Expectations and Interest Rate Changes in Economics
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Questions and Answers

What do economic agents expect to happen to economic activity and growth when interest rates increase?

  • It will slow down (correct)
  • It will remain unchanged
  • It will accelerate
  • It will fluctuate

    • What influences investments and purchasing decisions of companies and individuals?

  • Current interest rates
  • Past interest rates
  • Government policies
  • Expectations of interest rates (correct)

    • What happens to consumption, borrowing, and asset prices if an increase in the official policy rate is expected to be followed by other interest rate increases?

  • They increase
  • They decrease (correct)
  • They remain unchanged
  • They fluctuate

    • What is the effect of an increase in the central bank's interest rate on domestic demand and net external demand?

    <p>It decreases</p> Signup and view all the answers

    What is the effect of an appreciation or strong currency on import prices?

    <p>It decreases</p> Signup and view all the answers

    What determines whether monetary policy is contractionary or expansionary?

    <p>High or low policy rates compared to their historical values</p> Signup and view all the answers

    What is the purpose of the neutral rate of interest?

    <p>To serve as a point of comparison for monetary policy</p> Signup and view all the answers

    What happens when the policy rate is above the neutral rate?

    <p>Monetary policy is contractionary</p> Signup and view all the answers

    What is the composition of the neutral policy rate?

    <p>Real trend rate of growth and long-run expected inflation</p> Signup and view all the answers

    What is the concept of Money Neutrality?

    <p>The real rate of interest is stable over time</p> Signup and view all the answers

    What is the official interest rate set by the central bank?

    <p>The rate at which it lends money to commercial banks</p> Signup and view all the answers

    What is the purpose of the repo rate?

    <p>To achieve the policy rate</p> Signup and view all the answers

    What is the main purpose of commercial banks and thrift banks holding a certain percentage of their checkable account deposits as a reserve?

    <p>To meet their reserve requirements</p> Signup and view all the answers

    Why do banks with excess reserves make loans to other banks in the Central Bank Funds market?

    <p>To earn a higher interest rate than from the central bank</p> Signup and view all the answers

    What is the effect of the central bank buying government bonds on the total reserves in the banking system?

    <p>It increases the total reserves</p> Signup and view all the answers

    What is the equilibrium interest rate that arises in the market for bank reserves known as?

    <p>The Central Bank Funds Rate</p> Signup and view all the answers

    What happens to the excess reserve of Bank A when it ends up with one at the end of the business day?

    <p>It is lent to other banks in the Central Bank Funds market</p> Signup and view all the answers

    How does the central bank target the Central Bank Funds Rate?

    <p>By manipulating the supply of reserves in the CB funds market</p> Signup and view all the answers

    What is the purpose of a central bank buying bonds from commercial banks?

    <p>To increase money supply in the economy</p> Signup and view all the answers

    What is the term for a central bank's agreement to buy bonds from commercial banks with a pre-agreed repurchase price?

    <p>Repurchase agreement</p> Signup and view all the answers

    Why do commercial banks increase their base rate in response to an increase in the official interest rate?

    <p>To avoid lending at a rate lower than the central bank's rate</p> Signup and view all the answers

    What is the effect of an increase in the official interest rate on commercial banks' base rates?

    <p>It increases their base rate</p> Signup and view all the answers

    What is the tool of monetary policy that involves buying or selling government bonds to commercial banks and the public?

    <p>Open-market operations</p> Signup and view all the answers

    What is the primary goal of using tools of monetary policy by a central bank?

    <p>To influence the money supply in the economy</p> Signup and view all the answers

    What happens when the central bank buys securities from commercial banks?

    <p>The commercial banks' reserves increase, increasing their lending ability</p> Signup and view all the answers

    What is the result of the central bank selling securities to commercial banks?

    <p>The commercial banks' reserves decrease</p> Signup and view all the answers

    What happens when the central bank buys securities from the public?

    <p>The reserves of the commercial banks where the public deposited the payment increase</p> Signup and view all the answers

    What is the initial effect of open market operations on the money supply?

    <p>The money supply increases</p> Signup and view all the answers

    What is the purpose of the central bank's open market operations?

    <p>To increase the money supply and stimulate economic growth</p> Signup and view all the answers

    What is the effect of a repurchase agreement on commercial banks?

    <p>The commercial banks are forced to borrow from the central bank at a higher rate</p> Signup and view all the answers

    Study Notes

    Neutral Rate of Interest

    • The neutral rate is the rate of interest that neither stimulates nor slows down the underlying economy.
    • It is the average policy rate over a business cycle.
    • The neutral policy rate consists of the real trend rate of growth of the underlying economy and long-run expected inflation.
    • Example: Neutral policy rate = trend growth + inflation target = 3% + 2% = 5%.
    • If policy rate is above 5%, monetary policy is contractionary; if below 5%, it is expansionary.

    Official Interest Rate

    • The official interest rate is set by the central bank to influence short- and long-term interest rates and real economic activity.
    • It is the rate at which the central bank is willing to lend money to commercial banks.
    • The policy rate can be achieved by using short-term collateralized lending rates called repo rates.

    Money Neutrality Concept

    • States that the real rate of interest in an economy is stable over time, so changes in nominal interest rate result from changes in expected inflation.

    Expectations and Interest Rate

    • Economic agents view an increase in interest rate as a slowdown in economic activity and growth, reducing profits and borrowing.
    • Expectations influence investment and purchasing decisions of companies and individuals.
    • An increase in the official policy rate can lead to a reduction in domestic demand and net external demand, putting downward pressure on the rate of domestic inflation.

    Central Bank Funds Rate

    • Commercial banks are required to deposit a certain percentage of their checkable account deposits as a reserve.
    • Excess reserves are lent to other banks that temporarily need them to meet their reserve requirements.
    • The interest rate of reserves held by the central bank is less than the interest rate earned from overnight loans to other banks.
    • An equilibrium interest rate, Central Bank Funds rate, arises in the market for bank reserves.

    Targeting Central Bank Funds Rate

    • The central bank targets the CB funds by manipulating the supply of reserves in the CB funds market.
    • Buying and selling government bonds decrease or increase the reserves in the banking system, affecting the excess reserve available for supply to the CB funds market.

    Monetary Policy Tools

    • Three tools of the Central Bank to alter the reserves of commercial banks:
      • Open-market operations
      • The reserve ratio
      • The discount rates

    Open-Market Operations

    • Buying or selling government bonds from/to commercial banks and the public.
    • Buying securities from commercial banks:
      • Creates a shortage of money, forcing banks to sell bonds to the central bank with a pre-agreed repurchase price.
      • Increases the reserves of commercial banks, increasing lending ability and money supply in the form of checkable deposits.
    • Selling securities to commercial banks:
      • Increases the reserves of commercial banks, increasing lending ability and money supply.
      • Increases the lending ability of the commercial banking system, increasing money supply in the form of checkable deposits.

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    Description

    This quiz covers the impact of interest rate changes on economic activity, growth, and investments. It explores how economic agents' expectations influence their purchasing and borrowing decisions. Test your understanding of how interest rates affect the economy!

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