Economics IIDepartment of Tourism Management Faculty of Business

Problem Set 6

1.How do changes in interest rates affect the composition of bonds and money that people will want to hold?

2.Suppose that you own a $1000 bond which earns 20% interest. Now assume that interest rates on newly issued bonds fall to 10%. How much could you reasonably expect to receive for your bond if you were to sell it?

3.Summarize the determinants of the demand for money.

4.Label each of the following events as either leading to an increase or a decrease in the equilibrium interest rate?

5.Draw the demand and the supply for money and identify the equilibrium interest rate. Make sure to draw a money supply curve that is independent of the interest rate. Draw the curves so that the equilibrium interest rate is 8%. Explain why interest rates above or below 8% are not stable.

6.What is meant by the term “excess demand for money?” How does the money market resolve this disequilibrium?

7.Graphically demonstrate the effect on the interest rate of a decrease of the money supply by the Central Bank.

8.Use a graph to illustrate the effect an expansionary fiscal policy will have on the money market. What happens to the interest rate? What impact will this have on the effectiveness of fiscal policy?

9.Assume the money market is initially in equilibrium. Now, suppose the Central Bank sells bonds. Graphically illustrate and explain what effect this Central Bank open-market sale of bonds will have on the money market.

10. Sally's income is $2,000 a month. She deposits $500 in a saving account, buys $200 worth of government securities, and leaves the rest for daily transactions. Sally's money demand is

A) $2,000.

B) $1,300.

C) $700.

D) $1,500.

11.Lisa's optimal monetary balance has decreased. This could have been caused by

A) an increase in the amount of transactions spending.

B) a decrease in the interest rate.

C) a reduction in the costs paid for switching from bonds to money.

D) an increase in the price of bonds.

12.

Refer to the information provided in Figure below to answer the questions that follow.

1

i)

1

A movement from Point D to Point A can be caused by

1

A)

1

a decrease in the interest rate.

1

B)

1

an increase in income.

1

C)

1

a decrease in the price level.

1

D)

1

an increase in the interest rate.

1

ii)

1

A movement from Point B to Point A can be caused by

1

A)

1

a decrease in income.

1

B)

1

an increase in the price level.

1

C)

1

a decrease in the interest rate.

1

D)

1

an increase in the interest rate.

1

iii)

1

A movement from Point B to Point D can be caused by

1

A)

1

a decrease in income.

1

B)

1

an increase in the interest rate.

1

C)

1

a decrease in the interest rate.

1

D)

1

an increase in income.

1

1

iv)

1

All of the following events can cause a movement from Point E to Point A EXCEPT

1

A)

1

an increase in income.

1

B)

1

an increase in the price level.

1

C)

1

a decrease in the interest rate.

1

D)

1

an increase in transactions.

1

1

v)

1

Money demand curve will shift from to if

1

A)

1

the price level increases.

1

B)

1

income decreases.

1

C)

1

interest rates fall.

1

D)

1

interest rates rise.

1

vi)

1

The movement from C to B could be cause by

1

A)

1

a decrease in the interest rate.

1

B)

1

an increase in the interest rate.

1

C)

1

a decrease in income.

1

D)

1

an increase in the price level.

1

13.

Figure 11.3

1

i)

1

Refer to Figure 11.3. At an interest rate of 6%, there is a

1

A)

1

shortage of money and the interest rate will decline.

1

B)

1

shortage of money and the interest rate will rise.

1

C)

1

surplus of money and the interest rate will decline.

1

D)

1

surplus of money and the interest rate will rise.

1

ii)

1

Refer to Figure 11.3. At an interest rate of 3%, there is a

1

A)

1

shortage of money and the interest rate will decline.

1

B)

1

shortage of money and the interest rate will rise.

1

C)

1

surplus of money and the interest rate will decline.

1

D)

1

surplus of money and the interest rate will rise.

1

iii)

1

Refer to Figure 11.3. An decrease in the GDP, ceteris paribus, will likely

1

A)

1

increase the equilibrium interest rate without changing equilibrium money holdings.

1

B)

1

decrease both the equilibrium interest rate and equilibrium money holdings.

1

C)

1

increase the equilibrium interest rate and decrease equilibrium money holdings.

1

D)

1

decrease the equilibrium interest rate without changing equilibrium money holdings.

1

1

iii) Refer to Figure 11.3. A increase in the price level, ceteris paribus, will likely

1

A)

1

increase both the equilibrium interest rate and equilibrium money holdings.

1

B)

1

decrease the equilibrium interest rate without changing equilibrium money holdings.

1

C)

1

increase the equilibrium interest rate without changing equilibrium money holdings.

1

D)

1

keep the equilibrium interest constant and increase equilibrium money holdings

1

iv)

1

Refer to Figure 11.3. An increase in the money supply, ceteris paribus, will likely

1

A)

1

increase the equilibrium interest rate and decrease equilibrium money holdings.

1

B)

1

increase the equilibrium interest rate without changing equilibrium money holdings.

1

C)

1

decrease the equilibrium interest rate and increase equilibrium money holdings.

1

D)

1

decrease the equilibrium interest rate without changing equilibrium money holdings.

1

v)

1

Refer to Figure 11.3. An decrease in the money supply and an increase in the GDP will, for sure,

1

A)

1

increase the equilibrium interest rate.

1

B)

1

decrease the equilibrium interest rate.

1

C)

1

decrease the equilibrium interest rate.

1

D)

1

decrease equilibrium money holdings.

  1. Graphically illustrate and explain the effects of a reduction in government spending on the equilibrium interest rate, investment, and equilibrium output. Clearly label all curves and the initial and final equilibria. Does any crowding-out take place when government spending falls? Explain.

15. Explain the two key links between the goods market and the money market.

16.How can monetary policy be used to reduce the impact of the crowding-out effect?

  1. Summarize the effects of a contractionary monetary policy where the change in the money supply (Ms) impacts upon the rate of interest (r), investment spending (I), output and income (Y), and the demand for money (Md).
  1. Graphically illustrate the impact of a decrease and increase in the interest rate on aggregate expenditure. On your graph, illustrate the impact of an increase and decrease in the interest rate upon aggregate expenditure. Summarize the relationship among changes in the rate of interest (r), the change in planned investment spending (I), its impact on the aggregate expenditure function (AE), and the multiple effect on income (Y).
  1. What is determined in the goods market? What is determined in the money market? Explain the two links between the goods market and the money market.
  1. Using the short-hand symbols G, Y, Md, r and I to demonstrate the effects of an expansionary fiscal policy.

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