Week 4
1. Draw the graphs depicting the supply and demand for bonds and the supply and demand for loanable funds. Using both of these graphs, show what happens to prices and quantities in the bond and loanable funds markets, starting from initial equilibrium, in each of these scenarios:
i) Bonds become more illiquid relative to other financial assets.
ii) There is a decrease in expected inflation.
iii) The bond and loanable funds markets are out of equilibrium, with the interest
rate above its equilibrium value.
iv) The government deficit shrinks (the government surplus rises).
v) There is a simultaneous increase in the profitability of investment
opportunities and increase in the riskiness of bonds relative to other assets.
2. Draw a graph of the liquidity preference approach to interest rate determination in initial equilibrium. Using this graph, show what happens to the interest rate and the stock of real money balances in this market, starting from initial equilibrium, in each of these scenarios (holding all else constant):
i) The Federal Reserve decreases the money supply and as a result income falls.
ii) There is an increase in the riskiness of bonds.
iii) There is an increase in the overall price level in the economy.
3. Suppose the economy, in aggregate, has a money demand function given by
MD = 18 + .85Y -.70i,
where Y = national income (GDP) and i = the domestic nominal interest rate. The Federal Reserve exogenously sets the money supply at
MS = 15,
(all figures are in trillions of dollars).
a) Suppose GDP is initially at Y = 3 trillion. What amount of money will be held by the public? What is the equilibrium nominal interest rate? If the nominal interest rate is below this equilibrium rate (so that the money market is in disequilibrium) describe the forces that would move the money market into equilibrium.
b) Suppose the Fed conducts expansionary monetary policy, increasing the money supply to 17 (trillion dollars). What is the new equilibrium nominal interest rate and what are the new money balances held? Repeat this comparative statics exercise (starting from the initial equilibrium) for an increase in GDP from 3 trillion to 5 trillion dollars. Illustrate both changes graphically.
c) Suppose we do not know the MS and MD functions but we do know that the money market is in equilibrium. Let this equilibrium be disturbed by a simultaneous contraction in the money supply by the Fed and a contraction in money demand (due to, say, a financial innovation). After the money market settles at a new equilibrium can we say whether the new equilibrium nominal interest rate and money balances held are higher or lower than before? Why or why not?
4. (Mishkin p. 127 #6) An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using the loanable funds framework, show what effect this action has on interest rates. Is your answer consistent with what you would expect to find with the liquidity preference framework?
5. (Mishkin p. 127 #7) Using both the liquidity preference and loanable funds frameworks, show why interest rates are procyclical (rising when the economy is expanding and falling during recessions).