Question

The demand for money is given as Md = 1,910 - 110i, where Md is the quantity of money demanded (in billions of dollars) and i is the interest rate in percentage points. For example, if i = 2%, leave i = 2. The supply of money is set at $700 billion. Suppose that all demand deposits are held in commercial banks, and that all commercial banks have a fractional reserve ratio equal to 50%. The initial equilibrium interest rate is equal to _____, and if the Bank of Canada wants the interest rate to be 9%, it should ____ bonds in the amount of ____ billion of dollars. A) 3%; buy; $700 B) 5%; sell; $700 C) 11%; buy; $110 D) 11%; sell; $700 E) 11%; buy; $220

Answer 1

Solution:

Equilibrium occurs where money demand equals the money supply.

So, Md = Ms

1910 - 110i = 700

i = (1910 - 700)/110 = 11

So, initial equilibrium interest rate is 11%.

If the bank wants the interest rate to be 9%, money supply should be= 1910 - 110*9 = $920

Since, the money supply should be increased (from 700 to 920), Bank of Canada will buy the bonds (and pay the money which will increase it's supply). Amount worth of bonds to be bought is the amount by which money supply has to be increased = 920 - 700 = $220

So, correct option is (E) 11%, buy, $220