Question

The following question will examine what happens in the money market when the interest rate approaches zero.

a) Which interest rate represents the opportunity cost of holding money - the real or the nominal interest rate? Explain.

b) Argue intuitively why the nominal interest rate (eg, the yield on a riskless bond) cannot fall below zero.

c) Can the real interest rate fall below zero? Explain.

d) Modify Figure 28-2 in the textbook to take into account this "zero lower bound" for the nominal interest rate. You need to show graphically the slope of the MD curve as the nominal interest rate approaches 0. Explain the shape of the MD curve.

e) Using your graph in part (d), explain what happens following a monetary expansion when the nominal interest rate is already close to 0.