Economics 341 by pptfiles

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									Economics 341                                                            Professor Rafferty
Money & Banking                                                          Spring 2005

                                PRACTICE FINAL EXAM

1. Every time the economy enters a recession the Fed cuts the Federal Funds rate in an
attempt to stimulate the economy. Everybody knows and expects this.
a. Describe the mechanics of how the Fed would cut the Federal Funds rate. Use a
supply and demand model for banking reserves to illustrate the policy.
b. Explain the link between the short-term interest rates which the Fed influences and
output. Be thorough.

2. Suppose the economy enters a deep recession and the nominal Federal Funds rate is
already at 0.00%. A Fed spokesman says that there is nothing more that the Fed can do
to stimulate the economy. Is the Fed spokesman correct? Provide at least three reasons.
You may assume adaptive expectations.

3. Explain the effect of a decrease in consumer confidence. Make sure you discuss the
short run and the long run. Use the AS-AD model to graph the effects of the decrease in
consumer confidence. Assume that expectations are adaptive.


4. Explain the danger for the Fed of using monetary policy to eliminate a recession. Use
the AS-AD model to answer the question. Assume that expectations are adaptive.




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Answers

1.
a. If the Federal Reserve wanted to decrease the federal funds rate then it would purchase
government bonds from banks. To pay for the bonds, the Fed would increase the volume
of reserves available to the banking system. This would shift the supply curve for
reserves to the right and the federal funds rate would decline.




                                                                                               RS
                              iD
                            iFF1                                 A


                            iFF2                                                          B



                                                                                              RD


                                                           Rn1                     Rn2

b. The Fed influences the federal funds rate which is a twenty-four hour interest rate that
one bank charges another bank for borrowing reserves. The longer-term interest rates are
related to the federal funds rate as follows:

                   i FF ,t  i FF ,t 1  i FF ,t  2    i FF ,t  n 1
                               e            e                 e
        i n ,t                                                                  n ,t
                                              n

where n is the time to maturity (measured in days) of the long-term bond and n,t is the
term premium. Therefore, when the Fed decreases the federal funds rate this causes the
interest rate on long-term bonds to decline because the current federal funds rate, i FF ,t ,
directly influences the long-term interest rate. In addition, to the extent that the decrease
in the current federal funds rate is a signal that the Fed will continue to reduce interest
                                                               e
rates in the future, the expected future federal funds rate, i FF ,t  j , will decline which will
also cause the interest rate on long-term bonds to decline.

The decrease in long-term interest rates will make it cheaper for consumers and firms to
borrow funds from banks. As a result, consumption and investment expenditures will
increase and real GDP will increase.



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2. The Fed official is spewing complete and total bogus nonsense. We discussed
numerous alternative transmission mechanisms for monetary policy in class and your
book discusses them on pages 616 to 625. I describe three mechanisms below.

First, if the nominal interest rate is 0% then the Fed can still decrease the expected real
interest rate by committing to a positive inflation target. The equation for the expected
real interest rate is:

        ir  i   e
         e



If the Fed’s commitment to a positive inflation target then the expected interest rate will
become negative this will lead to increase consumption and investment expenditures.

Second, even if the nominal interest rate is zero the Fed can influence the economy
through asset prices. When the Fed buys government bonds this increases the money
supply and individuals find themselves with more of the liquid asset (money) than they
would normally want to hold. Individuals will purchase other less liquid assets (like
stocks and real estate). This increases the price of those assets so wealth increases. The
increased wealth leads to increased consumption.

Third, certain groups (like small firms and households) are limited to borrowing funds
from banks. When the Fed purchases government bonds this increases excess reserves
for banks. The banks will then loan out some of these excess reserves which will allow
firms to increase investment expenditures and/or allow households to increase
consumption expenditures.

All three mechanisms cause the aggregate demand curve to shift to the left and increase
real GDP.




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                                                                LRAS
3.


                                                                                      SRAS1
                                                                                              SRAS2



                                                          A
             P1e  P1
                                                  B
                     P2
                                                                    C
               P3e    P3
                                                                                              AD1
                                                                                AD2
                                                 Y2       Y   pot
                                                                     Y1  Y3


i. Start at initial long-run equilibrium: Point A where P1e  P1 and Y pot  Y1
ii. The decrease in consumer confidence causes the constant in the consumption function to decline which
causes the AD curve to shift to AD2. The economy is at point B where output is below potential. Since
output is below potential, the unemployment rate is higher than the natural rate of unemployment. In
addition, prices are less than expected.
iii. Since the unemployment rate is higher than the natural rate of unemployment, firms have the bargaining
strength in contract negotiations. As a result, workers, competing for scarce jobs, bid down the nominal
wage. The decrease in nominal wages represents a decrease in the costs of production and causes the
SRAS curve to shift to SRAS2. In addition, the expected price level begins to decline since P  P2 .
                                                                                              e
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iv. Stop when reach new long-run equilibrium: Point C where P3  P3 and Y pot  Y3
                                                                        e




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4. Consider the previous answer (but ignore prices). The decrease in consumer confidence shifts the AD
curve to AD2 and the economy is at Point B. Output is below potential and the economy is in a recession.

                                                  LRAS

                                                                              SRAS1



                                                                                     SRAS2




                                              A

                                 B                                    D



                                          C
                                                           AD2                AD1=AD3


                                 Y2           Y1  Y pot         Y3


If the Fed wants to eliminate the recession then it can increase the money supply which will decrease
interest rates, increase investment expenditures, and shift the AD curve from AD2 to AD3. This would
move the economy back to point A and eliminate the recession.

Due to the lags associated with monetary policy, it can take between 6 and 18 months for the increase in the
money supply to shift the AD curve from AD2 to AD3. If the economy self-corrects quickly then the
economy would be at point C before the AD shifts to AD3. In this case, the shift of the AD curve from AD 2
to AD3 will move the economy to point D. The Fed’s policy might not do anything to eliminate the
recession, but would move the economy to point D where output is above potential and inflation
accelerates. Therefore, the Fed may just create an inflationary problem rather than eliminating the
recession.




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