BUSI 101 - Chapter 15

(a)2 Review the three effects that make aggregate demand slope downward, and explain why the interest-rate and real-exchange-rate effects are especially important for understanding monetary policy in Canada.

(a)4 What is the theory of liquidity preference, and what variable adjusts to bring the money market into equilibrium?

(a)2 A lower price level raises real wealth and consumption, lowers interest rates and stimulates investment, and depreciates the real exchange rate and raises net exports. The wealth effect is relatively small because money is only a small part of household wealth. The interest-rate effect is central in a closed economy, while the exchange-rate effect is also important for Canada because Canada trades extensively with other countries.

(a)4 Liquidity-preference theory states that the interest rate adjusts until the quantity of money people want to hold equals the quantity supplied.

(b)1 In the liquidity-preference model, why is the money-supply curve vertical?

(b)2 How can the Bank of Canada increase or decrease the money supply through changes in bank reserves?

(b)5 Why can the chapter simplify monetary-policy analysis by treating the Bank of Canada as directly controlling the money supply?

(b)1 The Bank of Canada is assumed to choose the quantity of money independently of the prevailing interest rate. Therefore the same money supply exists at every interest rate.

(b)2 Increasing reserves gives commercial banks greater capacity to lend and create deposits, increasing the money supply. Reducing reserves has the opposite effect.

(b)5 The chapter is concerned mainly with the consequences of changes in money rather than the operational details used to create those changes.

(c)3 How do increases in the price level or real GDP affect the demand for money, and why?

(c)4 Distinguish between a movement along the money-demand curve and a shift of the money-demand curve.

(c)5 Suppose the interest rate rises while real GDP and the price level remain unchanged. What happens to the quantity of money demanded, and why?

(c)3 Both increase the dollar value of transactions. People therefore need larger money balances to make purchases, shifting money demand to the right.

(c)4 A change in the interest rate changes the quantity of money demanded along a given curve. A change in the price level, real GDP, or another determinant of transactions shifts the entire money-demand curve.

(c)5 Money demanded falls because the opportunity cost of holding non-interest-bearing money has increased.

(d)2 What adjustment occurs when people want to hold more money than the Bank of Canada has supplied?

(d)3 Why do purchases and sales of bonds help move the interest rate toward its money-market equilibrium?

(d)5 How does liquidity-preference theory therefore provide a deeper explanation of the interest-rate effect behind the downward-sloping aggregate-demand curve?

(d)2 People sell interest-bearing assets to obtain money. Bond issuers must offer higher interest rates to attract buyers, so the interest rate rises until money demand equals money supply.

(d)3 Portfolio adjustments change demand for bonds and other interest-bearing assets, causing the returns offered on those assets to adjust.

(d)5 It explains the mechanism between prices and spending: higher prices increase transaction demand for money, which raises interest rates and suppresses interest-sensitive expenditure.

(e)1 In a small open economy, what additional channel reinforces the decline in aggregate quantity demanded when the Canadian price level rises?

(e)2 Distinguish between a change in the price level causing movement along AD and a change in the money supply causing AD to shift.

(e)3 In a closed economy, trace the initial effects of an increase in the money supply on the money market, interest rates, investment, and aggregate demand.

(e)4 Why does the interest rate partially rise again after expansionary monetary policy has already stimulated spending and output?

(e)5 Why does this feedback make the increase in aggregate demand smaller than it would be if money demand did not respond to higher output?

(e)1 A higher Canadian price level appreciates the real exchange rate, makes Canadian goods relatively expensive, reduces exports, increases imports, and lowers net exports.

(e)2 A price-level change alters money demand and interest rates and therefore creates movement along AD. A money-supply change alters spending at every given price level and therefore shifts the AD curve.

(e)3 Money supply rises → excess money holdings appear → interest rate falls → borrowing becomes cheaper → residential and business investment rise → aggregate demand shifts right.

