MONEY AND AGGREGATE DEMAND - THE KEYNESIAN MODEL: PART TWO

RELATED CONCEPTS: BONDS |CROWDING OUT |INFLATIONARY PREMIUM EFFECT | INTEREST RAT | LIQUIDITY EFFECT | PRECAUTIONARY DEMAND FOR MONEY | SPECULATIVE DEMAND FOR MONEY | TRANSACTION DEMAND FOR MONEY |

How will the following events affect interest rates, investment spending, and aggregate demand?

Event A: The Fed buys government bonds in an open market operation.
Event B: The Fed sells government bonds in an open market operation.
Event C: Credit cards are outlawed: The public’s demand for money goes up as a consequence.
Event D: Banking by computer allows the public to more cheaply manage its money holdings: The public’s desired money holdings go down.

Event A: Increases money supply causes excess money supply. Bond prices rise, i falls, I rises, and AD goes up.
Event B: Decreases money supply, causes excess money demand. Bond prices fall, i rises, I falls, and AD falls.
Event C: Causes excess money demand, i rises, I falls, and AD falls.
Event D: Causes excess money supply, i falls, I rises, and AD rises.

A firm has the following menu of projects, listed in no particular order: project A, with a yield of 12% and a cost of $100,000; project B, with a yield of 8% and a cost of $200,000; project C, with a yield of 10% and a cost of $300,000; and project D, with a yield of 15% and a cost of $250,000. How much will this firm borrow and invest when the interest rate is 12%? 10%? 8%?

• At 12%, project A just covers its costs, and project D makes a 3% net rate of profit. The firm will invest $350,000. At 8%, it invests in projects A, B, C, and D, at a total cost of $850,000.

Describe the effect of a $40 billion increase in the money supply under these conditions: (a) a $40 billion increase in the money supply reduces the interest rate by 1%, (b) a 1% decrease in the interest rate increases investment spending by $60 billion, (c) the spending multiplier is 2.5, and (d) the economy is on the horizontal segment of its aggregate supply curve, so prices don’t rise when aggregate demand increases.

• GNP will be increased by $150 billion.

Select the correct term from the italicized choices. An increase in the money supply will increase real GNP more when:
a. It decreases the interest rate (more / less).
b. Investment spending responds (more / less) to changes in the interest rate.
c. The multiplier is (bigger / smaller).
d. The aggregate supply curve is (flatter / steeper).
e. Money demand increase (more / less) when the interest rate changes.

• (a) more, (b) more, (c) bigger, (d) flatter, (e) less. For (e) when money demand is less sensitive to changes in the interest rate, then the money demand curve is steeper. That means when the money supply goes up, interest rates must fall more to increase the quantity of money demanded to equal the new supply.

If the quantity of money demanded exceeds its supply; what will happen to interest rates?

• People will try to sell bonds to increase their money holdings. This attempt will cause bond prices to fall and interest rates to rise. As a consequence of the higher interest rates, the quantity of money demanded will fall until it equals the money supply.

In 1933, the interest rate on Aaa-rated corporate bonds was 4.49%. Consumer prices fell 5.1% in that year; In 1981, the bonds paid 14.16% and prices rose 10.4%. In which year would businesses have had to pay a lower real rate to borrow?

• The relevant rate for businesses is the real rate of interest. If we assume that the expected rate of inflation is also the current rate of inflation, then the real rate of interest was higher in 1933 than 1981. In 1933, the real rate of interest was 9.59% (= 4.49% - [ -5.1%]; note that when prices fall, we have a negative rate of inflation). In 1981, the real rate of interest was only 3.76% (= 14.16% - 10.4%).

At a cost of $2,000, Widget, Inc., can buy a machine that will add $500 to its annual revenues. The annual operating and maintenance costs of the machine will total only $300. The machine (with maintenance0 is expected to last forever. What is the highest interest rate at which Widget should be willing to borrow funds to buy this machine?

• 10%. The machine’s annual return is $200 ($500 -$300). At a 10% interest rate, the annual interest payments on the machine will be $200 (.10 x $2,000). Thus, at 10%, the machine’s return just covers its interest cost. At any higher rate, it would prove unprofitable.

Copyright 2008 by Sujanto Rusli
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MONEY AND AGGREGATE DEMAND - THE KEYNESIAN MODEL : PART ONE

RELATED CONCEPTS:BONDS |CROWDING OUT |INFLATION PRELIMINARY EFFECT |INTEREST LIQUIDITY EFFECT |PRECAUTION DEMAND FOR MONEY| SPECULATIVE DEMAND FOR MONEY |TRANSACTION DEMAND FOR MONEY |.

Why is the opportunity cost of holding money the interest rate that a bond pays?

• Because instead of holding money, people could hold bonds, which pay interest.

Why does the quantity of money people want to hold go up when the interest rate falls?

• At lower interest rates, bonds are less attractive, so people increase their money holdings.

How can a person reduce money holdings yet spend the same amount of money per period?

• The individual would have to hold more of other assets (such as money market funds, bonds, and stocks) and cash them in more frequently.

How does an excess supply of money lead to lower interest rates?

• People with an excess supply of money will try to increase their bond holdings, thereby increasing the demand for bonds. Bond prices will go up and interest rates will go down.

How does a lower interest rate increase investment spending?

• A lower interest rate makes more investment projects profitable, so total investment spending will go up.

Why does aggregate demand go up when interest rates fall?

• A lower interest rate increases investment spending, so aggregate demand will be higher.

Is it the nominal interest rate or the real interest rate that affects money demand? Investment spending?

• The basic rule is: Nominal assets (such as money) are affected by the nominal interest rate, and real assets (such as investment in plant and equipment) are affected by real interest rates.

