In This Question, We Try to Find Out Whether Using

question 114

Essay

In this question, we try to find out whether using the bank rate as a monetary policy tool is consistent with the liquidity-preference theory. Theoretically, when the Bank of Canada changes the bank rate and implicitly the money supply, the market interest rate would change to become equal to the bank rate AND to equate the new money supply with the money demand. But is this double role of the market interest rate possible? Let us give an example and see what happens. Assume the money demand curve is MD=150 - 15r, and the money supply curve is MS = 100 - 10R, where r is the market interest rate and R is the bank rate announced by the Bank of Canada.
a) Show that, for a given value of bank rate R, the equilibrium market rate is different from R. What does this example show?
b) Given the money demand equation MD=150 - 15r, find a money supply equation such that, for any value of R, the equilibrium market interest rate r is equal to R.
c) For the money supply equation MS = 100 - 10R and a given bank rate R, show how the market could balance at the market interest rate r = R (show what the Bank of Canada should do to balance the money market).
d) What have we learned from this exercise?

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