The Equilibrium Interest Rate - Essay Example

Macroeconomics Section I a) The equilibrium interest rate is determined where the money demand is equal to the money supply. It is the point of intersection of the money demand curve and the money supply curve. At this point, the economy will be at stability as there is neither excess demand nor excess supply of money in the economy. An interest rate above the equilibrium interest rate has more money supply than money demand. The market forces will pull the interest rates downward hence restoring the equilibrium rate. On the other hand, any interest rate below the equilibrium interest rate will experience a higher demand than supply causing a rise in the interest rate (Floyd 56). The amount of money supplied by the government fixed by Fed hence making it perfectly inelastic. b) In our situation, the equilibrium interest rate will be 5.8% as this is the point of intersection of the supply curve and the money demand curve. C) When the economy is at full employment, an increase in money supply will not result in an increase in the output. In this case, the increased money supplied will result in increased level of inflation. The excess money pumped in the economy will chase the same quantity of goods and services thereby making their prices to inflate. Normally, the increases in the money supply is intended to stimulate economic growth by reducing the level of interest rates (Floyd 58). In the case of full employment, all the resources are already utilized and the increased money supplied will not achieve the intended purpose of increasing production level. Besides, the increased inflation will make the local currency unstable and discourage foreign investors from holding the local currency. This can adversely affect the investment levels and increase the economic problems. Fed decision to increase money supply can be propelled by several factors. First, an increase in money supply can be aimed at increasing the level of expenditure in the economy. By increasing the level of money supply, the government will increase the amount of wealth held by individuals. This makes them increase their expenditure to stimulate economic growth. Money spent in both consumption and investment will increase because of the increase in the disposable income (Floyd 63). Individuals will as well increase the proportion of their investments in bonds, as they will use the excess money to buy bonds and shares in the capital markets. Secondly, Fed can decide to increase the money supply to stimulate investments. An increase in money supply will result in a fall in the nominal interest rates, which will further result in the fall in the real interest rates. Due to the fall in interest rates, the cost of borrowings will be reduced. Potential investors will therefore be encouraged to borrow and acquire capital necessary in pursuing their investment plans. Consequently, the increased investments will increase the level of employment because of the increased economic activities. Sometimes, the government through Fed can decide to increase the level of money supply to cause an increase the price levels by a desirable margin. According to the quantity theory of money, price levels depend directly on the money supply. In the long-run therefore, an increase in money supply will result in an increase in the price level by equal proportion. Fed can have this objective during the period of recession or depression when the level of economic activities is low to stimulate economic activities and increase the quantity of purchases. In addition, a decrease in the interest rates will increase the demand of the local currency hence cause depreciation in the currency. This is because in an open economy, interest rates parity must always be preserved. This will cause the currency to fall with a further expectation that it will fall faster in the future. The depreciation in the local currency will make the cost of local goods cheaper and attractive thereby causing a surge in both the foreign and local demand (Floyd 66). With the increase in the demand, there will be need to expand production hence increasing the output level and encouraging growth in the economy. This is also a possible reason why Fed can decide to increases the level of money supply. Question 2 a) Mm= Mm= = 2.6 b) From the money multiplier calculated, an increase in the money supply will cause an increase in the equilibrium by 2.6 times. By increasing money supply by $200b, the new equilibrium will be determined as follows. New equilibrium= 2.6*$200b =$520b c) An increase in money supply in an economy with full employment does not result in the increase in the level of output or economic growth. What it simply leads to is a proportionate rise in the price levels as there will be more money to spend on the same quantity of goods. From the calculation, the nominal, equilibrium will have increase while in real sense there will be no real growth in the level of real equilibrium. The high equilibrium has just been caused by inflation but not an improvement of increase in the level of output. d) To reverse the increase for money supplied in the economy, Fed