If the central bank attempts to “peg” the nominal interest rate at 5% by buying bonds, then every time the nominal rate exceeds 5%, the most likely effect of the bank’s policy will be: a. Low nominal interest rates and a reduction in the rate of inflation. b. Rapid expansion of bank reserves, rapid growth in the money supply, and inflation. c. Low nominal interest rates, a high rate of private investment, and rapid growth accompanied by price stability. d. A decline in the reserves of banks, a slow growth rate of the money supply, and deflation.

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why B?

B 100%

Buys bonds=> pumps money in the market=> money goes to banks=> increased excess reserves=> rapid growth of money supply=>money lended at lower rates=> inflation

C looks allright to me Nominal interest = real interest+inflation impact B----> indicates high inflation raising nominal interest rates. I think price stabilization with increase in money supply is key. Whats the official word ?

Because if interest rates are pegged at 5%, an excess above this limit will (considering the below formula: Mv=PY Money Supply x Velocity of Money= Nominal Inflation P and hence the right side of the equation will increase an as a consequence (to have equilibrium) also the left side will increase.

map1, you are saying that if the central bank tries to lower interest rates, it will create inflation?

in the end yes

So why do we all get excited when the Fed lowers interest rates?

Because it is cheaper to borrow, but hey, what comes up must come down, and vice-versa.

Correct answer is B. I just wanted to make sure you all get the point. Yes, lowering interest rates will have the bad side-effect of raising inflation. That’s why it is not a good idea to try to lower interest rates if there is already high inflation. Detailed answer follows: Purchasing bonds will put cash back in banks, which will result in a rapid expansion of excess reserves that the banks can then loan out at declining interest rates until the excess reserves are cleared. This increase in loanable funds will result in higher consumption and investment demand, and will be shortly followed by higher prices.

Shortly be followed by higher prices because more money in the markets dilutes the real value of money, and more money are after buying goods, and if that’s not inflation, I don’t know what it is.

Dreary, map1, look the way I reach the conclusion. may be it is not the perfect one, but I think it is very straigthforward.

yes, according to the quantity theory of money, it is strangedays.

thanks guys… this is useful stuff !

> look the way I reach the conclusion. true, that should also hold, but make sure you assume that velocity is not affected by the action. If so, this increase in money supply coul be reduced by a decrease in velocity.

Dreary Wrote: ------------------------------------------------------- > > look the way I reach the conclusion. > > true, that should also hold, but make sure you > assume that velocity is not affected by the > action. If so, this increase in money supply coul > be reduced by a decrease in velocity. Yes, thanks Dreary!