Exam 11: Money Demand and the Equilibrium Interest Rate

Explain the transaction and speculation motives for holding money.

Critically evaluate the following statement. "Higher bond prices are what causes lower interest rates."

Assume that Kelly could decide to deposit his entire paycheck ($1,200) into her checking account at the start of the month and run her balance down to zero by the end of the month. Illustrate this with the use of a graph and determine her average monthly holdings. What is the economic cost of this money management strategy?

Assume the money market is initially in equilibrium. Now, suppose that the aggregate price level falls. Graphically illustrate and explain what effect this reduction in the aggregate price level will have on the money market.

Why is the money supply curve discussed in the book a vertical line?

Assume that Joe chooses to deposit half his paycheck of $1200 and invests the remaining $600 in an interst-bearing account and runs his balance down evenly throughout the course of the month. Show with the use of a graph what his average monthly holdings would look like.

Suppose there is an excess supply for money. Explain what will happen in the money market as a result of this.

Assume for some reason that the demand for money has risen. In addition, the Fed has responded to this development by increasing the money supply. Explain why the movement of the interest rate is largely indeterminate. In other words, what information are we lacking in order to make a definitive statement about the direction of the interest rate?

Draw the demand curve for money balances and explain how the interest rate affects the number of switches that an individual would make between money balances and bonds.

Explain what is meant by the "speculation motive" for holding money.

Explain the speculative motive for holding money.

Explain why money management is costly.

Assume that Joe chooses to deposit his entire paycheck of $1200 and runs his balance down evenly throughout the course of the month. Show with the use of a graph what his average monthly holdings would look like.

Critically evaluate the following statement. "A decrease in the interest rate will not increase the demand for money."

Label each of the following events as either leading to an increase or a decrease in the equilibrium interest rate?

Draw the demand and the supply for money and identify the equilibrium interest rate. Make sure to draw a money supply curve that is independent of the interest rate. Draw the curves so that the equilibrium interest rate is 8%. Explain why interest rates above or below 8% are not stable.

It is clear that the Fed can affect short-term interest rates by changing the money supply. Can it also affect long-term interest rates? That is, if it can affect the interest rate on a one-year security can it also affect the interest rate on a two-year security? If so, explain your reasoning.

Briefly explain the concept of the "term structure of interest rates."

Graphically demonstrate the effect on the interest rate of a decrease of the money supply by the Fed.

Summarize the determinants of the demand for money. (a) aggregate output (b) the prices of goods and services