(e)4 Higher output means more transactions, increasing money demand. That puts some upward pressure on the interest rate.

(e)5 The partial recovery of the interest rate reduces some of the investment stimulus created by the original monetary expansion.

f)3 Why does a monetary expansion shift the entire aggregate-demand curve rather than simply move the economy along the existing AD curve?

(f)4 What crucial restriction does perfect capital mobility impose on Canada’s interest rate in the small-open-economy model?

(f)5 Why is the closed-economy monetary-policy story incomplete when applied to Canada?

(f)3 At every possible price level, the larger money supply produces lower interest rates and greater desired expenditure. Thus the relationship between price level and quantity demanded changes.

(f)4 The domestic interest rate must ultimately equal the world interest rate, ignoring differences in taxes and default risk.

(f)5 A monetary expansion initially lowers Canada’s interest rate below the world rate. International investors then respond, generating capital flows and exchange-rate changes that do not exist in a closed economy.

(g)4 Why does the increase in net exports eventually help bring Canada’s interest rate back to the world interest rate?

(g)5 Give the complete causal chain for expansionary monetary policy in a small open economy with a flexible exchange rate.

(g)4 Higher net exports increase Canadian output and transactions, increasing money demand. The resulting increase in money demand raises the domestic interest rate until it again equals the world rate.

(g)5 Money supply rises → Canadian interest rate falls → investment and durable consumption rise → Canadian assets become relatively unattractive → capital flows toward foreign assets → Canadian dollars are sold → dollar depreciates → NX rises → output rises further → money demand rises → Canadian interest rate returns to the world rate.

(h)1 Why does expansionary monetary policy shift aggregate demand farther to the right in a small open economy with a flexible exchange rate than in a closed economy?

(h)2 Compare the two channels through which monetary expansion stimulates Canadian aggregate demand under a flexible exchange rate.

(h)3 If the Bank of Canada contracts the money supply under a flexible exchange rate, predict the effects on the Canadian interest rate initially, capital flows, the Canadian dollar, net exports, and aggregate demand.

(h)4 Why is exchange-rate flexibility important if the Bank of Canada wants to use monetary policy independently?

(h)5 What fundamental conflict arises if the Bank of Canada tries simultaneously to increase the money supply and prevent the Canadian dollar from depreciating?

(h)1 It receives both the domestic interest-rate stimulus and an additional stimulus from currency depreciation and rising net exports.

(h)2 The first channel is lower interest rates increasing domestic investment and durable consumption. The second is depreciation increasing exports and decreasing imports.

(h)3 Money supply contracts → Canadian interest rate initially rises → Canadian assets become relatively attractive → capital flows toward Canada → demand for Canadian dollars rises → dollar appreciates → NX falls → aggregate demand shifts left.

(h)4 Independent monetary policy changes domestic monetary conditions in ways that temporarily move the interest rate away from the world rate. The exchange rate must be free to change as international capital responds.

(h)5 The monetary expansion puts downward pressure on the interest rate and dollar. Preventing the dollar from depreciating requires the Bank to buy Canadian dollars, which removes money from circulation and reverses the original expansion.

(i)4 What general conclusion does the chapter draw about simultaneously choosing the money supply and the exchange rate?

(i)5 Compare the effectiveness of expansionary monetary policy under a flexible exchange rate with its effectiveness under a fixed exchange rate in this model.

(i)4 The Bank cannot independently control both. Maintaining a fixed exchange rate constrains monetary policy, while controlling the money supply requires allowing the exchange rate to adjust.

(i)5 Under a flexible rate, monetary expansion can strongly raise aggregate demand through both interest rates and net exports. Under a fixed rate, defending the exchange rate forces the Bank to reverse the monetary expansion, making independent monetary policy ineffective in the model.

(j)2 What is a liquidity trap in the context of liquidity-preference theory?

(j)3 How might a central bank continue stimulating the economy even when nominal interest rates are already near zero?

