Intermediate macro
Solutions #2
Solutions 2: Week starting August 8th
Solutions
Reading guide
Review chapter 4, chapter 6, and chapter 5 sections 5.1-5.2 of the textbook as preparation for this
tutorial. You should also look over your lecture notes for week 2.
Key concepts
The demand for money. Equilibrium in financial markets. Maturity mismatch. Leverage. IS curve.
LM curve.
Solutions to pre-tutorial problems
1. Label each of the following statements as true, false or uncertain. You must be able to justify
your answer.
(a) Because only bonds pay interest, the demand for money is independent of the interest rate.
(b) In the last 40 years, the ratio of money to nominal income has moved in the same direction
as the nominal interest rate.
(c) To increase the supply of money, the Reserve Bank sells bonds.
Solution:
(a) False. The interest rate is an important factor in determining the demand for money since
it determines the opportunity cost of holding money.
(b) False. The relationship between the ratio of money to nominal income and the nominal
interest rate is negative.
(c) False. The sale of bonds by the Reserve Bank in the overnight cash market has the effect
of reducing the money supply.
2. Demand for money.
Suppose that a person has financial wealth of $50,000 and an annual income of $60,000. Suppose
their demand for money is given by:
M d = $Y (0.35 − i)
(the notation $Y is to remind you that this is nominal income, the same thing as P Y ).
Intermediate macro: Solutions #2 2
(a) What is their demand for money and bonds when the interest rate is 5% (that is, i = 0.05).
What about when the interest rate is 10%?
(b) Describe the effect of changes in the interest rate on the demand for money and the demand
for bonds.
(c) Suppose that the interest rate is 10%. What happens to the demand for money if their
annual income falls to $30,000?
(d) Outline the effect of changes in income on money demand. How does this effect depend
on the interest rate i?
Solution:
(a) Wealth is either money or bonds, so B d = $50, 000 − M d . At i = 0.05, money demand is
M d = $60, 000 × (0.35 − 0.05) = $18, 000
and so bond demand is B d = $32, 000. At i = 0.10, money demand is M d = $15, 000 and
bond demand is B d = $35, 000.
(b) Money demand decreases and bond demand increases when the interest rate increases. As
the opportunity cost of holding money rises, people abandon money and switch to bonds.
(c) With an interest rate of i = 0.10 and nominal income of $60,000 money demand is $15,000.
If annual income falls to $30,000 money demand falls by 50% from $15,000 to $7,500. Note
that for given nominal interest rate, money demand is proportional to income.
(d) A 1% increase (decrease) in income leads to a 1% increase (decrease) in money demand.
This effect is independent of the interest rate. The percentage change in money demand is
independent of the interest rate, but the absolute change in money demand does depend on
the interest rate. To see this, suppose we’re comparing money demands M d = $Y × L(i)
0
and M d = $Y 0 × L(i). Then the percentage change in money demand is equal to the
percentage change in income
0
Md − Md $Y 0 × L(i) − $Y × L(i) $Y 0 − $Y
= =
Md $Y × L(i) $Y
but the absolute change in money demand does depend on the interest rate
0
M d − M d = $Y 0 × L(i) − $Y × L(i) = ($Y 0 − $Y ) × L(i)
so that the L(i) term does not drop out.
3. Bond prices.
Consider a bond promises to pay $100 in one year.
(a) What is the interest rate on the bond if its price today is $75? what about $85? $95?
(b) What is the relation between the price of the bond and the interest rate?
(c) If the interest rate is 8%, what is the price of the bond today?
Solution:
Intermediate macro: Solutions #2 3
(a) Letting PB denote the price now of a bond that pays $100 in one year, we have
$100
PB =
1+i
or
$100
i= −1
PB
so for i = 0.33, 0.18, 0.05 we have PB = 75, 85, 95 (all in dollars), respectively.
(b) Bond prices and the interest rate are negatively related. As the interest rate rises the price
falls.
(c) Using the formula above PB = $100/(1 + i) = $100/(1.08) ≈ $93.
4. List one factor that can shift the IS curve. Briefly explain how this factor shifts the IS curve.
Solution:
Changes in taxes T will shift the IS curve. The IS curve gives the equilibrium level of output
as a function of the interest rate. An increase in T implies that disposable income decreases
at any given interest rate. It follows that consumption falls and demand for goods falls. As a
result, equilibrium output falls at any given interest rate. The IS curve shifts to the left. A
decrease in T implies that disposable income increases at any given interest rate. It follows
that consumption increases and demand for goods increases. As a result, equilibrium output
increases at any given interest rate. The IS curve shifts to the right.
Changes in government spending G will shift the IS curve. The IS curve gives the equilibrium
level of output as a function of the interest rate. An increase in G implies that demand for
goods increases at any given interest rate. As a result, equilibrium output increases at any
given interest rate. The IS curve shifts to the right. A decrease in G implies that demand for
goods falls at any given interest rate. As a result, equilibrium output falls any given interest
rate. The IS curve shifts to the left.
