Question

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) The answer is given below -

A6-6) This is the multiplier effect. Multiplier in the economy is always = 1/CRR. Money creation from the $10B on continuous lending of the amount left after keeping reserves results in an amount much greater than 10B. Considering CRR of 10% (for illustration) say BOC gets 10B. It keeps 1B and lends 9B. This 9B is deposited in some other bank (We assume entire amount deposited) which again lends 90%*9B = 8.1B. This process continues unless there is almost nothing left to lend. This (10+9+8.1) = $27.1B > $10B. On continuously lending, the net effect can be seen using the multiplier. Here multiplier = 1/5% = 20. Thus net effect of 10B is 10*20 = 200B as given.

A6-7) This is the neutrality of money theory which states that an increase in money supply or inflation for that matter has an impact on only the nominal variables whereas the real variables remains unchanged.

A6-8) If the money supply increases and the demand curve is interest rate responsive or elastic, it is indeed easier to get shifted as compared to an interest inelastic demand curve which is obvious as interest inelastic means that changes in interest rate won't have much effect on the demand curve. If money supply increases, there is excess supply of money in the money market, which causes an excess demand for bonds in the bond market. This excess demand for bonds causes the price of bonds to fall and thus the interest rate rises. If the demand curve is interest elastic, this increase in interest rate easily shifts the AD curve.

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