ChapterTheMoneyMarketandtheInterestRate.docVIP

Chapter 12 The Money Market and the Interest Rate Review Questions 2. The money demand curve gives the total quantity of money demanded in the economy at each interest rate. As the interest rate rises, the opportunity cost of holding money increases. Individuals want to take advantage of the rising interest rate and choose to hold more bonds, and thus they demand less money. This inverse relationship explains why the curve slopes downward. A change in the interest rate involves a movement along the money demand curve. In part (a), there is a rightward movement along the money demand curve, and in part (b), there is a leftward movement along the curve. As the price level or real income decreases [parts (c) and (f)], money demand decreases, and the curve shifts leftward. As the price level or real income increases [parts (d) and (e)], money demand increases, and the curve shifts rightward. 4. An excess supply of money implies an excess demand for bonds. As the public buys bonds, the price of bonds increases. An increase in the price of bonds results in a lower interest rate. At a lower interest rate, people are willing to hold more money. The excess supply of money disappears, and the market returns to equilibrium. In the case of an excess demand for money, there is an excess supply of bonds. As people sell their bonds, the price of bonds falls. Falling bond prices means a higher interest rate. As the interest rate increases, the opportunity cost of holding money rises, and money demand decreases. The money market returns to equilibrium. 6. a. An increase in the interest rate discourages business spending on plant and equipment. If the firm must borrow funds to invest, then a higher interest rate means that the firm will have to pay back more to the lender. If instead the firm finances its project out of its own funds, a higher interest rate implies a higher opportunity cost of using the firm’s funds on plant and equipment instead of lending them out. b. New housing