of 5 percent. The real interest rate is equal to the nominal interest rate minus the rate of inflation.

During periods of hyperinflation, money does not hold its value and, therefore, people hold as little as possible for as short a time as possible. This description implies that the

✓ transactions demand for money has increased. Holding money for everyday purchases refers to the transactions demand for money, which will be higher when money rapidly loses its value during periods of hyperinflation.

Carolina holds $2,000 in her wallet so that she can buy snacks at the gas station. This represents a

✓ transactions demand for money. Precautionary demand for money exists for unexpected purchases or for emergencies. transactions demand for money exists for routine purchases and so the individual can easily buy what they need, when they need it. Finally, speculative demand for money exists when people hold money while waiting for better financial opportunities.

According to Ben Bernanke's policy guide, a 1 point decrease in long-term interest rates results in a

✓ $200 billion stimulus for the economy. According to Bernanke's policy guide, a 1/4 point reduction in the long-term interest rate leads to $50 billion in fiscal stimulus. Thus, a 1 point reduction in long-term interest rates benefits total spending by $50 billion × 4 = $200 billion.

Which of the following is consistent with the monetarist view?

✓ A reduction in taxes will leave the value of real output unaffected. This follows the logic of crowding out. Specifically, lower taxes will lead to lower government spending but ultimately to higher private sector spending that makes up the difference.

In which of the following situations is expansionary monetary policy most effective?

✓ Banks are willing to lend excess reserves. When the banking system lends out excess reserves, it complements fed action that will result in successful monetary policy.

Which of the following is true about monetary policy in the liquidity trap?

✓ Monetary policy will be unable to reduce interest rates further to stimulate investment. In a liquidity trap, investment will not increase when the money supply is increased because interest rates will not fall any further.

What should happen to the equilibrium interest rate and the corresponding rate of investment if the Fed decreases the discount rate?

✓ The equilibrium interest rate should decrease, and the equilibrium rate of investment should increase. A lower rate of interest will cause business investment to rise, resulting in a movement along the investment curve downward and to the right.

Monetary restraint is associated with each of the following except

✓ a decrease in interest rates. Monetary restraint uses increases to the required reserve ratio, increases to the discount rate, and/or openmarketsalestoreducemoneysupplyandtherebyincreaseinterestrates.Thiscausesadecrease ininvestmentthatlowersaggregatedemand.Ontheotherhand,monetarystimulususesdecreasesto the required reserve ratio, decreases to the discount rate, and/or open market purchases to increase the money supply and thereby decrease interest rates. This causes an increase in investment that raises aggregate demand

Banks and customers are most likely to be reluctant to use the full lending capacity made available by the Federal Reserve when the economy experiences

✓ a deep recession. A deep recession offers little guarantee of future profits. In fact, it increases the risk of investment spending. This clearly discourages businesses from bearing the risk associated with an increase in investment spending.

A monetary stimulus is designed to shift the

✓ aggregate demand curve to the right. Increasing the money supply triggers a lower interest rate consequently leading to an increase in investment activities, thereby increasing aggregate demand.

(Figure 15.2) At an interest rate of 9 percent, there is

✓ an excess supply of money of $100 billion. Any interest rate above the equilibrium interest rate will lead to a surplus of funds in the money market.

Monetary stimulus will fail if

✓ banks are reluctant to lend money. If the Fed increases the money supply but banks refuse to lend, then the money multiplier does not work, thereby rendering monetary policy ineffective.

The success of fed intervention depends on how well

✓ changes in long-term interest rates closely follow changes in short-term interest rates. Monetary policy will be less effective if the long-term rates diverge too far from short-term rates.

Monetary policy will not be effective if interest rates

✓ do not respond to changes in the money supply and investment spending does not respond to changes in the interest rate. In order to be effective, interest rates need to respond to changes in the money supply and businesses need to respond to interest rates; otherwise, AD doesn't change.

Using the equation of exchange and assuming fixed price controls and a constant velocity of money, a decrease in the discount rate could temporarily result in

✓ higher quantity of real output. A lower discount rate expands the money supply which, with a fixed price level and velocity of money, must increase output.

