Money and Banking: Problem Set 3 Answers and Explanations | Assignments Banking and Finance

Econ 325

Money and Banking

Answers to Problem Set 3

Note: these are only suggested answers to make sure you're on the right track. Expand upon them

as necessary from your class notes and your book.

I. Definitions

On your own. See your class notes and your book.

II. Short-Answer Questions/Essays/Calculations

Interest Rate Determination

1. Earnings rise over a person's lifetime, falling after retirement. Desired consumption is much

smoother than income. As a result, individuals want to borrow early in their working lives, save

during middle age, and dissave in retirement.

(i) Substitution Effect. As r decreases, saving falls through the substitution effect. Lower r means

the price of current consumption falls so current consumption rises and saving falls (substitute

out of the more expensive good into the relatively less expensive good).

(ii) Income Effect. As r decreases, saving rises through the income effect. For a net saver, a fall in

r means a fall in real income, leading to decreased consumption in both periods (assuming

consumption is a normal good) and thus increased saving in period one (from the lower C1).

Overall, the effect of a decrease in r for a saver is ambiguous (SE and IE work in opposite

directions). Note that we get an upward sloping saving supply curve as long as the Substitution

Effect is bigger than the Income Effect.

For a net borrower, the substitution effect stays the same. The income effect indicates decreased

saving due to the following: the decrease in r raises real income since the individual must pay

less interest on all borrowed funds. This in turn leads to increased consumption in both periods

and thus lower saving in period one. Therefore, for a net borrower, the SE and IE work in the

same direction: a decrease in r leads to lower saving (giving us an upward sloping saving supply

curve).

3. If private (household) saving does not increase one-for-one with deficit spending, the saving

curve shifts to the left (from deficit spending), increasing the real interest rate and reducing the

quantity of investment (crowding out private investment). If private saving exactly offsets the

change in government saving (as under Ricardian Equivalence), the saving curve shifts back out

(after shifting left due to deficit spending) and the real interest rate and the quantity of

investment do not change. In this case, it would be equivalent to finance government spending

through deficits (i.e., higher taxes in the future) or through higher taxes today (definition of

Ricardian Equivalence) – either way, household consumption ends up lower but private

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Econ 325

Money and Banking

Answers to Problem Set 3

Note: these are only suggested answers to make sure you're on the right track. Expand upon them as necessary from your class notes and your book.

I. Definitions On your own. See your class notes and your book.

II. Short-Answer Questions/Essays/Calculations Interest Rate Determination

Earnings rise over a person's lifetime, falling after retirement. Desired consumption is much smoother than income. As a result, individuals want to borrow early in their working lives, save during middle age, and dissave in retirement.

(i) Substitution Effect. As r decreases, saving falls through the substitution effect. Lower r means the price of current consumption falls so current consumption rises and saving falls (substitute out of the more expensive good into the relatively less expensive good).

(ii) Income Effect. As r decreases, saving rises through the income effect. For a net saver, a fall in r means a fall in real income, leading to decreased consumption in both periods (assuming consumption is a normal good) and thus increased saving in period one (from the lower C 1 ). Overall, the effect of a decrease in r for a saver is ambiguous (SE and IE work in opposite directions). Note that we get an upward sloping saving supply curve as long as the Substitution Effect is bigger than the Income Effect.

For a net borrower, the substitution effect stays the same. The income effect indicates decreased saving due to the following: the decrease in r raises real income since the individual must pay less interest on all borrowed funds. This in turn leads to increased consumption in both periods and thus lower saving in period one. Therefore, for a net borrower, the SE and IE work in the same direction: a decrease in r leads to lower saving (giving us an upward sloping saving supply curve).

If private (household) saving does not increase one-for-one with deficit spending, the saving curve shifts to the left (from deficit spending), increasing the real interest rate and reducing the quantity of investment (crowding out private investment). If private saving exactly offsets the change in government saving (as under Ricardian Equivalence), the saving curve shifts back out (after shifting left due to deficit spending) and the real interest rate and the quantity of investment do not change. In this case, it would be equivalent to finance government spending through deficits (i.e., higher taxes in the future) or through higher taxes today (definition of Ricardian Equivalence) – either way, household consumption ends up lower but private

investment is not crowded out by the government’s activities.

When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the Bs (Ld^ ) curve to the right. The equilibrium interest rate rises. In the liquidity preference model, the decrease in the money supply shifts the M s^ curve to the left, and the equilibrium interest rate rises. Thus, the answer from the loanable funds framework is consistent with the answer from the liquidity preference framework.
In the loanable funds framework, when the economy booms, the demand for bonds (supply of loans) increases because the public's income and wealth rise. The supply of bonds (demand for loans) also increases because firms have more attractive investment opportunities. If the demand curve for bonds shifts less than the supply curve for bonds (i.e., Ls^ shifts less than Ld), the equilibrium interest rate rises. So, the interest rate may be procyclical (rising with economic booms and falling with economic recessions). It depends on the relative sensitivity of the demand and supply curves to changes in incomes (make sure that you can explain which curve must be more sensitive to show procyclical interest rates in the model).

In the saving-investment framework, when the economy booms, both curves shift to the right. Thus, the change in the equilibirum interest rate depends on the sensitivity of the curves to changes in income (similar answer to the loanable funds framework).

The liquidity preference framework unambiguously shows that the interest rate is procyclical. When the economy booms, the demand for money increases and the nominal interest rate rises. When the economy enters a recession, the demand for money falls, and the nominal interest rate decreases.

Hint - a graph is often worth a thousand words.

For U.S. data see figure in the chapter “Evidence on Business Cycles and Interest Rates.”

When the price level rises, the quantity of money in real terms falls (holding the nominal supply of money constant, i.e., holding Ms^ constant). To restore their holdings of money in real terms to their former level, people will want to hold a greater nominal quantity of money (i.e., you need more money to buy the same amount of goods). Thus, the money demand curve shifts to the right, and the interest rate rises.

Money and Banking: Problem Set 3 Answers and Explanations, Assignments of Banking and Finance

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Econ 325

Money and Banking

Answers to Problem Set 3