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Chapter 16: Q6. (page 347)

Explain the links between changes in the nation's money supply, the interest rate, investment spending, aggregate demand, real GDP, and the price level.

Short Answer

Expert verified

The nation's money supply, interest rates, investment spending, aggregate demand, real GDP, and price levels are interlinked in a way that the increase or decrease in one of these will cause an increase or decrease in the other.

Step by step solution

01

Step 1. Relation between money supply, interest rate, investment spending, aggregate demand, real GDP, and price level

Their linkage can be explained through an example. Suppose there is an increase in the economy's money supply due to some exogenous factors. With the increase in money supply, investment spending will increase as people will have more purchasing power.

The aggregate demand will increase with increased spending asthe investment will cause more employment and eventually more income.This will lead to an increased GDP. However, if the demand goes on to increase, it will increase the money supply. The price levels will increase, causing inflationary tendencies, and the Fed will increase the interest rates to snatch the purchasing power from the hands of the people and bring inflationary tendencies down.

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Most popular questions from this chapter

In 2009, the inflation rate reached a negative 0.4 percent while the unemployment rate hit 10 percent. If the target inflation rate was 2 percent and the full-employment rate of unemployment was 5 percent, what value does the Taylor Rule predict for the Fed’s target interest rate back then? Would that rate have been possible given the zero lower bound problem?

a. negative 4.6 percent, not possible.

b. positive 0.4 percent, possible.

c. negative 5.6 percent, not possible.

d. positive 6.4, possible.

What are the two parts of the Fed’s dual mandate? How does the dual mandate relate to the bullseye chart? Which quadrants of the bullseye chart give conflicting signals to the Fed, and what is the source of the confusion in each case?

In the tables that follow, you will find consolidated balance sheets for the commercial banking system and the 12 Federal Reserve Banks. Use columns 1 through 3 to indicate how the balance sheets will read after each transaction a to c is completed. Do not cumulate your answers; that is, analyze each transaction separately, starting in each case from the numbers provided. All accounts are in billions of dollars.


\(

Consolidated Balance Sheet:

All commercial banks

1

2

3

Assets


Reserve

Securities

Loans




33

60

60





150

3














Liabilities and net worth:



Checkable deposits

Loans from federal reserve banks


\)

Consolidated Balance Sheet:

The 12 Federal Reserve Banks

1

2

3

Assets


Securities

Loans to commercial banks




60

03





33













Liabilities and net worth:



Reserves of commercial bank


Treasury deposits

Federal reserve notes

3

27






a. A decline in the discount rate prompts commercial banks to borrow an additional \(1 billion from the Federal Reserve Banks. Show the new balance-sheet numbers in column 1 of each table.

b. The Federal Reserve Banks sell \)3 billion in securities to members of the public, who pay for the bonds with checks. Show the new balance-sheet numbers in column 2 of each table.

c. The Federal Reserve Banks buy $2 billion of securities from commercial banks. Show the new balance-sheet numbers in column 3 of each table.

d. Now review each of the previous three transactions, asking yourself these three questions: (1) What change, if any, took place in the money supply as a direct and immediate result of each transaction? (2) What increase or decrease in the commercial banks' reserves took place in each transaction? (3) Assuming a reserve ratio of 20 percent, what change in the money-creating potential of the commercial banking system occurred as a result of each transaction?

In 1980, the U.S. inflation rate was 13.5 percent, and the unemployment rate reached 7.8 percent. Suppose that the target rate of inflation was 3 percent back then and the full employment rate of unemployment was 6 percent at that time. What value does the Taylor Rule predict for the Fed’s target interest rate? Would you be surprised to learn that the Fed’s targeted interest rate (the federal funds rate) reached 18.9 percent in December 1980?

A bank currently has \(100,000 in checkable deposits and \)15,000 in actual reserves. If the reserve ratio is 20 percent, the bank has ______ in money-creating potential. If the reserve ratio is 14 percent, the bank has _______ in money-creating potential

a. \(20,000; \)14,000

b. \(3,000; \)2,100

c. −\(5,000; \)1,000

d. \(5,000; \)1,000
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