(j)5 What is quantitative easing, and how can it potentially stimulate aggregate demand when conventional interest-rate policy is constrained?

(j)2 A situation in which additional money primarily increases liquid balances but cannot reduce interest rates enough to stimulate additional spending, leaving aggregate demand weak.

(j)3 It can influence expected inflation or use unconventional asset purchases such as quantitative easing.

(j)5 Quantitative easing involves large-scale purchases of financial assets beyond the central bank’s normal operations, such as longer-term or private financial instruments. These purchases can lower relevant borrowing rates and support investment.

(k)2 Why do central banks pay attention to major movements in stock prices even though stabilizing stock prices is not their direct objective?

(k)4 Why might a central bank respond to a stock-market boom with tighter monetary policy, and how could it respond to a stock-market crash?

(k)2 Stock prices affect household wealth, investment conditions, aggregate demand, and therefore output and inflation—the variables central banks do care about.

(k)4 A boom may push AD excessively right, so tighter policy can offset it. A crash reduces consumption and investment, so expansionary policy can help support AD.

(l)2 How does the chapter reconcile the claim that the interest rate is determined by saving and investment with the claim that it is determined by money supply and money demand?

(l)3 In the long run, what determines output, the interest rate, and the price level according to the classical model?

(l)4 Why does price stickiness cause the short-run determination of the interest rate to differ from its long-run determination?

(l)5 In a closed economy, what variable adjusts in the short run to equilibrate the money market when prices are sticky?

(l)2 They apply to different time horizons. Loanable-funds theory is primarily a long-run framework, while liquidity-preference theory explains short-run interest-rate adjustments when prices are sticky.

(l)3 Output is determined by factor supplies and technology. In a closed economy the real interest rate balances saving and investment; in a small open economy it is tied to the world interest rate. The price level adjusts to equilibrate money supply and money demand.

(l)4 In the long run, prices can change to equilibrate the money market. In the short run, prices adjust slowly, so the interest rate must respond instead.

(l)5 The interest rate.

(m)1 In a small open economy with a flexible exchange rate, how is money-market equilibrium restored while keeping the Canadian interest rate equal to the world interest rate?

(m)2 In a small open economy with a fixed exchange rate, how is money-market equilibrium restored while keeping the Canadian interest rate equal to the world interest rate?

(m)3 Why does the exchange rate adjust under a flexible regime while the money supply adjusts under a fixed regime?

(m)4 A recession causes private consumption and investment to fall. Using the chapter’s framework, explain how expansionary monetary policy could partially offset the decline in aggregate demand under Canada’s flexible exchange rate.

(m)5 What is the chapter’s overall lesson about how monetary policy influences aggregate demand differently in closed economies, flexible-exchange-rate open economies, and fixed-exchange-rate open economies?

(m)1 The interest rate cannot permanently differ from the world rate. Capital flows change the exchange rate, which changes net exports and output. The resulting change in output changes money demand until the money market clears at the world interest rate.

(m)2 The Bank intervenes in foreign-exchange markets. Its purchases or sales of Canadian dollars alter the domestic money supply until the money market clears at the world interest rate while the exchange rate remains fixed.

(m)3 With a flexible rate, the central bank allows currency markets to absorb the adjustment. With a fixed rate, it must intervene to prevent currency movement, and that intervention changes the money supply.

(m)4 The Bank can increase the money supply. Interest rates initially fall, stimulating domestic spending. Capital then flows toward higher-return foreign assets, causing the Canadian dollar to depreciate. The depreciation increases NX, providing an additional increase in Canadian aggregate demand.

(m)5 In a closed economy, monetary policy works mainly through interest rates and domestic spending. In a small open economy with flexible exchange rates, it also works through capital flows, currency depreciation or appreciation, and net exports, making its effect on AD stronger. Under a fixed exchange rate, defending the currency forces the central bank to offset changes in the money supply, greatly limiting independent monetary policy.