10.3 Review and Practice

Summary

We saw how the money market works. The quantity of money demanded varies negatively with the interest rate. Factors that cause the demand curve for money to shift include changes in real GDP, the price level, expectations, the cost of transferring funds between money and nonmoney accounts, and preferences, especially preferences concerning risk. Equilibrium in the market for money is achieved at the interest rate at which the quantity of money demanded equals the quantity of money supplied. We assumed that the supply of money is determined by the Bank of Canada. An increase in money demand raises the equilibrium interest rate, and a decrease in money demand lowers the equilibrium interest rate. An increase in the money supply lowers the equilibrium interest rate; a reduction in the money supply raises the equilibrium interest rate.

Concept Problems

  1. How would each of the following affect the demand for money?

    1. A tax on bonds held by individuals
    2. A forecast by the central bank that interest rates will rise sharply in the next quarter
    3. A wave of crime
    4. An announcement by the Prime Minister that, beginning in the next fiscal year, government spending will be reduced by an amount sufficient to eliminate all future borrowing
  2. Some low-income countries do not have a bond market. In such countries, what substitutes for money do you think people would hold?
  3. Explain what is meant by the statement that people are holding more money than they want to hold.
  4. Explain how  the action of the Bank of Canada to sell bonds in the open market would shift the supply curve for money.

Numerical Problems

  1. Suppose that the demand and supply schedules for bonds that have a face value of $100 and a maturity date one year hence are as follows:

    Price Quantity Demanded Quantity Supplied
    $100 0 600
    95 100 500
    90 200 400
    85 300 300
    80 400 200
    75 500 100
    70 600 0
    1. Draw the demand and supply curves for these bonds, find the equilibrium price, and determine the interest rate.
    2. Now suppose the quantity demanded increases by 200 bonds at each price. Draw the new demand curve and find the new equilibrium price. What has happened to the interest rate?
  2. Consider the euro-zone of the European Union and Japan. The demand and supply curves for euros are given by the following table (prices for the euro are given in Japanese yen; quantities of euros are in millions):

    Price (in euros) Euros Demanded Euros Supplied
    ¥75 0 600
    70 100 500
    65 200 400
    60 300 300
    55 400 200
    50 500 100
    45 600 0
    1. Draw the demand and supply curves for euros and state the equilibrium exchange rate (in yen) for the euro. How many euros are required to purchase one yen?
    2. Suppose an increase in interest rates in the European Union increases the demand for euros by 100 million at each price. At the same time, it reduces the supply by 100 million at each price. Draw the new demand and supply curves and state the new equilibrium exchange rate for the euro. How many euros are now required to purchase one yen?
    3. How will the event in (b) affect net exports in the European Union?
    4. How will the event in (b) affect aggregate demand in the European Union?
    5. How will the event in (b) affect net exports in Japan?
    6. How will the event in (b) affect aggregate demand in Japan?
  3. Suppose the quantity demanded of money at an interest rate of 5% is $2 billion per day, at an interest rate of 3% is $3 billion per day, and at an interest rate of 1% is $4 billion per day. Suppose the money supply is $3 billion per day.

    1. Draw a graph of the money market and find the equilibrium interest rate.
    2. Suppose the quantity of money demanded decreases by $1 billion per day at each interest rate. Graph this situation and find the new equilibrium interest rate. Explain the process of achieving the new equilibrium in the money market.
    3. Suppose instead that the money supply decreases by $1 billion per day. Explain the process of achieving the new equilibrium in the money market.
  4. We know that the economy faced a recessionary gap in 2008 and that the central bank responded with an expansionary monetary policy. Present the results of the bank’s action in a two-panel graph. In Panel (a), show the initial situation, using the model of aggregate demand and aggregate supply. In Panel (b), show how the Bank’s policy affects the money market.

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