THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 143

CHAPTER 5
Answer each question by drawing the appropriate supply
and demand diagrams.
*6. An important way in which the Bank of Canada
decreases the money supply is by selling bonds to
the public. Using a supply and demand analysis for
bonds, show what effect this action has on interest
rates. Is your answer consistent with what you
would expect to find with the liquidity preference
framework?
7. Using both the liquidity preference and supply and
demand for bonds frameworks, show why interest
rates are procyclical (rising when the economy is
expanding and falling during recessions).
*8. Why should a rise in the price level (but not in
expected inflation) cause interest rates to rise when
the nominal money supply is fixed?
9. What effect will a sharp increase in personal savings
rates have on Canadian interest rates?
10. What effect will a sudden increase in the volatility
of gold prices have on interest rates?
*11. How might a sudden increase in people s expectations of future real estate prices affect interest rates?
12. Explain what effect a large federal deficit might have
on interest rates.
*13. Using both the supply and demand for bonds and
liquidity preference frameworks, show what the effect
is on interest rates when the riskiness of bonds rises.
Are the results the same in the two frameworks?

The Behaviour of Interest Rates

111

14. If the price level falls next year, remaining fixed
thereafter, and the money supply is fixed, what is
likely to happen to interest rates over the next two
years? (Hint: Take account of both the price-level
effect and the expected-inflation effect.)
*15. Will there be an effect on interest rates if brokerage
commissions on stocks fall? Explain your answer.

Predicting the Future
16. The governor of the Bank of Canada announces in a
press conference that he will fight the higher inflation
rate with a new anti-inflation program. Predict what
will happen to interest rates if the public believes him.
*17. The governor of the Bank of Canada announces that
interest rates will rise sharply next year, and the
market believes him. What will happen to today s
interest rate on long-term corporate bonds?
18. Predict what will happen to interest rates if the public suddenly expects a large increase in stock prices.
*19. Predict what will happen to interest rates if prices in
the bond market become more volatile.
20. If the next governor of the Bank of Canada has a reputation for advocating an even slower rate of money
growth than the current governor, what will happen
to interest rates? Discuss the possible resulting situations.

Q U A N T I TAT I V E P R O B L E M S
1. The demand curve and supply curve for one-year
T-bills (with a face value of $1000) were estimated
using the following equations:

Bd: Price
B s: Price

2
Quantity
5
Quantity

940

100

CANSIM Questions

a. What is the expected equilibrium price and
quantity of T-bills in this market?
b. Given your answer in (a), which is the expected
interest rate in this market?
*2. The demand curve and supply curve for one-year
T-bills (with a face value of $1000) were estimated
using the following equations:
Bd: Price
s

B : Price

2
Quantity
5
Quantity

resulted in a parallel shift in the demand curve for
bonds, such as the price of bonds at all quantities
increased $100. Assuming no change in the supply
function for bonds, what is the new equilibrium price
and quantity? What is the new market interest rate?

940

100

Following a dramatic decline in the value of the stock
market, the demand for bonds increased and this

3. Get the monthly data from 1976 to 2009 on the M2
(gross) monetary aggregate (CANSIM series
V41552796) and the three-month T-bill rate (series
V122531) from the Textbook Resources area of the
MyEconLab.
a. Calculate the annual money growth rate, using
the formula
mt

100

(Mt

12

Mt ) /Mt

b. Plot the monetary growth rate, mt, and the nominal interest rate, it.
c. What is the correlation coefficient between the
money growth, mt, and the nominal interest rate,
it ? Do you find anything interesting?