MONEY AND BANKING

Chapter 3.2: The behavior of interest rate

1. Briefly explain whether each of the following statements is true or false:

a. The higher the price of bonds, the greater the quantity of bonds demanded.
b. The lower the price of bonds, the smaller the quantity of bonds supplied.
c. As the wealth of investors increases, all else held constant, the interest rate on bonds
should fall.
d. If investors start to believe that the U.S. government might default on its bonds, the
interest rate on those bonds will fall.
2. For each of the following situations, explain whether the demand curve for bonds, the supply
curve for bonds, or both would shift. Be sure to indicate whether the curve(s) would shift to the
right or to the left. Be sure to include in your answer the graphs.
a. The Federal Reserve publishes a forecast that the inflation rate will average 5% over the
next five years. Previously, the Fed had been forecasting an inflation rate of 3%.
b. The economy experiences a period of rapid growth, with rising corporate profits.
c. The federal government runs a series of budget surpluses.
d. Investors believe that the level of risk in the stock market has declined.
e. The federal government imposes a tax of $10 per bond on bond sales and bond
purchases.
3. Use a demand and supply graph for bonds to illustrate each of the following situations. Be sure
that your graph shows any shifts in the demand or supply curves, the original equilibrium price
and quantity, and the new equilibrium price and quantity. Also be sure to explain what is
happening in your graphs.
a. The government runs a large deficit, holding everything else constant.
b. Households believe that future tax payments will be higher than current tax payments,
so they increase their saving.
c. Both (a) and (b) occur.
4. Explain what will happen to the equilibrium price and equilibrium quantity of bonds in each of
the following situations. (If it is uncertain in which direction either the equilibrium price or
equilibrium quantity will change, explain why.)
a. Wealth in the economy increases at the same time that Congress raises the corporate
income tax.
b. The economy experiences a business cycle expansion.
c. The expected rate of inflation increases.
d. The federal government runs a budget deficit.
5. How would the following events affect the demand for loanable funds in the United States?
a. Many U.S. cities increase business taxes to help close their budget deficits.
b. Widespread use of handheld computers helps reduce business costs.
c. The government eliminates the tax deduction for interest homeowners pay on
mortgage loans.
6. We have seen that Federal Reserve Chairman Ben Bernanke has argued that low interest rates
in the United States during the mid-2000s were due to a global savings glut rather than to
Federal Reserve policy. In an interview with Albert Hunt of Bloomberg Television, Alan
Greenspan, who was Federal Reserve Chairman from August 1987 through January 2006 made a
 similar argument. Greenspan argued, “Behind the low level of long-term rates: a global savings
glut as China, Russia and other emerging market economies earned more money on exports
than they could easily invest.”
a. Use loanable funds graphs to illustrate Greenspan’s argument that a global savings glut
caused low interest rates in the United States. One graph should illustrate the situation
in the United States, and the other graph should illustrate the situation in the rest of the
world.
b. Why should a debate over the cause of low interest rates matter to Alan Greenspan?
7. In a small open economy, how would each of the following events affect the equilibrium interest
rate?
a. A natural disaster causes extensive damage to homes, bridges, and highways, leading to
increased investment spending to repair the damaged infrastructure.
b. Taxes on businesses are expected to be increased in the future.
c. The World Cup soccer matches are being televised, and many people stay home to
watch them, reducing consumption spending.
d. The government proposes a new tax on saving, based on the value of people’s
investments as of December 31 each year.
8. In a large open economy, how would each of the following events affect the equilibrium interest
rate?
a. A natural disaster causes extensive damage to homes, bridges, and highways, leading to
increased investment spending to repair the damaged infrastructure.
b. Taxes on businesses are expected to be increased in the future.
c. The World Cup soccer matches are being televised, and many people stay home to
watch them, reducing consumption spending.
d. The government proposes a new tax on saving, based on the value of people’s
investments as of December 31 each year.
Closed economy: An economy in which households, firms, and governments do not borrow or lend
internationally.
Open economy: An economy in which households, firms, and governments borrow and lend
internationally.
Small open economy: An economy in which total saving is too small to affect the world real interest
rate.
Large open economy: An economy in which shifts in domestic saving and investment are large enough
to affect the world real interest rate.