ECON 104 HOMEWORK #9 (100 points total)

 

ECON 104 HOMEWORK #9 (100 points total) Part 1: 70 points total 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, Russian 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 B, C, and 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, M s = 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.

 

Part 2: True/False (30 points total – 2 points each)

1) Open market operations influence reserve supply. For example, an open market sale will increase reserve supply.

2) According to our discussion on the FOMC statement from August 2007, the Fed was worried about inflation getting too high.

 

3) Following the 2001 recession (aka, the job-loss recovery), the Federal Reserve lowered their target for the federal funds rate all the way down to 1%.

 

4) Following the job-loss recovery, the FOMC raised the target for the federal funds rate 17 meetings in a row.

5) Since December 2007, the federal funds rate has been at the zero bound with the official target being a range from zero to .25%.

6) During the lead up to Y2K, reserve demand was decreasing since banks were afraid to make loans.

 

7) During the lead up to Y2K, the Fed, to keep the federal funds rate from rising, had to conduct open market purchases. This action is referred to as ‘accommodating’ the shock to reserve demand.

 

8) During normal times, before the zero bound, the Fed forecasts reserve demand and supples the necessary reserves to meet their federal funds target. The better the forecast, the closer the actual federal funds rate is to the target federal funds rate.

 

9) In order to raise the federal funds rate the Fed would conduct open market sales.

 

10) When discussing money demand, we argued that people tend to hold more money as the interest rate rises, all else constant.

 

11) If the Fed conducts open market sales then the price of bonds should fall.

 

12) According to our money demand / money supply analysis, an increase in GDP = Y, all else constant, will result in a rise in nominal interest rates.

13) According to the percent change form of the quantity theory of money, if velocity falls by 10%, then the Fed, in order to achieve their dual mandate, should let the nominal money supply grow by 15%.

14) A portfolio shock such that households want to hold less money, at any given interest rate, will result in the velocity of money falling.

 

15) Milton Friedman felt that high inflation was always caused by excessive money growth. In fact, he has been quoted as “Inflation is always and everywhere a monetary phenonemon.”