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Chapter 16: Q. 22 - Problems (page 370)

Take a look at Figure 16-6. Suppose that a multiple reduction in GDP is the final outcome that the Fed desires in the last box in the figure. Explain the required directions of efforts - that increases or decreases - that most occur in the preceding boxes in the figure in order to yield in this desired decrease in real GDP

Short Answer

Expert verified

Contractionary monetary policy reduces excess reserves & credit creation, liquidity in the economy. It increases interest rates & decreases investment, aggregate demand & real GDP

Step by step solution

01

Monetary Policy & Money Supply Concept 

Monetary Policy is the central bank's credit policy used to control money supply in the economy

  • Increase in Bank rate, Increase in Legal Reserve Ratio, Increase in Marginal requirement are credit & money, GDP contraction tools

They decrease the monetary (excess) reserves of commercial banks, which further decrease their credit creation capacity and money supply in the economy.

02

Interest Rates, Investment & Real GDP Concept 

  • Decrease in money supply (due to credit contraction monetary policy) lead increase in interest rates respectively, as interest is the price of money.
  • Increase interest rates implies corresponding decrease in investment.
  • Decrease in investment increases or decreases Aggregate Demand & real GDP (total value of goods & services in economy) further.

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Most popular questions from this chapter

Assume that the following conditions exist :

a. All banks are fully loaned up - there are no excess reserves, and desired excess reserves are always zero.

b. The money multiplier is 3.

c. The planned investment schedule is such that at a 6percent rate of interest, the investment is \(1200billion; at 5 percent, investment is \)1225billion

d. The investment multiplier is 3.

e. The initial equilibrium level of real GDP is \(18trillion.

f. The equilibrium rate of interest is 6percent.

Now the Fed engages in expansionary monetary policy. It buys \)1billion worth of bonds, which increases the money supply, which in turn lowers the market rate of interest by 1percentage point. Determine how much money supply must have increased, and then trace out the numerical consequences of the associated reduction in interest rates on all the other variables mentioned.

On the basis of Problem 16-1, imagine that initially the market interest rate is 5 per cent and at this interest rate you have decided to hold half of your financial wealth like bonds and half as holdings of non-interest-bearing money. You notice that the market interest rate is starting to rise, however, and you become convinced that it will ultimately rise to 10 per cent.

a. In what direction do you expect the value of your bond holdings to go when the interest rate rises?

b. If you wish to prevent the value of your financial wealth from declining in the future, how should you adjust the way you split your wealth between bonds and money? What does this imply about the demand for money?

What do you think might be lost-and by whom - if the Fed were to follow an easily understood rule as a guide for conducting monetary policy? Explain.

Why might the fact that private economic forecasters compete to sell their services help to constrain behavioural tendencies for too much optimism in projections of real GDP growth? Explain your reasoning.

Consider the data in Problem 16-10. Suppose that the money supply increases by $ 100 billion and real GDP and the income velocity remain unchanged.

a. According to the quantity theory of money and prices, what is the new equilibrium price level after full adjustment to the increase in the money supply?

b. What is the percentage increase in the money supply?

c. What is the percentage change in the price level?

d. How do the percentage changes in the money supply and price level compare?
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