Question

 

Explain why each of the following statements is True, False, or Uncertain according to economic principles. Use diagrams where appropriate. Unsupported answers will receive no marks. It is the explanation that is important.

A6-5. Suppose a $1000 bond pays annual “coupon interest” equal to 10% and matures in two years. If the yield on bonds with similar risk characteristics is 3%, the price of this bond today is greater than $1000.

A6-6. Suppose the Bank of Canada (BOC) buys $10B worth of bonds from the Canadian banking system that operates with a desired reserve ratio of 5%. Immediately after the transaction, the balance sheet of the BOC expands by $10B, while balance sheet of the banking system is the same size, but in the long run, the balance sheet of both the BOC and the banking system expand by $200B.

A6-7. In the long-run, the money supply is neutral with respect to (does not affect) real GDP.

A6-8. A given increase in the money supply is more effective at shifting the aggregate demand curve the more interest rate responsive (elastic) is the money demand curve.

Answer 1

A6-5 True. Since the bonds with similary risk characteristic is giving only 3% yield and this bond is giving 10% coupon interest, for these two to be equal at the end of 2 years, this bond must have a value higher than 1000 today.

A6-6 True. This is because of the multiplier effect. In simple terms, this is because banks are not required to keep the whole money they have in reserve. For example, in our case the reserve ratio is 5%. So after borrowing $10B, BOC has to keep 500m in reserve and is free to lend rest 9500m to others. The others will deposit it to another bank and that bank will require to keep only 5% of 9500m in reserve and lend the rest. So on and so forth. The multiplier effect is given by 1/CRR. Our CRR is 5%, so 1/.05 gives us 20. Multiplying 10B by 20, we get 200B.

A6-7 True. This is called 'Neutrality of money'. it says that any change in money supply does not change the underlying factors of an economy and hence market will always gravitate towards equilibrium and 'real' variables such as GDP will not be affected by the money supply. Money supply cant change trade partners, machines available etc., hence it cant change real variables.

A6-8. True. This is because the real GDP varies with the interest rate in the economy and the interest rate varies with the money supply. The more elastic the money demand curve is, the farther the interest rate will fall when money supply increases. And the farther the interest rate falls, the higher the real GDP will rise. Aggregate demand will rise and fall with GDP and hence its true.