Homework Exercises – 5 Chapter 10 problems 1. “Unemployment us a bad thing, and the government should make every effort to eliminate it.” Do you agree or disagree? Explain your answer. 2. Which goals of the Fed frequently conflict? 3. “If the demand for reserves did not fluctuate, the Fed could pursue both a non-borrowed reserves target and an interest-rate target at the same time.” Is this statement true, false or uncertain? Explain your answer. 4. Classify each of the following as either an operating target or an intermediate target, and explain why. a. The three-month Treasury bill rate. b. The monetary base c. M2 5. Which procedures can the Fed use to control the three-month Treasury bill rate? Why does control of this interest rate imply that the Fed will lose control of the money supply? 6. If the Fed has an interest-rate target, why will an increase in the demand for reserves lead to a rise in the money supply? 7. “Interest rates can be measured more accurately and more quickly than the money supply. Hence an interest rate is preferred over the money supply as an intermediate target.” Do you agree or disagree? Explain your answer. 8. Compare the monetary base to M2 on the grounds of controllability and measurability. Which to do you prefer as an intermediate target? Why? 9. “Discounting is no longer needed because the presence of the FDIC eliminates the possibility of bank panics.” Is this statement true, false or uncertain? Explain your answer. 10. The benefits of using Fed discount operations to prevent bank panics are straightforward. What are the costs? 11. What are the benefits of using a nominal anchor for the conduct of monetary policy? 12. Give an example of the time-inconsistency problem that you experience in your everyday life? 13. What incentives arise for a central bank to fall into the time-inconsistency trap of pursuing overly expansionary monetary policy? 14. What are the advantages of monetary targeting as a strategy for the conduct of monetary policy? 15. What is the big if necessary for the success of monetary targeting? Does the experience with monetary targeting suggest that the big if is a problem? 16. What methods have inflation-targeting central banks used to increase communication with the public and increase the transparency of monetary policy making? 17. Why might inflation targeting increase support for the independence of the central bank to conduct monetary policy? 18. “Because the public can see whether a central bank hits its monetary targets almost immediately, whereas it takes time before the public can see whether an inflation target is achieved, monetary targeting makes central banks more accountable than inflation targeting does.” Is this statement true, false or uncertain? Explain your answer. 19. “Because inflation targeting focuses on achieving the inflation target, it will lead to excessive output fluctuations.” Is this statement true, false or uncertain? Explain your answer. 20. “A central bank with a dual mandate will achieve lower unemployment than a central bank with a hierarchical mandate in which price stability takes precedence.” Is this statement true, false or uncertain? Chapter 10 – Quantitative Problems 1. Consider a bank policy to maintain 12% of deposits as reserves. The bank currently has $10m in deposits and $400,000 in excess reserves. What is the required reserve on a new deposit of $50,000? 2. Estimates of unemployment for the upcoming year have been developed as follows. What is the expected unemployment rate? What is the standard deviation? Economy Probability Unemployment Rate (%) Bust .15 20 Average .5 10 Good .2 5 Boom .15 1 3. The Federal Reserve wants to increase the supply of reserves, so it purchases 1m USD worth of bonds from the public. Show the effect of this open market operation using T-accounts. 4. Use T-accounts to show the effect of the Federal Reserve being paid back a $500K discount loan from a bank. 5. The short-term nominal interest rate is 5%, with an expected inflation of 2%. Economists forecast that next year’s nominal rate will increase by 100 basis points, but inflation will fall to 1.5%. What is the expected change in real interest rates? For problems 6-8 recall from introductory macroeconomics that the money multiplier = 1/(required reserve ratio). 6. If the required reserve ratio is 10%, how much a new $10,000 deposit can a bank lend? What is the potential impact on the money supply? 7. A bank currently holds $150,000 in excess reserves. If the current reserve requirement is 12.5%, how much could the money supply change? How could this happen? 8. The trading desk at the Federal Reserve sold $100,000,000 in T-bills to the public. If the current reserve requirement is 8.0%, how much could the money supply change? Chapter 10 – Additional Problems 1. Define Monetary Base, M1 and M2. 2. Assume Fred has $500 in cash and that this is the entire monetary base. Assume that the reserve requirement for banks is 5% and that reserves are taken on checking accounts but not money market accounts. a. What is the current level for M1 and M2? b. If Fred deposits the $500 into his checking account what happens to M1 and M2? What are the required reserves? How much of the cash can the bank leave in its own vault? c. The bank where Fred has a checking account would like to extend a loan to another customer, Sue. How large a loan can the bank extend? After the loan what happens to the Monetary Base, M1 and M2? If the bank deposits the proceeds of the loan into Sue’s checking account what are the required reserves of the bank? d. If both Fred and Sue want to withdraw their money at the same time this would cause a run on the bank. What options does the bank have? 3. If excess reserves have increased by 100,000 dollars and the required reserve ratio is 5% then what is the most that M1 can increase? 4. What is the money multiplier? The following graph shows the Monetary Base, M1 and M2. Given a reason that might explain why M1 and the Monetary Base lines crossed in 2008. 12000.0 10000.0 8000.0 6000.0 4000.0 BASE 2000.0 M1 M2 0.0 Jan-00 Nov-01 Sep-03 Jul-05 May-07 Mar-09 Jan-11 Source: Federal Reserve Bank of St. Louis/Board of Governors of the Federal Reserve System/Board of Governors of the Federal Reserve System/FRED 5. Using T-Accounts show the effect of the Fed reserve buying $1,000 of T-bills from the Fred and Fred depositing the proceeds into his checking account at Bank A. What effect will this have on reserves – both required and excess (assume a reserve ratio of 10%)? What effect will this have on the Monetary Base, M1 and M2? 6. In the previous problem if Bank A already had excess reserves at the Fed would Bank A expect to be able to lend any additional excess reserves to Bank B at a higher or lower rate than the rate seen before the Fed’s open market operation?
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