3). What is the money multiplier and what factors determine its size? 4). Use the market for central bank money to answer this question. Graphically illustrate and ...
Exam Name___________________________________ ESSAY. Write your answer in the space provided or on a separate sheet of paper. 1) First, explain why the money demand curve is downward sloping. Second, explain what factor(s) will cause shifts in the money demand curve.
2) First, define the velocity of money. Second, explain what effect an increase in the interest rate should have on the velocity of money.
3) What is the money multiplier and what factors determine its size?
4) Use the market for central bank money to answer this question. Graphically illustrate and explain what effect a Federal Reserve purchase of bonds will have on this market and on the equilibrium interest rate.
1) The money demand curve is downward sloping (with the interest rate on the vertical axis). It is assumed that money pays no interest. At the same time, individuals earn interest when they hold bonds. So, as the interest rate increases, individuals are more willing to incur the costs associated with converting bonds to money when they wish to buy goods. So, an increase in the interest rate causes a reduction in money demand. Money demand depends on the level of transactions and on the interest rate. As the level of transactions increases, individuals will increase money demand. Assuming that nominal income is correlated with nominal transactions, an increase in nominal income will cause an increase in money demand and shifts in the curve. 2) Velocity is defined as the ratio of nominal income to nominal money supply. An increase in the interest rate will likely result in an increase in velocity as individuals attempt to reduce their holdings of money. 3) The money multiplier represents the effect of a given change in high powered money on the money supply. The money multiplier will be affected by changes in two parameters: c and q. An increase in either parameter will cause a reduction in the money multiplier. 4) A Fed purchase of bonds will cause an increase in the supply of central bank money. To restore equilibrium in this market, the interest rate will have to fall. As it does, the quantity demanded for central bank money will rise and, therefore, restore equilibrium.