(Figure 15.2) The equilibrium rate of interest

✓ is 6 percent. The equilibrium interest rate corresponds to the interest rate that prevails when the money supply and money demand curves intersect.

Which of the following causes the opportunity cost of holding money in the form of cash to decrease?

✓ lower interest rates When interest rates are lower, holding cash means one gives up less potential interest made on income.

Effective expansionary monetary policy, according to Keynesian theorists, will do each of the following except

✓ lower real output. Expansionary policy, when successful, drives down interest rates, increases the money supply through the money multiplier and increases spending on interest-sensitive goods.

If a lender desires to earn a real return of 9 percent on a loan and the anticipated inflation rate is 5 percent, the lender should charge a

✓ nominal interest rate of 14 percent. The real interest rate is equal to the nominal interest rate minus the rate of inflation.

If a lender desires to earn a return of 4 percent on a loan and the anticipated rate of inflation is 3 percent, the lender should charge a

✓ nominal interest rate of 7 percent. The real interest rate can be calculated by subtracting the inflation rate from the nominal interest rate.

Individuals hold precautionary balances in order to

✓ pay for emergency purchases. Keeping some idle funds available to cover unforeseen events like a trip to the emergency room is part of the precautionary demand for money.

(Figure 15.6) Which of the following Fed actions is most likely to decrease the aggregate demand curve from AD2 to AD1?

✓ raising the federal funds rate Raising the federal funds rate will lower the money supply, raising interest rates, reducing investment, and causing aggregate demand to shift to the left.

The liquidity trap

✓ refers to the possibility that interest rates may not respond to changes in the money supply. A liquidity trap describes the portion of the money demand curve that is horizontal: people are willing to hold unlimited amounts of money at some interest rate. Individuals may choose to hold lots of money and no bonds when rates are very low; additional increases in the money supply will have no effect on interest rates. At interest rates approaching zero, the opportunity cost of holding money approaches zero.

The choice to hold money in the form of cash

✓ results in forgone interest. Since physical currency pays no interest, when one chooses to hold money, one is necessarily forgoing the opportunity to earn interest.

Money held to take advantage of future financial opportunities is the

✓ speculative demand for money. Speculative demand for money is described as money held for speculative purposes, for later financial opportunities. Keeping a sum of money, such as a few thousand dollars, available to purchase assets at bargain prices is part of the speculative demand for money.

To reduce the level of unanticipated inflation, monetarists advocate

✓ steady and predictable changes in the money supply. By steadily and predictably altering the money supply, the Fed can reduce uncertainties and stabilize long-term interest rates and GDP growth.

The precautionary demand for money is most closely associated with which of the following functions of money?

✓ store of value Precautionary demand for money only exists if money holds its value through time. There would be no reason to save for a rainy day if the saved money did not have value in the future.

Ceteris paribus, if the Fed sells bonds through open market operations, the money

✓ supply curve should shift leftward. An open market sale decreases the money supply and shifts the curve to the left, resulting in a higher equilibrium interest rate.

Which of the following increases the effectiveness of monetary policy from a monetarist perspective?

✓ the constant velocity of money A constant velocity of money reduces one variable from the equation, meaning a change in the money supply must affect either prices, output, or both.

Using the equation of exchange, if real output increases by 5 percent per year and velocity is stable, in order to keep the price level stable

✓ the money supply must increase by 5 percent per year. The equation of exchange indicates that if the right side of the equation increases by 5 percent, then with velocity constant, the money supply must increase by 5 percent also.

According to monetarists, the aggregate supply curve is

✓ vertical at the natural rate of unemployment. This implies that a change in the money supply will shift the aggregate demand curve, but it will merely intersect the vertical aggregate supply curve at a different price level leaving the level of output unchanged.

The Front Page Economics article titled "Fed Opens the Money Spigots" suggests that the Fed implement policy in the wake of the COVID-19 pandemic so that interest rates

✓ will fall to encourage more borrowing to prevent income and jobs from being lost. The Fed aggressively purchased bonds to stimulate the economy in the wake of the COVID-19 pandemic.