Why is the horizontal shift in aggregate demand greater than the equilibrium increase in real GNP?

• A shift to the right in aggregate demand causes prices to go up. So while total dollar spending has gone up, the higher price level means that real spending (and real GNP) have gone up less.

When will an increase in the money supply cause higher, not lower, interest rates?

• When people expect a higher growth rate of the money supply to produce higher rates of inflation.

Why is the spending multiplier weaker when we consider the effects of higher real income on money demand?

• Because people want to put some of their higher income into money holdings. This reduces the savings available for investment spending, and therefore investment spending will fall. In turn, this offsets to some degree the initial increase in aggregate demand.

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
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THE SUPPLY OF MONEY: PART TWO

RELATED CONCEPTS: | CHECKABLE DEPOSITS| COMMODITY MONEY| DISCOUNT RATE| DOUBLE COINCIDENCE OF WANTS| EXCESS RESERVES| FLAT MONEY| LIQUIDITY| M1| M2| MONETARY BASE| MONEY| OPEN MARKET OPERATION| REQUIRED RESERVE RATIO (R)|

In a barter economy, how would an economics professor survive?

• The professor would have to find students that wanted economic lessons and had something the professor wanted (such as food, housing, and clothing). Obviously, there aren’t too many professors of economics in barter economies. Indeed, there is very little specialization in barter economies, since most people produce only goods that are in common demand.

Assume the required reserve ration is 20%.
a. If a single bank in the banking system has $10 million in excess reserves, how much new money, at most, could it create by itselft?
b. If the whole banking system has $10 million in excess reserves, how much new money, at most, could it create?

a. $8 million.

b. $40 million (5 x $8 million)

Indicate whether the following events will increase or decrease the money supply:
Event A : The Fed buys government securities from the public.
Event B : Banks decide to hold more excess reserves.
Event C : The public wants less cash because of an increased fear of being robbed.
Event D : The Fed raises the discount rate.
Event E : The Fed prints more currency.
Event F : Interest rates rise.

Event A : Increase.
Event B : Decrease (smaller multiplier).
Event C : Increase (larger multiplier because more of the money lent will be redeposited).
Event D : Decrease (reduces the base when banks borrow less from the Fed).
Event E : Increase.
Event F : Increase (banks hold smaller excess reserves when they can make more on them by lending them out: This increases the multiplier).

Jane withdraws $1,000 from her checking account and puts it in a cookie jar. How much, at most, could the money supply fall if the required reserve ration is 10%?

• $9,000 (checking deposits will fall $10,000 but currency held by the public will go up $1,000)

During Christmas time, the public’s demand for cash goes up. How should the Fed react to this if it wants to keep the money supply constant? What will happen to the monetary base and the money multiplier?

• The increased demand for cash reduces the actual multiplier (because less lent money is redeposited). So the Fed must increase the monetary base. Typically, it does this by buying government securities.

If the public suddenly wanted to hold all its money in the form of cash (withdrawing all its money from checking and savings accounts), what would happen to the money supply?

• The money supply would shrink back down to the size of the monetary base.

If banks could not find anyone willing to borrow funds at the interest rate they charge, what would happen to the money supply?

• The money supply would shrink, because banks could not lend and relend.

One of the liabilities of the Federal Reserve is Federal Reserve notes (the dollar bill is an example). Since this is a liability, what does the Fed “owe” the public or banks that hold these dollars?

• Our currency is a flat currency. The Fed really doesn’t owe anything.

How can the public cause the money supply to shrink?

• By holding more in cash and less in checking and savings accounts.

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com

THE SUPPLY OF MONEY: PART ONE

RELATED CONCEPTS :|CHECKABLE DEPOSITS| COMMODITY MONEY| DISCOUNT RATE| DOUBLE COINCIDENCE OF WANTS| EXCESS RESERVES| FLAT MONEY| LIQUIDITY| M1| M2| MONETARY BASE | MONEY | OPEN MARKET OPERATION| REQUIRED RESERVE RATIO (R)|

How does money make it easier for people to trade?

• With money, people don’t have to sell their goods and services only to those who have goods and services they want.

Why is income not money?

• Income is the goods and services one earns; money is only a measure of its value.

What is it that is really “borrowed” when people borrow “money”?

• A borrower is actually borrowing real goods and services.

Are credit cards money?

• No. Credit cards are a means of spending money. Money is what people use to pay their credit card bills.

How does the lending of excess reserves by banks create money?

• The lending of excess reserves creates money 91) instantly when the borrower’s checkable deposit is increased (this is how banks give people loans), and (2) later, when the lent money is redeposited by the people from whom the borrower buys goods and services, and this is relent and so on.

If the legal reserve requirement is 20%, what is the most the banking system can lend out if an individual deposits $1,000?

• $4,000.

How does the Fed’s buying government securities add to monetary base? How does this change the money supply?

• This increases the monetary base, and through the money multiplier process, the money supply is increased even more.

Why does lowering of the discount rate add to the monetary base?

• A lower discount rate encourages banks to run down their excess reserves, since it is then cheaper to get some extra cash from the Fed when needed. Banks run down their excess reserves by lending them: This creates money.

What factors make the actual money multiplier smaller than 1/R?

• The two main factors are (1) banks don’t lend all their excess reserves and (2) the public does not redeposit all the funds it has been lent.

How does increasing the monetary base change the money supply?

• The bigger the monetary base, the more money that can be created through the money multiplier process.

Copyright 2008 by Sujanto Rusli
http://economicslessons.blogspot.com
http://become-debt-free.blogspot.com
http://humorandwit.blogspot.com