9

 

1)    
(25 points total) We are going back to the fall of 1998, back in the ‘midst’ of the new economy.  The US economy weathered the E. Asian quite well and the US economy, by almost all accounts, was performing brilliantly.  In August of 1998, Russia defaulted on all the debt held by foreign investors.  This “shock” rattled financial markets so much that the Fed went into action and lowered short term interest rates 3 times in a seven week period.  In what follows, we are going to model this 7 weeks period using our new acquired reserve demand / reserve supply diagram. In order to do this problem correctly, we need to go back to 1998 and ‘fetch’ the three relevant FOMC statements.  To help you along, I provide the links for you below. Statements (1998)   September 29   October 15   November 17 Note importantly, we are modeling the behavior of the federal funds rate during this period.  The forecasted reserve demand at this time is given below.  For simplicity, this reserve demand function is stable (constant) throughout this exercise. Rd = 900 –  100 iff 

a)    

(10 points for correct and completely labeled diagram) In the space below, draw a reserve demand / reserve supply diagram depicting as point A, the conditions before the FOMC meeting in September, 1998.  Note, you need to use the prevailing federal funds target and solve for the appropriate reserve supply. You will be adding points B, C, and D to this diagram. 

b)    

(5 points) Now show as point B, the conditions shortly after the FOMC meeting on September 29, 1998.  Please show work.

c)     

(5 points) Explain exactly how the Fed (the FOMC in Washington DC) changes conditions in the federal funds market. Be sure to refer this particular case, the movement from point A to point B. Now add to your diagram as point C, the conditions in the federal funds market shortly after the statement in October and point D, the conditions in the federal funds market following the FOMC meeting in November (the points for this part are included in the points for the complete and correctly labeled diagram.

d)    

(5 points) Now label points A, B, C, and D on the diagram below.

2)    
(45 points total) In this problem, we are going to use the money market to model two real world events: i) a portfolio shock to money demand and ii) a shock to the money multiplier. Suppose you have the following information: Original money demand function: Md = P X [ 200 + .5 Y – 200 i] where P = 1 (P remains constant in this problem), Y = 1600, Ms = 600, MB = 400 MM=1.5

a)     (5 points) Solve for the nominal interest rate ( i ) that clears the money market.

b)     (10 points for correct and completely labeled diagram) In the space below, draw a money demand / money supply diagram depicting these initial conditions.

c)      (5 points) We now experience a portfolio shock to money demand so that the new money demand function is: Md = P X [ 400 + .5 Y – 200 i] Solve for the new market clearing interest rate, assuming there is no change in the money supply and label as point B on your diagram.

d)     (5 points) Assuming the Fed wanted to keep interest rates constant, what would they need to do exactly?  Please explain and show as point C, the conditions after the Fed did what they need to do to keep interest rates steady and their initial level as in part a). (10 points for a correct and completely labeled diagram)  Re-draw a money demand and money supply diagram showing the initial conditions and label as point A.

e)    
(5 points) Instead of a portfolio shock to money demand, we now experience a shock to the money multiplier.  In particular, the money multiplier (MM) falls and is now = .8 (it was 1.5 before the shock).  Assuming the Fed does nothing, what is the new money market clearing interest rate?  Label this as point B on your diagram.

f)     
(5 points) Now we assume that the Fed is pro-active and responds to the money multiplier shock immediately to keep interest rates at their initial level.  What would the Fed have to do exactly in terms of open market operations (show work) and label this as point C on your diagram.