Using the information in this chapter, label each of the following statements true, false or uncertain. Explain briefly.
a. Income and financial wealth are both examples of stock variables.
b. The term investment, as used by economists, refers to the purchase of bonds and shares of stock.
c. The demand for money doesn’t depend on the interest rate, because only bonds earn interest.
d. The central bank can increase the supply of money by selling bonds in the market for bonds.
e. The Reserve Bank can determine the money supply, but it cannot determine interest rates—not even the cash rate—because interest rates are determined in the private sector.
f. Bond prices and interest rates always move in opposite directions.
g. Since the Great Depression, the United States has used federal deposit insurance to deal with bank runs. Australia hasn’t.
h. Financial innovations are the reason why velocity has increased dramatically in the last 50 years.
The Correct Answer and Explanation is :
Let’s go through each statement:
a. Income and financial wealth are both examples of stock variables.
- False. Income is a flow variable because it is measured over a period of time (e.g., per month or per year). In contrast, financial wealth is a stock variable because it represents the total value of assets at a specific point in time.
b. The term investment, as used by economists, refers to the purchase of bonds and shares of stock.
- False. In economics, “investment” refers to the purchase of physical capital, such as machinery, buildings, or infrastructure, that will be used in the production process. Buying bonds or stocks is considered a financial transaction, not an investment in the economic sense.
c. The demand for money doesn’t depend on the interest rate, because only bonds earn interest.
- False. The demand for money is indeed affected by the interest rate. Higher interest rates make holding money less attractive because people can earn more by holding bonds or other interest-bearing assets. Therefore, as interest rates rise, the demand for money typically falls.
d. The central bank can increase the supply of money by selling bonds in the market for bonds.
- False. When the central bank sells bonds, it reduces the supply of money, as buyers pay for the bonds with their money, which then leaves circulation. To increase the money supply, the central bank buys bonds.
e. The Reserve Bank can determine the money supply, but it cannot determine interest rates—not even the cash rate—because interest rates are determined in the private sector.
- Uncertain. The central bank can influence interest rates, particularly the short-term cash rate, through its monetary policy operations, such as open market operations. While market forces play a role in determining interest rates, the central bank’s actions heavily influence them.
f. Bond prices and interest rates always move in opposite directions.
- True. There is an inverse relationship between bond prices and interest rates. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. This is because the fixed coupon payments of existing bonds become more or less attractive as the prevailing interest rates change.
g. Since the Great Depression, the United States has used federal deposit insurance to deal with bank runs. Australia hasn’t.
- False. The U.S. established federal deposit insurance (FDIC) in 1933 following the Great Depression. Australia also has deposit insurance through the Financial Claims Scheme (FCS), introduced in 2008, which provides protection for deposits up to a certain limit in the event of a bank failure.
h. Financial innovations are the reason why velocity has increased dramatically in the last 50 years.
- Uncertain. Financial innovations, such as the development of new financial instruments, digital payments, and changes in banking practices, may have played a role in increasing the velocity of money. However, other factors, such as economic growth, technological advancements, and changes in payment systems, could also contribute to this increase.
For a visual representation of the relationship between interest rates and bond prices, I can create a graph showing this inverse relationship. Would you like me to proceed with that?