Changes in consumer confidence will shift the IS curve. The IS curve gives the equilibrium level
of output as a function of the interest rate. An increase in consumer confidence implies that
consumption increases and demand for goods increases at any given interest rate. As a result,
equilibrium output increases at any given interest rate. The IS curve shifts to the right. A
decrease in consumer confidence implies that consumption falls and demand for goods falls. As
a result, equilibrium output falls at any given interest rate. The IS curve shifts to the left.
Overall, changes in factors that decrease the demand for goods given the interest rate shift the
IS curve to the left. Changes in factors that increase the demand for goods given the interest
rate shift the IS curve to the right.
5. List one factor that can shift the LM curve. Briefly explain how this factor shifts the LM curve.
Solution:
Changes in the interest rate will shift the LM curve. The LM curve is a horizontal line at the
value of the interest rate chosen by the Reserve Bank. An increase in i is a contractionary
monetary policy that shifts the LM curve up. A decrease in i is an expansionary monetary
policy that shifts the LM curve down.
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Solutions to in-tutorial problems
1. Make sure that you understand the problems set in the blue sheet (pre-tutorial work) for this
week’s tutorial. Ask others in your group if you are still unsure about any of the blue sheet
problems.
2. Assume that money demand is given by:
M d = $Y (0.25 − i)
where nominal income is $100. You may also suppose that the money supply is $20. Assume
that the financial markets are in equilibrium.
(a) What is the equilibrium interest rate?
(b) If the Reserve Bank wants to increase i by 10 percentage points (that is the equilibrium
interest rate you find in (a) plus 10%), at what level should it set the supply of money?
(c) If the money supply decreases to $15, what wil be the impact on i?
Solution:
(a) The equilibrium condition in the money market is M = M d . Using this
$20 = $100 × (0.25 − i)
Solving for i gives i = 0.05 or 5%.
(b) The Reserve Bank wants to set i = 5% + 10% = 15%. Using i = 0.15, in the expression
for money demand M = $100 × (0.25 − 0.15), therefore the RBA should set the supply of
money M = $10.
(c) Using M = 15, the equilibrium condition in the money market is
$15 = $100 × (0.25 − i)
Solving for i gives i = 0.1 or 10%.
3. Briefly explain how leverage can be used to amplify an investor’s risk and return.
Solution:
Consider the following example. A bank has liabilities of $1400 (million) and assets of $1500m.
So its net worth or equity is $100m which is held by various shareholders. Its leverage ratio is
assets/equity, 1500/100 or 15:1. In a good year, the value of the bank’s assets might rise by 5%
from $1500m to $1575m. If so, the new equity held by the bank’s shareholders is $100m+$75m
so that the percentage return to equity holders is 75% (i.e., amplified 15 times the return on
the assets). Symmetrically, in a bad year, the value of the bank’s assets might fall by 5% from
$1500m to $1425m. If so, the new equity held by the bank’s shareholders is $100m−$75m so
that the percentage return to equity holders is −75%. At a new equity level of $25m, the bank
is much closer to being insolvent.
4. Suppose that nominal income in an economy is $5000 and the demand for money is given by
M d = $Y (0.08 − 0.4i)
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(a) If the money demand is equal to $100, what is the interest rate?
(b) What should the central bank do to interest rates if it wants to increase the money supply
to $300?
(c) What is the demand for money when the central bank sets the interest rate at zero?
(d) How would people choose between bonds and money when the interest rate is zero?
(e) Explain why there is a zero lower bound of the interest rate when the economy is in a
liquidity trap.
Solution:
(a) From the money demand function, we have
$100 = $5000 × (0.08 − 0.4i)
Solving for i gives i = 0.15.
(b) If the central bank wants to increase the money supply to $300, the equilibrium condition
in the money market implies
M s = $300 = M d = $5000 × (0.08 − 0.4i)
It follows that i = 0.05.
(c) When the central bank sets the interest rate at zero, the money demand function implies
M d = $5000 × (0.08 − 0)
We can solve for M d = $400.
(d) When the interest rate is zero, the opportunity cost of holding money is zero. Once
people have enough money for transaction purposes, they are indifferent between holding
money and holding bonds. In figure 1, the distance OB shows the demand for money for
transaction purposes. People are willing to hold money money beyond point B at zero
interest rate. Therefore, the demand for money becomes horizontal beyond point B.
(e) Generally, an increase in the money supply leads to a decrease in the interest rate. Once the
equilibrium interest rate reaches zero, further increases in the money supply have no effect
on the equilibrium interest rate, which remains equal to zero. The interest rate cannot
go below zero, a constraint known as the zero lower bound. At the zero lower bound,
monetary policy cannot decrease the interest rate further. In this case, the economy is
said to be in a liquidity trap.
Intermediate macro: Solutions #2 6
Figure 1: Money and interest rates
