2010 Macro FRQ #2
(A) Using a CLG of the money market, show how the nominal interest rate will be affected.
There is the idea that people need a certain amount of cash monthly, daily to pay for incidentals. Lunch, snacks, school play, whatever. If credit card fees fall, then it is cheaper to use credit cards and they don't need to keep as much money on hand as now it is more affordable to just use a credit card.
The problem even tells you that the demand for money falls. So the demand for money will fall.
(B) Given the interest rate change in part (A), what will happen to bond prices in the short-run?
This is more of a finance question than an AP economic one. You must understand that a Bond is a financial asset that is bought (usually for a $1,000) and then the company that sells you the bond promises to pay you a yearly rate of interest (like 5%) to borrow your $1,000. At the end of the time the $1,000 is paid back to you in full.
If interest rates fall to lets say 2%, and you have a bond that is paying 5%, your 5% bond is worth more than the Bonds that now only pay 2%.
If interest rates fall, the bonds with higher paying amounts (Yields) will have higher prices as your bond, having a higher yield will be worth more than the lower yield bond.
(C) Given the interest rate change in part (A), what will happen the price level in the Short-run? Explain?
If interest rates fall, then more consumption and investment will occur, as it is now cheaper to borrow money. Therefore the AD curve will shift rightward and the price level will increase. (I wouldn't have thought of exports)
(D) Identify an open market operation that the FED could use to keep the nominal interest rate constant at the level that existed before the drop in credit card fees. Explain.
If the demand for money is falling which reduces the interest rate then the FED can reduce the money supply which will increase the interest rate. So the FED should sell bonds.