MACROeconomics Chapter 7 Interest rates

Assignment 1: Money
1. Money has three basic characteristics. What are they?
2. What three parameters determine demand for money?
As illustrated in the figure below, credit institutions are responsible for the most
important part of money creation. Total money supply is calculated in different
ways.

3. What is meant by money supply, how is it calculated, and how big was it at the
end of 2011? (See Danmarks Nationalbanks Quarterly Review on its website,
under Publications.)
During a specified period, the following transactions take place in an economy:
The state has a funding gap due to a DKK 40 billion
deficit. The deficit is financed by issuing DKK 30 billion in
government bonds. The rest is drawn from the states account
in the National Bank.

40 billion

The National Bank sells certificates of deposit to the

credit institutions for DKK 5 billion.

5 billion

The credit institutions borrow DKK 1 billion from the

National Bank.

1 billion

The private sector has a current deficit in the balance of

payments of DKK 15 billion, with net capital imports of DKK 7
billion.

15 billion

4. How will each of these transactions affect the liquidity of the banks?
5. How is money supply determined in practice?

Assignment 2: Monetary Policy

1. What instruments does the National Bank use when drawing up monetary
policy?
2. How does the National Bank control the seven-day money-market rate?
3. Illustrate equilibrium on the seven-day money-market rate by means of an
interest-volume diagram.
4. How will it affect the seven-day money-market rate if liquidity demand falls
5. Is the National Bank able to control the day-to-day interest rate in the same
way?
6. What is meant by an intermediate target in monetary policy, and which criteria
can be placed on intermediate targets? Discuss the difference between the
intermediate targets pursued by the Danish National Bank and by the ECB.
7. What is the main difference between the ECB and the Danish National Banks
options for pursuing an independent (autonomous) monetary policy? What
consequences does this have for determining interest rates in Denmark?
8. During periods of unrest on the foreign-exchange markets, the National Bank
will often use the interest-rate weapon to defend the krone. What does this
mean in practice?
9. What is the consequence of this policy for currency inflow i.e. foreign capital
flowing into Denmark?
10.

How does it affect the domestic economy?

Assignment 3: The bond rate

1. What factors determine the ten-year government bond yields (long-term rates)
in Denmark?
2. Can the National Bank influence the ten-year bond rate? If so, how?
3. How will the interest rate on mortgages and corporate bonds, all other things
being equal, compare to the yield on government bonds?
A number of events may exert an influence on interest rates in Denmark.
4. In each case, state whether bond yields will rise or fall and describe the effect
on the Danish economy. Provide brief justifications for your answers.

1. The deficit in state funding in Denmark grows

2. Euro bond yields fall
3. Rumours circulate that the krone will be devalued against the euro
The chart below illustrates the horizontal structure of interest rates.
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
0

10

Year

5. What does it reveal?

6. What is meant by a normal yield curve?
The figure below shows the yield trends for ten-year government bonds and 12-month
CIBOR in the period from January 2004 to February 2012.

7. Explain the trend for the horizontal structure of interest rates during the period.
Describe the factors that might cause this trend.
The table below from April 2012 lists Sydbanks expectations for interest rates up to
one year ahead.
03
36
612 months
months months
30-year mortgage
rates

4.15%

4.30%

4.50%

One-year mortgage
rates

1.05%

1.15%

1.40%

8. Account for these expectations.

9. Based on expectations theory, how will an expectation of rising inflation affect
the interest-rate structure?
Assume that the European Central Bank (ECB) places greater emphasis on fighting
inflation than the American Fed.

10.

With reference to recent interest-rate structure theories, evaluate whether,

in the event of an increased risk of inflation worldwide, short- and long-term
interest rates will increase most in Europe or in the USA?

11.

Evaluate how the short- and long-term interest rates will be affected if, as
a result of the international debt crisis, the European Central Bank comes under
pressure to place greater emphasis on national income than inflation?

Assignment 4: The transmission mechanism

1. Based on the figure below, account for how the short- and long-term interest
rates affect the real economy (economic growth) through:
a)
b)
c)
d)

the
the
the
the

interest-rate channel
wealth channel
credit channel
exchange-rate channel

2. What does it mean that a country has fallen into a liquidity trap?

Assignment 5: The real interest rate after tax

The table below shows Danish banks average lending rates and inflation, as measured
by increases in the consumer price index.
1977

1987

1997

2007

Average lending rate

18.2%

13.3%

7.8%

6.3%

Inflation

11.1%

4.0%

2.1%

1.7%

The real interest rate can be calculated as:

Real interest rate after tax=

1+theinterest rate(1marginal tax rate)

1
1+ inflation

1. In what year was the real borrowing cost greatest? Repeat these calculations at
a marginal tax rate of 33% and of 68%.