Chapter 12: Money, Interest Rates and Economic Activity

1. Why do people hold money?

Transactions motive to pay for bills and purchase of G&S
Precautionary motive to pay for unexpected and unplanned expenses.
Speculative motive to buy or not buy stocks and bonds depending on interest rates.

2. Money demand is likely to increase the most during which part of the business
cycle?
Recovery

3. What is the effect of interest rates, GDP income and Price level on the money
demand curve?
Interest rate is inversely proportional to MD curve and the GDP income and Price level are
directly proportional to money demand.

4. If there is an increased transactional demand how does that affect the MD curve
and equilibrium interest rate?
The MD curve will shift right( because there is a need for money to be more liquid) and the
interest rates will rise until equilibrium rate.

5. If the interest rate rises, how does that affect the purchase and sales of bonds?
There is an supply of​money, resulting in higher bond​demand(purchase), raising bond​prices,
decreasing interest rates to​equilibrium (Increased money investing)

6. If the interest rates fall, how does that affect the purchase and sales of bonds?
There will be an increased demand for​money, resulting in bond​sales, lowering bond​prices,
increasing interest rates to​equilibrium. (Increased money hoarding)

7. If Bank of Canada decreases money supply what is it called? And how would that
affect interest rates and desired investment expenditure?
It is called contractionary monetary policy where MS curve will shift left. Interest rates will rise
and the quantity of desired investment expenditure will fall. (movement up left along the MD
curve)

8. How would a contractionary monetary policy affect the AD curve and the output
gap?
There will be a leftward shift in AD curve due to decreased desire to spend and create an
recessionary gap.

9. If Bank of Canada increases money supply what is it called? And how would that
affect interest rates and desired investment expenditures?
It is called expansionary monetary policy where the MS curve will shift right. Interest rates will
fall and the quantity of desired investment expenditure will rise. (movement down right along the
MD curve)

10. What is the relationship between interest rates and bond purchases?
There will be higher bond demand at higher interests and lower bond demands at lower interest
rates.

11. What are the 3 stages of Monetary Transmission Mechanism?

Money market, Interest Rates and Investment/Expenditure and aggregate demand.

12. Summarize the Monetary Transmission Mechanism:

An excess supply of money will result in a fall in the equilibrium interest rate which will increase
desired investment expenditures causing an upward shift in the AE curve(increase GDP) and a
rightward shift in the AD curve(increase demand).

13. How does an increase in Canada’s money supply affect Canadian investors in an
open economy?
There will be a decrease in Canadian interest rates making Canadian bonds less attractive in
relation to foreign bonds. This will cause a depreciation of the Canadian dollar.

14. Why would an increase in Canada’s money cause a depreciation of the Canadian
dollar?
Because the purchase of foreign bonds will increase the demand for foreign currency.

15. What causes an upward right shift in the money demand curve?
● The economy moving into a recovery period because increased economic activity
typically leads to a higher demand for money for transactions (to buy G&S).
● Increased speculative demand will encourage people to hold more money in stocks for a
potential investment.

16. What would cause a downward shift in money demand?

Decrease in real GDP, Loss of income, Innovations in the financial sector (makes it easy to not
do transactions in cash.), Decrease in price level(deflation) etc.

17. What is Capital Inflow?

Occurs when money, investments or financial assets flow into a country from foreign investors
or institutions. Occurs when domestic interest rates are high and will lead to an appreciation
of domestic currency, leading to a decrease in net exports. AD curve shifts left.

18. What is capital outflow?

Occurs when money or investments flow out of a country. Occurs when domestic interest
rates are low and leads to a depreciation of domestic currency, leading to an increase in
net exports. AD curve shifts right.
 19. How would the increase in money supply affect aggregate demand?
There will be higher investments and net exports, which will increase aggregate demand.

