25.3 Review and Practice

Summary

We began this chapter by looking at bond and foreign exchange markets and showing how each is related to the level of real GDP and the price level. Bonds represent the obligation of the seller to repay the buyer the face value by the maturity date; their interest rate is determined by the demand and supply for bonds. An increase in bond prices means a drop in interest rates. A reduction in bond prices means interest rates have risen. The price of the dollar is determined in foreign exchange markets by the demand and supply for dollars.

We then 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 Fed. 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. What factors might increase the demand for bonds? The supply?
  2. What would happen to the market for bonds if a law were passed that set a minimum price on bonds that was above the equilibrium price?
  3. When the price of bonds decreases, the interest rate rises. Explain.
  4. One journalist writing about the complex interactions between various markets in the economy stated: “When the government spends more than it takes in taxes it must sell bonds to finance its excess expenditures. But selling bonds drives interest rates down and thus stimulates the economy by encouraging more investment and decreasing the foreign exchange rate, which helps our export industries.” Carefully analyze the statement. Do you agree? Why or why not?
  5. What do you predict will happen to the foreign exchange rate if interest rates in the United States increase dramatically over the next year? Explain, using a graph of the foreign exchange market. How would such a change affect real GDP and the price level?
  6. Suppose the government were to increase its purchases, issuing bonds to finance these purchases. Use your knowledge of the bond and foreign exchange markets to explain how this would affect investment and net exports.

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

    1. A tax on bonds held by individuals
    2. A forecast by the Fed that interest rates will rise sharply in the next quarter
    3. A wave of muggings
    4. An announcement of an agreement between Congress and the president that, beginning in the next fiscal year, government spending will be reduced by an amount sufficient to eliminate all future borrowing
  8. Some low-income countries do not have a bond market. In such countries, what substitutes for money do you think people would hold?
  9. Explain what is meant by the statement that people are holding more money than they want to hold.
  10. Explain how the Fed’s sale of government bonds shifts the supply curve for money.
  11. Trace the impact of a sale of government bonds by the Fed on bond prices, interest rates, investment, net exports, aggregate demand, real GDP, and the price level.

Numerical Problems

  1. Compute the rate of interest associated with each of these bonds that matures in one year:

    Face Value Selling Price

    a.

    $100

    $80

    b.

    $100

    $90

    c.

    $100

    $95

    d.

    $200

    $180

    e.

    $200

    $190

    f.

    $200

    $195

    g.

    Describe the relationship between the selling price of a bond and the interest rate.

  2. 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?

  3. Compute the dollar price of a German car that sells for 40,000 euros at each of the following exchange rates:

    1. $1 = 1 euro
    2. $1 = 0.8 euro
    3. $1 = 0.75 euro

  4. 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?

  5. Suppose you earn $6,000 per month and spend $200 in each of the month’s 30 days. Compute your average quantity of money demanded if:

    1. You deposit your entire earnings in your checking account at the beginning of the month.
    2. You deposit $2,000 into your checking account on the 1st, 11th, and 21st days of the month.
    3. You deposit $1,000 into your checking account on the 1st, 6th, 11th, 16th, 21st, and 26th days of the month.
    4. How would you expect the interest rate to affect your decision to opt for strategy (a), (b), or (c)?

  6. 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.
  7. We know that the U.S. economy faced a recessionary gap in 2008 and that the Fed responded with an expansionary monetary policy. Present the results of the Fed’s action in a four-panel graph. In Panel (a), show the initial situation, using the model of aggregate demand and aggregate supply. In Panel (b), show how the Fed’s policy affects the bond market and bond prices. In Panel (c), show how the market for U.S. dollars and the exchange rate will be affected. In Panel (d), incorporate these developments into your analysis of aggregate demand and aggregate supply, and show how the Fed’s policy will affect real GDP and the price level in the short run.

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