Chapter 12: Money, Interest Rates, and Economic Activity

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Answers to Even-Numbered Study Exercises

Fill-in-the-Blank Questions
Question 2
a) real GDP (and any other real variables)
b) steep; large
c) flat; small
d) large; investment; aggregate demand (AD)
e) small; investment; aggregate demand (AD)
f) steep; flat

Review Questions
Question 4
a) The MD function is downward sloping because the nominal interest rate is the opportunity cost of
holding money. Thus a fall in the nominal interest rate should lead to an increase in the quantity of
money demanded.
b) At iA, there is excess demand for money balances. Firms and households attempt to sell their
current holdings of bonds (in return for money). This attempt in the aggregate to sell bonds drives
down their price and thus drives the interest rate up. As the interest rate rises, firms and households
reduce the quantity of money demanded. This process continues until i* is reached, at which point
the amount of money available is willingly held.
c) At iB, there is excess supply of money balances. Firms and households attempt to get rid of their
excess money holdings by purchasing bonds. This attempt in the aggregate to buy bonds drives the
price of bonds up and thus reduces the interest rate. As the interest rate falls, firms and households
increase the quantity of money demanded. This process continues until i* is reached, at which point
firms and households are willing to hold the available supply of money.
d) An increase in the transactions demand for money, caused for example by an increase in real
GDP, is illustrated in the figure by a rightward shift in the MD curve. At i*, there is excess demand
for money. People try to sell some of their current bond holdings to satisfy their increased demand
for cash. But there is only so much cash available. The effort in the aggregate to sell bonds drives
the price of bonds down and thus causes the interest rate to rise, choking back the quantity of money
demanded (an upward movement along the new MD curve). This adjustment continues until the
existing supply of money is willingly held, at a new higher equilibrium interest rate.

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 Chapter 12: Money, Interest Rates, and Economic Activity 49

Question 6
a) An increase in the Canadian money supply initially leads to a reduction in Canadian interest rates.
Other things equal, the rate of return on Canadian bonds has fallen relative to the rate of return on
bonds in other countries. This will lead investors, both in Canada and abroad, to switch away from
Canadian bonds and toward foreign bonds.
b) As investors switch their portfolio away from Canadian bonds toward foreign bonds they must
sell the Canadian bonds in return for Canadian dollars, then sell the Canadian dollars in return for
foreign currency, and then use the foreign currency to purchase foreign bonds. The selling of the
Canadian dollars in the foreign-exchange market will cause a depreciation of the Canadian dollar.
c) As the Canadian dollar depreciates, the Canadian-dollar price of foreign goods rises, which leads
Canadian consumers to reduce their imports. In addition, foreigners will now find that Canadian
products are cheaper in terms of foreign currency, and so will demand more Canadian goods. On
both counts, therefore, Canadian net exports will rise.
d) If the Bank of Canada does nothing to change its policy, but the U.S. Federal Reserve increases
the U.S. money supply, then the initial effect will be a reduction in U.S. interest rates. Now the rate
of return on Canadian bonds will have increased relative to those in the United States, and so
investors will switch toward Canadian bonds. This portfolio switch will cause the Canadian dollar
to appreciate and, other things equal, will cause a reduction in Canada’s net exports. This reduction
in net exports will shift Canada’s AD curve to the left and reduce Canada’s equilibrium real GDP.
The monetary expansion in the United States, if not matched by the Bank of Canada, will generate
a negative aggregate demand shock in Canada.

Question 8
a) Large-scale declines in the value of stock markets lead to declines in the wealth of the households
and firms who own shares of the companies whose stock-market value declines. This reduction in
wealth is predicted to have a negative effect on desired aggregate spending—such as a reduction in
desired consumption spending for any given level of real GDP. In addition, large and sudden stock-
market declines often lead to crises of confidence which generally lead to reductions in desired
investment. The AD curve is predicted to shift leftward—a negative aggregate demand shock.
b) The decline in aggregate demand, other things being equal, is predicted to lead to a short-run
reduction in real GDP. The likely response by central banks is to reduce their policy interest rates in
an attempt to stimulate aggregate demand to offset the initial shock. This is precisely what occurred
throughout 2008 and 2009 in most countries.
c) Yes, the Bank of Canada reduced its policy rate dramatically, by roughly 400 basis points (4
percentage points) from early 2008 to mid 2009. This can be easily verified by checking on the Bank
of Canada’s website (www.bankofcanada.ca) and searching for data on the Bank’s target for the
overnight interest rate during this period.