has to adopt contractionary measures that would help mop out the excess money in the economy. By moping out, the inflation level will be lowered to correct the increases in prices. Fed will correct the effect by reducing the level of money in supply by use of the following tool. To begin with, Fed can use open market operation to reduce the amount of money in circulation. In this policy, the government will issue securities in the form of bonds and bills (Floyd 67). By taking part in the buying of the government issued securities, the amount of money with the public will be reduced. Secondly, Fed can increase the reserve ratio of commercial banks. Reserve ratio is the proportion of deposits with commercial banks that must be retained by the banks and therefore cannot be lent. By increasing the reserve ratio, the amount available for lending will be reduced hence leading to a proportional decline in the amount of money in circulation. In addition, Fed can reverse the excess money in circulation by increasing the window rate. The window rate is the rate at which Fed extends loans to the commercial banks. Commercial banks have to lend money at a rate higher than the window rate in order to make profits. It therefore means that an increase in the window rate will be translated in increases in the commercial lending rates. The increases in the lending rate will discourage borrowing by individuals and institutions because the interest rates will be high. This will reduce the amount of money in circulation. Lastly, the government could reverse the decision by cutting the level of government spending. A decline in the level of government spending will reduce the amount of money supply in the future or reduce the proportion of deficit budget (Floyd 71). Selective credit control whereby the government restricts the sectors of the economy to receive loans and cash can also be adopted to reduce the amount of excess money in circulation. Section three a) By continually selling dollars, the stock of foreign reserves will reduce. This is because by selling the dollars, the amount of dollars in stock will be reduced as the amount of the foreign currency is increased. If the condition persists, it could lead to a depletion in the foreign reserves that is held by Fed or commercial banks. The forces of demand and supply determine the determination of exchange rates, just as any other market. The change in demand and supply of a currency will result into changes in the equilibrium exchange rates. In this case, one US dollar is equivalent to 80 Japanese Yen. A permanent fall in the demand for US dollars will make the dollar depreciate. This therefore means that few Japanese Yen will buy more dollars. Yen/$ From the diagram, a shift in the demand of dollars from D0 to D1 will make the equilibrium fall from A to B. It shows that few Japanese Yen can be used to buy a dollar, hence depreciation in the dollar. b) In order to maintain the equilibrium at 80, Fed can formulate policies that would increase the demand of the dollar. This can be achieved by increasing the interest rates on their securities like the bonds and bills in order to attract more foreign investment from Japan. The Japanese citizens who wish to invest in US will require dollars and this would increase the demand for dollars hence maintain the current exchange rate. Moreover, the Fed can also take measures that reduce the supply of the dollars. This can be done by increasing the interest rates on loans of US and therefore limiting the supply of the dollar. A combination of the increase in the demand of the dollar and a decline in the supply of the dollar will restore the exchange rate of the dollar to the Yen at the required equilibrium. c) An increase in the US interest rates will make their cost of borrowing expensive compared to those of other nations. This will result in a decline in both domestic and foreign borrowings, as US citizens will prefer borrowings from abroad while foreign investors will not be willing to borrow from US commercial banks. Because of borrowing from abroad, the US nationals will want to exchange the foreign currencies to dollars. This situation will cause an increase in the demand of the dollar. At the same time, the high interest rates will lead to low supply of the dollars since the amount of money borrowed in the form of dollars and converted to other currencies would be reduced. A simultaneous increase in the demand for a currency and decrease in its supply will cause a shortage in the market hence leading to the appreciation of the currency (Floyd 75). The increase in the interest rates of US will therefore lead to an appreciation in the US dollar relative to those of the other countries. In summary, the forces of the demand and supply determine the exchange rate of a currency, just like that other commodities. In ensuring that the economic performance is sound, the policy makers have to ensure that their actions are in line with the desired economic goals of reducing inflation, unemployment and increasing economic growth. Work Cited Floyd, John E. Interest Rates, Exchange Rates and World Monetary Policy. Berlin: Springer, 2010. Print. Read More