Study Guide for Chapter 5 - Money and Banking

Essays

1. Explain why federal budget deficits may increase interest rates. Use a graph.
2. Explain why interest rates are usually procyclical using the loanable funds framework and the liquidity preference framework.
3. Define the following interest rates and find their current values: prime rate, discount rate, federal funds rate, call money rate, LIBOR, Treasury securities (3 month, 6 month, 1 year, 5 year, 10 year, 20 year, 30 year), mortgage bonds, municipal bond index, corporate bond rate, junk bond rate. Why do these rates vary?
4. The way the FRS increases the money supply is to buy treasury bonds. Using the loanable funds framework and the liquidity preference framework, show what effect this has on interest rates.
5. Bond prices recently increased because bond investors expect future inflation to decrease. Use the loanable funds framework to explain what happened in the bond market.
6. Predict what will happen to interest rates if the public suddenly expects a large increase in stock prices.
7. Show with a graph what typically happens to interest rates in the long run, as a result of expansionary monetary policy, clearing showing the liquidity effect, the income effect, the price level effect and the expected inflation effect.
8. Show graphically how interest rates could rise immediately in repsonse to expansionary monetary policy.
8. In the early 1980s, the new Fed chairman, Paul Volcker, announced that he was determined to lower inflation by slowing the growth rate of the money supply. Interest rates initially rose but then later fell. Explain what happened using the concepts of liquidity, income, price level, and expected inflation effects. Use a graph.
9. Explain the difference between the price level effect on interest rates and the inflation expectation effect on interest rates.

T-F-U, explain answer

1. Interest rates will always increase during an economic expansion.
2. Interest rates will always increase if expected inflation increases.
3. An increase in expected inflation from 3% to 5% will cause interest rates to increase by exactly 2%.
4. When the riskiness of bonds decreases, the effect on interest rates is the same in both frameworks (loanable funds vs. liquidity preference).
5. Increases in the money supply will raise interest rates.
6. An increase in stock market volatility will raise interest rates in the bond market.
7. A decrease in the money supply has the same effect on interest rates in both frameworks (loanable funds vs. liquidity preference).
8. An increase in the money supply will lead to an immediate increase in interest rates only when the expected inflation effect dominates the liquidity effect.