Chapter 15 Flashcards
What is the theory of liquidity preference?
It’s Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance in the short run.
What are the two tools the Bank of Canada uses to alter the money supply?
Changing the bank rate
Open-market operations (buying/selling government bonds)
Why is the interest-rate effect the most important reason for the downward slope of the aggregate-demand curve?
Because a lower price level reduces money demand → lower interest rate → stimulates investment and consumption → increases quantity of goods/services demanded.
What happens when the price level increases in the money market?
Money demand increases, causing interest rates to rise, which reduces consumption and investment, shifting aggregate demand left.
In a closed economy, what is the effect of a monetary injection?
Increases money supply → lowers interest rate
Stimulates investment and consumption
AD curve shifts right
In a small open economy with a flexible exchange rate, what is the effect of a monetary injection?
Interest rate falls below world rate → capital outflow increases
Dollar depreciates → net exports rise
AD curve shifts farther right than in a closed economy
What happens in a small open economy if the Bank of Canada fixes the exchange rate during monetary expansion?
The BOC must sell foreign currency to buy CAD, offsetting the money supply increase and nullifying the expansionary effect.
What is the opportunity cost of holding money?
The interest rate, because you forgo returns from interest-bearing assets.
What is the shape of the money supply curve in the liquidity preference model?
Vertical, because the Bank of Canada controls the supply directly.
What causes shifts in the money-demand curve?
Changes in the price level
Changes in real GDP (more transactions = more demand for money)
How does an increase in real GDP affect the money market?
Increases money demand → raises interest rates → reduces investment → moves AD left (unless BOC offsets)
What is the “exchange-rate effect” of monetary policy in an open economy?
Lower interest rates lead to capital outflow → CAD depreciates → net exports rise → further shift in AD.
What’s the difference in aggregate demand shift between closed and open economies during monetary policy?
The shift is larger in an open economy with flexible exchange rates due to the boost in net exports.
What happens if people hold less cash due to credit card use?
Money demand falls
Interest rates fall
AD shifts right (more consumption/investment)
If the BOC wants to stabilize AD after people reduce money demand, what should it do?
Reduce the money supply to prevent interest rates from falling and maintain original AD.
What is the case for active monetary stabilization policy?
Offsets harmful fluctuations
Reduces unemployment/inflation
Smooths the business cycle
What is the case against active stabilization policy?
Long lags in monetary policy effects
Economic forecasts may be inaccurate
Risk of worsening instability if mistimed
What is a flexible exchange rate?
A policy where the exchange rate is allowed to fluctuate freely based on market conditions.
What is a fixed exchange rate?
A policy where the central bank intervenes in currency markets to maintain a set exchange rate.
How does a rise in the world interest rate affect Canada under a flexible exchange rate?
CAD depreciates
Net exports rise
AD shifts right
Interest rate rises to match world rate
