Unit 9

Question 1

What is the opportunity cost of holding cash

Answer 1

cash is convenient, you give up earning interest income if you had it invested

Question 2

What are short term interest rates

Answer 2

the interest rates on financial assets that mature within a year

Question 3

What are long term interest rates

Answer 3

interest rates on financial assets that mature a number of years in the future

Question 4

How do interest rates and the opportunity cost of holding cash relate

Answer 4

The higher the interest rate, the higher the opportunity cost of holding money
The lower the interest rate, the lower the opportunity cost of holding money

Question 5

What causes shifts in the quantity of cash demanded

Answer 5

Changes in aggregate price level
Changes in real GDP
Changes in technology
Changes in institutions

Question 6

What is the money demand curve

Answer 6

This shows the relationship between the quantity of cash demanded and the interest rate

Question 7

What is the liquidity preference model

Answer 7

It is a method of setting interest rates based on the supply and demand for money

Question 8

How can the FED influence the interest rate

Answer 8

They can change the quantity of money supplied, which would influence the interest rate

Question 9

What happens when interest rates are high

Answer 9

This means that MS > MD
There is a surplus of money, meaning that there is a shortage of other assets such as bonds. Investors will realise that they can reduce rates on bonds and still find buyers.

Question 10

What happens when interest rates are low

Answer 10

There is a shortage of money
MD > MS
This means that there is a surplus of other assets such as bonds. To make bonds more attractive they will raise the rates.

Question 11

Why would investors buy short term bonds even if long term bond rates are higher

Answer 11

This means that they expect the short term rates to increase
E.g. one-year bond at 4% v.s. two-year bond at 5%. You may want to buy the former if you expect interest rate of one-year bond to rise to 8% next year.

Question 12

What do long-term interest rates reflect

Answer 12

They reflect the markets expectation for short-term rates

Question 13

What is expansionary monetary policy

Answer 13

monetary policy that increases aggregate demand

Question 14

How does expansionary monetary policy work

Answer 14

Increase money supply → lower interest rate → higher interest spending raises income → higher consumer spending (via multiplier) –. Increase in aggregate demand and AD curve shifts to the right

Question 15

What is contractionary monetary policy

Answer 15

Monetary policy that reduces aggregate demand

Question 16

How does contractionary monetary policy

Answer 16

Decrease money supply → higher interest rate → lower investment spending reduces income → lower consumer spending (via multiplier) → decrease in aggregate demand and AD curve shifts to the left

Question 17

How do you track monetary policy

Answer 17

The federal funds rate usually rises when the output gap is positive and falls when the output gap is negative
The federal funds rate tends to be high when inflation is high and low when inflation is low

Question 18

What is the taylor rule of monetary policy

Answer 18

That you should set the federal funds rate according to the level of inflation rate and either the output gap or the unemployment rate

Question 19

What is inflation targeting

Answer 19

the central bank setting an explicit target for the inflation rate and using monetary policy to hit that target

Question 20

What are the differences between inflation targeting and taylor rule

Answer 20

inflation targeting is forward looking : taylor rule is backwards-looking

Question 21

What is monetary neutrality

Answer 21

changes in the money supply have no real effect on the economy
In the long run, changes in the quantity of money affect the price level but not the output or interest rate

Question 22

In the short run what does an increase in the money supply do

Answer 22

It increases the income of individuals, increasing consumer spending and AD.
MS > MD meaning It lowers interest rates,

Question 23

In the long run what does an increase in money supply do

Answer 23

The increase in money supply raises wages and nominal prices. As this shifts the money demand, causing a rise in the interest rate, real GDP and saving falls, shifting the loanable funds supply curve back