AK Macroeconomics – Chapter 9
CHAPTER NINE
Answers to Self Test Questions
1. a) and b)
(The total money demand curve is $80 to the right of the asset demand curve.)
c) Equuilibrium r = 8%; equilibrium quantity = $150 (Where MD and MS intersect.)
d) Surplus of $10 . (The money supply of 150 is 10 more than the demand of 140)
2. See the table below:
Interest Rate% / Asset Demand / Transactions Demand / Total Demand
12 / 50 / 80 / 130
11 / 55 / 80 / 135
10 / 60 / 80 / 140
9 / 65 / 80 / 145
8 / 70 / 80 / 150
7 / 75 / 80 / 155
6 / 80 / 80 / 160
a) equilibrium interest rate: 8% (This is where the money demand of 150 is equal to the money supply.)
b) equilibrium interest rate: 10% (This is where the money demand of 140 is equal to the money supply.)
c) Surplus of money of $15 (At 11 percent interest, the money supply of 150 exceeds the money demand of 135).
3. Whether the Bank of Canada buys bonds from chartered banks or from the public makes no difference to the change in the commercial banks' reserves. If the bonds are bought from the banks, there will be no change in the amount of demand deposits and the extra reserves can all be lent out. However, if they are bought from the public, then the amount of demand deposits at the chartered banks will increase as the bond sellers deposit their Bank of Canada cheques. Here, the amount of excess reserves will be slightly lower since the banks will want to keep a small fraction of these increased deposits.
4. a) Balance sheets after the purchase of securities from the chartered banks (the affected accounts are highlighted):
All Commercial Banks
Assets / LiabilitiesReserves in vaults / $70 / Deposits / 800
On deposit with the Bank of Canada / 12
Securities / 118
Loans / 600
Totals / 800 / Totals / 800
Bank of Canada
Assets / LiabilitiesSecurities / $ 82 / Notes in Circulation / 65
Deposits of banks / 12
Other liabilities / 5
Totals / 82 / 82
5. As a result of the switch, the reserves and the deposits of the chartered bank will increase by $100. Although the money supply is not immediately affected by the switch, the bank will find itself over-reserved by 90 (increased actual reserves of 100 minus increased target reserves of 10% x 100 = 10). Loaning out these excess reserves will result in an increase in demand deposits, which is part of the money supply.
6. Economic growth and full-employment are compatible goals but both can come into conflict with the goals of stable prices and a favorable balance of trade. In addition, full-employment and stable prices are in conflict.
7. It should sell bonds.
8. If prices increase, so too will money demand, which will push up interest rates and cause a drop in investment and real GDP. The aggregate demand curve, however, will not shift, but the aggregate quantity demanded will decrease, i.e., the price change causes a movement along the AD curve, not a shift in it.
9. A reduction in the money supply will cause interest rates to rise and this will cause a decrease in investment and real income.
10. a) velocity of money: 10 (2 x 500 ÷ 100)
b) P = $2.40 (120 x 10 ÷ 500)
Answers to Study Guide Questions
1. False: it is determined by their nominal GDP
2. True
3. False: it is determined by the demand and supply of money
4. True
5. True.
6. False: notes in circulation are a liability to the Bank of Canada.
7. False: it causes the AD to shift left.
8. True
9. False: refers to the number of times money changes hands in a year.
10. True
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AK Macroeconomics – Chapter 9
11. c 16. a 21. d 26. a 31. b
12. b 17. c 22. d 27. a 32. e
13. a 18. c 23. a 28. a 33. c
14. b 19. a 24. a 29. a 34. d
15. c 20. b 25. a 30. b 35. e
36A. Key Problem
a) See Figure 9.13
Figure 9.13 (completed)
b) 4%. This is where the new MS2 curve intersects the MD curve
c) Increase of $20 billion. Figure 9.14 shows that at the previous interest rate of 5%, the quantity of investment was $80. At the new interest rate of 4%, the quantity of investment is $100. The difference is $20 billion higher.
d) See the following figure:
Figure 9.15 (completed)
e) Price level = 125; real GDP = $750 billion. (Where AD2 intersects AS.)
f) AD must be decreased by $200 billion. (The AD curve must be shifted 4 squares to
the left so that it intersects the AS curve at a price level of 110 and a GDP level of
$600.)
g) Decrease of $40. (The change of investment is 1/5 of the change in AD.)
h) Target interest rate = 7%. (For investment to fall by $40 (2 squares), the interest rate
must increase from 5% to 7%.
i) Decrease of $20 billion. (The money supply must drop by 2 squares in order to
increase the interest rate from 5% to 7%.
37A. a) 77 million drams (nominal GDP is real GDP x price level (70 x 1.1 = 77)
b) 12.1 million drams.
(the money supply must rise by the same 10% that GDP has increased: 11 million + 10% = 12.1)
38A. a) $30B (so that all three curves intersect at a GDP of 420).
b) 5% (20/400 x 100)
c) 16.67% (20/120 x 100)
39A. a) price level = 2; nominal GDP = 200
b) price level = 2.4; nominal GDP = 240
c) Since a 20% increase in the price level leads to the same percentage increase in
nominal GDP, we can conclude that there is a direct and proportional relationship between the two.
40A. 2.9% interest.
Using the formula:
Rate of return (rate of interest) = coupon interest +/- change in the bond price x100 Price paid for bond
gives us: $350 - $200 x 100 = 2.9%
$5200
41A. a) Pabst: 6% Kokanee: 7%
b) Pabst: + 40 Kokanee: + 10
c) Pabst: + 80 Kokanee: + 20
d) Pabst
42A. a) Interest rate: 10%; investment: $160.
b) Interest rate: 6%; investment: $200.
c) Interest rate: 12%; investment: $140.
