Tutorial 3 (Financial Markets) (Answers are provided as a guide but not limited to the

following)

1. First, explain why the money demand curve is downward sloping. Second, explain
what factor(s) will cause shifts in the money demand curve.

Suggested answer:

The money demand curve is downward sloping (with the interest rate on the vertical axis). It
is assumed that money pays no interest. At the same time, individuals earn interest when they
hold bonds. So, as the interest rate increases, individuals are more willing to incur the costs
associated with converting bonds to money when they wish to buy goods. So, an increase in
the interest rate causes a reduction in money demand. Money demand depends on the level of
transactions and on the interest rate. As the level of transactions increases, individuals will
increase money demand.

Assuming nominal income is correlated with nominal transactions, an increase in nominal

income will cause an increase in money demand and shifts in the curve.

2. Explain what types of policies or tools a central bank can implement to reduce the
interest rate.

Suggested answer:

Central banks have two options to reduce the interest rate:

 Open market operation (OMO): the central bank expands the supply of money by
buying bonds (OMO purchase). This will expand money supply with a one for one
effect and increases supply of loanable funds, thus reduces interest rate imposed on
loans extended.

 Discount Operation – reduction of discount rate by Central Bank will reduce cost of
borrowing by commercial banks from Central Bank, hence will enable commercial
bank to have a lower base rate for loan extension. This will expand money supply with
a one for one effect and increases supply of loanable funds, thus reduces interest rate
imposed on loans extended.

 Reduction in Reserve requirement: will enable commercial bank to have higher

capacity to extend loan as the money multiplier is greater when reserve requirement is
reduced by Central bank. Supply of loanable funds will increase, thus reduces interest
rate imposed on loans extended,

All the above policies will result in an increase in the money supply and a reduction in the
interest rate.
3. Graphically illustrate and explain what effect an increase in nominal income will
have on the money market.

Suggested answer:

An increase in income will cause an increase in transactions and an increase in money demand.
The money demand curve will shift to the right causing an excess demand for money and excess
demand for bonds. The interest rate will rise to restore money market equilibrium. There is
no change in money supply as a result of this.
4. Using the money market graph, graphically illustrate and explain what effect a
purchase of bonds by the Central Bank will have on the money market.

Suggested answer:

A Central Bank purchase (buy) of bonds will cause an increase in H (increase in the money
supply). At the initial interest rate, there will be an excess supply of money. The interest rate
will fall to restore money market equilibrium. All else fixed, there will be no change in money
demand.

5. Using the money market graph, graphically illustrate and explain what effect a Federal
Reserve purchase of bonds (expansionary monetary policy) will have on this market and
on the equilibrium interest rate.

Suggested answer:

A Central Bank purchase of bonds will cause an increase in the supply of central bank money.
To restore equilibrium in this market, the interest rate will have to fall. As it does, the quantity
demanded for central bank money will rise and, therefore, restore equilibrium.
6. Using money market diagram, graphically illustrate and explain what effect an
increase in the reserve requirement ratio will have on this market and on the equilibrium
interest rate.

Suggested answer:

When reserve requirement ratio increases, commercial banks need to put aside more reserve
from the deposits they received from their customers (savers) as required by Central Bank. The
supply of loanable funds will decrease, shifting the money supply curve to left. At the
prevailing interest rate i’, a situation of excess demand (or shortage) for central bank money
(reserves in this case) exists, therefore, an increase in the demand for central bank money (ie
reserve) by commercial banks to fulfill loans requirement. As such, this situation will exert
upward pressure on the interest rate will rise to restore equilibrium.