Question

Diagram the effect of each of the following on U.S interest rates. (Show the initial equilibrium in black or blue (pencil or pen). Show the change with an arrow or with a contrasting color. YOU MUST LABEL YOUR AXES AND LABEL THE CURVES.

5. Increased capital requirements imposed on U.S. banks, making them less able to lend.

6. An increase in foreign interest rates.

7. Reduced political instability in third world countries, which makes investors in the U.S. and Europe more interested in investing in these countries.

Answer 1

5

Increased capital requirements imposed on U.S. banks, making them less able to lend.

when the capital requirement increases, the banks have lower funds to lend out. Hence, the overall money supply in the economy lowers. This conclusion is also supported by the multiplier effect calculation. higher capital requirement implies that the multiplier in the denominator is higher, thus creating less money supply. In such condition, the interest rates will increase

6

An increase in foreign interest rates.

when foreign interest rate increases wrt to the domestic/ US interest rate, the capital from US will run towards the foreign capital thus lowering the supply of money. The demand for money will increase and the supply will remain stable. Hence, the interest rates will increase

S1 D1= D2- initial demand for money after equilibrium demand of money Interest 12 initial supply of money initial interest rate after equilibrium interest rate rate ....- S1- D2 12- Green line: initial state Red line new state Dotted arrows- movement qunatity of money

7

Reduced political instability in third world countries, which makes investors in the U.S. and Europe more interested in investing in these countries.

when the stability in third world countries increases, the risk in investing in these countries decreases. The investment becomes more attractive as the interest rate in these countries are relatively higher as compared developed countries in US and Europe. The capital from US will run towards the foreign capital thus lowering the supply of money. The demand for money will increase and the supply will remain stable. Hence, the interest rates will increase