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Chapter 5: Q.19 (page 164)

M1 money growth in the U.S. was about 15%in localid="1647014587488" 2011and2012, and 10%in 2013. Over the same time period, the yield on 3-month Treasury bills was close to 0%. Given these high rates of money growth, why did interest rates stay so low, rather than increase? What does this say about the income, price-level, and expected-inflation effects

Short Answer

Expert verified

The interest rate was low since the liquidity effect outweighed all other benefits.

Step by step solution

01

Introduction

Inflation is defined as a condition in which the price of all goods and services begins to rise, reducing people's real purchasing power.

02

Explanation

Money supply expansion is typically associated with high predicted inflation, strong economic growth, and a rise in interest rates over time. However, between 2011 and 2013, unemployment was high, economic growth was slow, and economists were more concerned about deflation. All other effects were smaller at the time in comparison to the liquidity effect. As a result, the interest rate remained low for a long time.

As a result, the interest rate was low since the liquidity effect outweighed all other benefits.

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Most popular questions from this chapter

Using both the supply and demand for bonds and liquidity preference frameworks, show how interest rates are affected when the riskiness of bonds rises. Are the results the same in the two frameworks?

How might a sudden increase in people’s expectations of future real estate prices affect interest rates?

Go to the St. Louis Federal Reserve FRED database, and find data on the M1money supply (M1SL) and the 10-year U.S. Treasury bond rate (GS10). For the M1money supply indicator, adjust the units setting to “Percent Change from Year Ago,” and for both variables, adjust the frequency setting to “Quarterly.” Download the data into a spreadsheet.

a. Create a scatter plot, with money growth on the horizontal axis and the 10-year Treasury rate on the vertical axis, from 2000:Q1to the most recent quarter of data available. On the scatter plot, graph a fitted (regression) line of the data (there are several ways to do this; however, one particular chart layout has this option built in). Based on the fitted line, are the data consistent with the liquidity effect? Briefly explain.

b. Repeat part (a), but this time compare the contemporaneous money growth rate with the interest rate four quarters later. For example, create a scatter plot comparing money growth from 2000:Q1with the interest rate from 2000:Q1, and so on, up to the most recent pairwise data available. Compare your results to those obtained in part (a), and interpret the liquidity effect as it relates to the income, price-level, and expected-inflation effects.

c. Repeat part (a) again, except this time compare the contemporaneous money growth rate with the interest rate eight quarters later. For example, create a scatter plot comparing money growth from 2000:Q1with the interest rate from 2002:Q1, and so on, up to the most recent pairwise data available. Assuming the liquidity and other effects are fully incorporated into the bond market after two years, what do your results imply about the overall effect of money growth on interest rates?

d. Based on your answers to parts (a) through (c), how do the actual data on money growth and interest rates compare to the three scenarios presented in Figure 11of this chapter?

Would fiscal policymakers ever have reason to worry about potentially inflationary conditions? Why or why not?

Suppose you visit with a financial adviser, and you are considering investing some of your wealth in one of three investment portfolios: stocks, bonds, or commodities. Your financial adviser provides you with the following table, which gives the probabilities of possible returns from each investment.

a. Which investment should you choose to maximize your expected return: stocks, bonds, or commodities?

b. If you are risk-averse and had to choose between the stock and the bond investments, which would you choose? Why?
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