Question 10
a) If portfolio managers substantially increase their demand for liquid assets such as cash, they
accomplish this by selling some of their short-term or longer-term bonds and perhaps also some
of their stocks. The resulting increase in the supply of bonds (and increase in the demand for
money) leads to an increase in interest rates.

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50 Student Solutions Manual for Ragan, Macroeconomics, Seventeenth Canadian Edition

b) The rise in interest rates described in part (a), ceteris paribus, would be expected to lead to a
reduction in the interest-sensitive components of aggregate demand, especially business
investment, residential investment, and the consumption of durables. Such a reduction in aggregate
demand would tend to reduce the growth of real GDP and could even cause GDP to decline.

c) Central banks could respond to this situation by increasing the supply of money and driving
interest rates back down. Most central banks responded to the COVID-induced increase in cash
demand in precisely this way: by providing massive amounts of liquidity to the financial system,
they increased the supply of money and reversed the rise in interest rates.

Problems
Question 12

a) Present Value (PV) = $100/(1.08) + $100/(1.08)2 + $1000/(1.08)3

= $92.59 + $85.73 + $793.83 = $972.15

b) You should not buy the bond at $995 because it is only “worth” $972.15. This is a different way
of saying that if, instead of buying the bond at this high price, you invested $995 at the market
interest rate (8 percent), you would do better than buying the bond. The implied bond yield (at a
price of $995) is less than the market interest rate. In this situation, since there should be little
demand for the bond at this price, we should expect the bond price to decline in the near future.
c) You should buy the bond at the price of $950 because you can make a profit by doing so. You
could buy the bond for $950 and ought to be able to sell it for $972.15 since that is the bond’s
“worth” in terms of present value. The implied yield at the offered price is greater than the market
interest rate. Since there should be great demand for the bond at this price, we should expect the
bond price to rise in the near future.
d) If the bond price is exactly $972.15, then the implied yield is exactly equal to the market interest
rate, 8 percent.
e) We have just seen that if bond prices differ from their PV, then there will be market pressures
moving the bond price toward the PV. The competitive market equilibrium price of bonds is
exactly the bond’s PV. So if bond prices tend to be equal to PV, then bond yields tend to equal the
market interest rate. Thus market interest rates and bond yields tend to rise and fall together.

Question 14
a) As the money supply increases to $385 billion, MS0 shifts to MS1, but before real GDP or the
price level change, the effect is to reduce the interest rate from 3% to 1%.
b) In response to the lower interest rate, the AD curve shifts to AD1, which increases real GDP to
$1250 billion and the price level to 105. The increase in P and Y both have the effect of increasing
money demand, so MD shifts from MD0 to MD1, and the interest rate increases to 2%.

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 Chapter 12: Money, Interest Rates, and Economic Activity 51

c) In the short-run equilibrium described in (b), real GDP is above potential GDP, and so there is
an inflationary gap. There is excess demand in factor markets which puts upward pressure on
wages and other factor prices.
d) As wages and other factor prices rise, firms’ unit costs also begin rising. These cost increases
mean that the AS curve begins shifting upward, eventually shifting all the way to AS1.
e) Wages and other factor prices stop rising when there is no longer excess demand in the factor
markets; this occurs only when real GDP returns to potential GDP. The new (long-run) equilibrium
occurs when real GDP is $1200 billion and the price level is 110. As the economy adjusts (with
rising P and Y falling back toward Y*), the money demand curve continues shifting to the right.
In the new long-run equilibrium, money demand is MD2 and the interest rate is back to its starting
point at 3%.
f) The increase in the money supply was not neutral in the short run since its impact was to
increase real GDP (and other real variables, too).
g) The increase in the money supply was neutral in the long run since there was no change in any
real variable once the economy attained its new long-run equilibrium. The long-run change in the
real money supply was zero; the nominal money supply increased by 10 percent, but the price level
also increased by 10 percent.
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