43A. a) The transactions demand for money will increase because an increase in the price
level will increase nominal income.
b) The transactions demand for money will increase because an increase real income will increase nominal income.
c) The transactions demand for money will increase because nominal income has
increased.
d) The transactions demand for money will increase because; nominal income has
increased.
44A The two major determinants of the transactions demand for money are the price level and the real GDP of the economy (together, they make up the nominal GDP). An increase in either will increase the transactions demand for money. (The transactions demand is also affected by institutional factors like the efficiency of the payments system, the use of electronic money and so on.)
45A. When a treasury bill is sold at a discount it means that is sold for a price below its face value. The buyer earns a return on the bill because it will be redeemed at its face value.
46A. a) See the following figure:
Figure 9.19 (completed)
A rightward shift of 1 square of the MS curve in graph A will reduce the interest rate by 1% and this will cause a movement along the Id curve in graph B, which will increase investment spending by $50 (from $50 to $100).
b) investment spending: $100
c) See Figure 8.19 (completed)
The AD will increase by $200. (The AD curve in graph C shifts to the right by 2 squares.)
d) GDP: $700
47A. a) see the Table 9.2 (completed) A and B (column 1) below:
Table 9.2 (completed)
A: Central Bank of Beckland
Assets / (1) / Liabilities / (1)Treasury bills / $190 / $191 / Notes in Cir- culation / $185 / $185
Short-term loans to banks / 5 / 5 / Government Deposits / 6 / 6
Deposits of banks / 4 / 5
B: Beckland's Banking System
Assets / (1) / (2) / Liabilities / (1) / (2)Reserves:
In vaults / 8 / 8 / 8 / Deposits / 120 / 120 / 130
in Bank of Beckland / 4 / 5 / 5
Securities / 30 / 29 / 29 / Short-term loans from Bank of Beckland / 5 / 5 / 5
Loans to customers / 90 / 90 / 100 / Equity / 7 / 7 / 7
b) no effect in the money supply
c) excess reserves of $1B
d) see Table 9.2B (completed) column (2)
e) + $10B
48A. $4 / $96 X 100 X 4 (quarters) = 16.7%
$4 / $96 X 100 X 6 (2 month periods) = 25%
Thus, the rate of return has increased by 8.3% points
49A. To begin re-arrange the equation of exchange, to get V = P x Q
100M
Using this formula, we get:
1993: V = 15 (101.2/100 x 716/48.3); 1994: V = 14.1 (102.4/100 x 744/54.2) ; 1995: V = 14 (105.1/100 x 760/57.1); 1996: V = 13 (106.6/100 x 770/63.1); 1997: V = 11.6 (107.1/100 x 798/73.5).
50A. $10 285. Whoever is holding the bond when it is redeemed in one year will receive $10 800, (principal of $10 000 plus the coupon interest of $800). Alternatively a prospective investor could invest that money ($X) at the market rate of 5% for one year. So we ask the question: What sum of money ($X) invested at 5% will equal $10 800 in one year? Or algebraically, $X x (1.05) = $10 800. X therefore equals $10 800/1.05 = $10 285. So a person paying $10 285 for the bond will earn $800 in coupon interest but lose $285 on the depreciation of the bond, totaling $515. This works out to an interest rate of $515/$10 285 = 5%.
51A. A surplus of money would lead people to get rid of the excess by buying bonds. This would increase the demand for bonds, so pushing up their prices, which implies a lower interest rate. As the interest rate drops, people’s desire to hold money will increase; this process continues to the point that at a lower interest rate people’s desire to hold money is equal to the supply of money; in other words, until the surplus has disappeared.
52A. A contractionary monetary policy implies a leftward shift in the aggregate demand curve because a reduction in the money supply will cause an increase in the interest rate. This, in turn, will reduce investment spending and aggregate expenditures thus causing GDP to be lower at each price level.
53A. An increase in the supply of money causes a surplus of money. People react by
buying bonds, causing the price of bonds to increase and the interest rate to drop. The
lower interest rate will lead to an increase in investment and in income.
The process is more direct, according to Monetarists, since the surplus of money will lead to an increase in spending (not just on bonds) which will lead to an increase in aggregate demand and in nominal income.
54A. $21 200. Whoever buys the bond expects to receive a return equal to that on other investments, i.e. $2000 over two years ($20 000 @ 5% x 2). Since the holder will receive $3200 ($1600 x 2) in interest from the bond, that investor would be prepared to lose $1200 on the sale of the bond, i.e. they would be prepared to pay $21 200.
55A. a) Keynesian view: graph A; Monetarist view: graph B.
b) Keynesian view: graph B; Monetarist view: graph A.
c) increase by $10. (interest rate changes by 1%).
d) increase by $160. (interest rate changes by 4%).
56A. a) Beckland: interest rate ↓ by 1% → (I & XN) ↑ by 20 → AD ↑ by 40 →
P: increases 4 points GDP: increases $20
Heineken: : interest rate ↓ by 2% → (I & XN) ↑ by 20 → AD ↑ by 60 →
P: increases 12 points GDP: increases $18
57A. Keynesian monetary policy, it is thought, is more effective when dealing with an inflationary gap than with a recessionary gap. This because in either instance, the policy operates through the banking system and it is easier for banks to call in loans to help cool an inflationary boom than it is for them to extend loans to help boost the economy during a recession. In the latter case, there will be few applicants of sufficient credit-worthiness who would be willing to get into debt during a recession.
58A. They do not believe that there is an asset demand because they feel that people would not hold idle balances of cash. This is because, according to Monetarists, there are many financial instruments available which are as safe and as liquid as cash.
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