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 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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