money interest rates and monetary policy

Question 1

Why do people hold money instead of bonds

Answer 1

• Money provides liquidity, allowing instant transactions.
• Bonds provide financial returns through interest but lack liquidity

Question 2

What determines the demand for money

Answer 2

• Higher real GDP → Higher demand (more transactions).
• Higher interest rates → Lower demand (higher opportunity cost of holding money)

Question 3

How is money market equilibrium achieved

Answer 3

• If interest rate is too high, there’s excess demand for bonds, leading to lower rates.
• If interest rate is too low, there’s excess demand for money, leading to higher rates

Question 4

What is the monetary base and how does it relate to money supply

Answer 4

• The monetary base (currency + reserves) is controlled by the central bank.
• It determines broader money supply through the money multiplier

Question 5

Do central banks directly choose the money supply

Answer 5

No, they set interest rates and adjust the money supply to maintain equilibrium

Question 6

Why do modern central banks use interest rates rather than money supply?

Answer 6

• Uncertainty in the money multiplier makes supply control difficult.
• Money demand is unpredictable due to alternative financial assets

Question 7

What are the primary goals of monetary policy?

Answer 7

Price stability (low, stable inflation).
- Economic growth & employment support

Question 8

How does monetary policy affect consumption

Answer 8

• Lower interest rates increase asset values, making households feel wealthier.
• More credit becomes available at lower borrowing costs

Question 9

How does monetary policy affect investment

Answer 9

• Lower rates reduce borrowing costs, making investment projects more viable.
• Central banks use forward guidance to influence future rate expectations

Question 10

What is the role of the yield curve

Answer 10

• Upward-sloping curve: normal economic conditions.
• Flattening/inverted curve: potential economic slowdown or recession

Question 11

Why do long-term bond yields sometimes rise despite falling bank rates

Answer 11

• Market expectations of future inflation.
• Increase in the term premium (compensation for risk)

Question 12

What determines investment demand

Answer 12

• Interest rates (lower rates encourage investment).
• Future output expectations (higher expected demand increases investment).
• Capital goods costs (lower costs make investment more feasible)