20. What is money neutrality?

When economists say that money is neutral, they mean that changes in the amount of
money in an economy don't affect the real things we care about in the long run, like how
much stuff we produce (GDP) or how many people are working (employment). Instead,
changes in the money supply just affect prices — like how much things cost.

21. How does the changes in money supply affect GDP and price levels in the short
run?
There will be more or less economic activity amongst households and firms which will cause a
temporary inflationary output.

22. How does the changes in money supply affect GDP and price levels on the long
run?
Changes in money supply is directly proportional to price levels but it will have no real effect on
real GDP because the prices will increase or decrease to bring GDP to equilibrium.

23. What is hysteresis effect?

It occurs when a short term change in the economy like recessions affects GDP in the long run.

24. How does an increase in the money supply affect an economy experiencing
hysteresis in the long run?
The GDP will be unlikely to reach equilibrium because the scars of past recessions are still
affecting the choices people make. Ex: unemployed people will most likely quit the labour
market and people may hold more money due to a mistrust in investments.

25. If the demand for money is not very sensitive to the changes in interest rate, how
would that affect the MD curve?
The MD curve will be steep and the interest rates won’t fall much if there is an increased money
supply. Steeper curves have a lower slope than flatter curves.

26. What is the effect of a steep investment demand curve on investment demand and
aggregate demand when there are changes in money supply?
There will be a small effect on the investment demand and a relatively small shift in the
aggregate demand curve.

27. What demonstrates an efficient monetary policy?

The steeper is the MD curve, and the flatter is the ID curve, the more effective is monetary
policy.
 28. Describe the Monetarist view:
Changes in money supply have a larger impact on the aggregate demand. The MD curve is
steen and ID curve is flat.

29. Describe the Keynesian view:

Changes in money supply have smaller impact on the aggregate demand. The MD curve is
steep and the ID curve is steep. They believe in the effectiveness of fiscal policy rather than
monetary policy.

Chapter 13: Monetary Policy in Canada

1. What are the two methods by which the central bank implements monetary policy
to reduce the effect of inflation?
By targeting money supply and interest rate directly.

2. Which method is most effective at implementing monetary policy?

Targeting interest rates directly

3. Explain why money supply can be endogenous:

Money supply in endogenous when it depends on money demand.

4. How does open-market operation affect the amount money circulation?

The Central Bank will buy or sell bonds for cash to increase or decrease the amount of currency
in circulation available to commercial banks. This passively changes Money demand.

5. How will Bank of Canada implement contractionary monetary policy? How will that
affect aggregate demand?
By increasing overnight interest rates and or selling government securities to banks; the
aggregate demand will shift down left.

6. How will Bank of Canada expansionary monetary policy?

By decreasing overnight interest rates and or buying government securities; the aggregate
demand will shift up right.

7. What prompts contractionary monetary policy? What effect does that have on the
exchage rate?
Positive shocks to the economy; appreciation of the dollar

8. What prompts expansionary monetary policy? What effect does that have on the
exchange rate?
Negative shocks to the economy; depreciation of the dollar
 9. How do commercial banks respond to increased demand in loans? What is the
effect on Money supply?
They sell government bonds to the Central Bank resulting in an open-market purchase which
then increases money supply.

10. At what rate would the Bank of Canada accept deposits from commercial banks?
0.25 or 25 points below target; more money circulating.

11. At what rate would the Bank of Canada lend money to commercial banks?
0.25 or 25 points above target; less money circulating.

12. Why is the CPI inflation rate more volatile than the core inflation rate?
Because the CPI inflation includes price of volatile items like food , energy and the effect of
indirect taxes.

13. What would bank of Canada do in the event of an inflationary gap?

Reduce money supply or increasing interest rates

14. What is the target inflation rate that Bank of Canada expects to keep?
Near a 2 percent target.

15. When will a change in monetary policy have an effect on real GDP?
After a period of 9-12 months.

16. When will a change in monetary policy have an effect on price level?
After a period of 18-24 months