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ECON 2020—Macroeconomics
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Question 1: Suppose that you are a member of the Board of Governors of the Federal
Reserve System. The economy is experiencing a sharp rise in the inflation rate. What
change in the Federal funds rate would you recommend? How would your recommended
change get accomplished? What impact would the actions have on the lending ability of the
banking system, the real interest rate, investment spending, aggregate demand, and
inflation?
Answer:
To reduce inflation, the Federal funds rate should be raised. This would be accomplished typically
through open-market operations (selling bonds), but could also be achieved with an increase in the
reserve ratio or discount rate.
The restrictive monetary policy would reduce the lending ability of the banking system, increase the
real interest rate, reduce investment spending, reduce aggregate demand, and reduce inflation.
Question 2: What is the basic objective of monetary policy? What are the major strengths
of monetary policy? Why is monetary policy easier to conduct than fiscal policy in a highly
divided national political environment?
Answer:
The basic objective of monetary policy is to assist the economy in achieving a full-employment,
non-inflationary level of total output.
The major strengths of monetary policy are its speed and flexibility compared to fiscal policy, the
Board of Governors is somewhat removed from political pressure, and its successful record in
preventing inflation and keeping prices stable. The Fed is given some credit for prosperity in the
1990s and early 2000s.
Monetary policy is formed by the 7 members of the Board of Governors. Fiscal policy requires the
consent of both houses in Congress, plus the President. One of the implications is that monetary
policy has a much shorter administrative lag than fiscal policy.
Question 3: How do stocks and bonds differ in terms of the future payments that they are
expected to make? Which type of investment (stocks or bonds) is considered to be more
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ECON 2020—Macroeconomics
risky? Given what you know, which investment (stocks or bonds) do you think commonly
goes by the name “fixed income”?
Answer:
Stocks pay dividends out of profits to the shareholders that own them, with the percentage of the
total dividend received being based on the percentage of stocks owned. While many corporations
pay regular dividends on their stocks, there is no requirement to do so, and many corporations pay
no dividends or pay them on an irregular basis. Stocks also return capital gains when their owners
sell their shares, assuming that the price they receive for the shares is greater than what they paid
for them. Bonds pay a predetermined amount of interest at regular intervals.
Stocks are considered more risky. Stock prices and profits are highly variable, so the capital gains
and dividends tied to them can also fluctuate greatly. There is some risk with bonds, particularly
with bonds issued by corporations that are struggling financially, but on average they are less risky
than stocks, in part because government bonds (U.S. Federal government bonds in particular)
carry virtually no risk of losing the amount invested.
Bonds are frequently referred to as “fixed income” investments because of the regularity in size
and timing of the payments to their owners.
Question 4: Mutual funds are very popular. What do they do? What sorts of different types
of mutual funds are there? And why do you think they are so popular with investors?
Answer:
Mutual funds pool investors money and buy a collection of stocks or bonds. Some are narrowly
defined, focusing on a particular sector of the economy (technology, health care) or type of asset
(small cap stock funds; long-term government bonds); others are more broadly defined (growth,
income funds); others have a social agenda (ethical investment). There are both actively managed
funds (with frequent buying and selling of assets in the fund) and passively managed funds (such
as index funds where the allocation is tied to an index rather than varying according to a manager’s
discretion).
Investing in a specific stock or bond can be risky, and some of this risk (diversifiable or
“idiosyncratic” risk) can be reduced by buying many different stocks and/or bonds. By pooling the
funds of many investors, the mutual fund can invest in many different financial assets
simultaneously, diversifying the risk. Mutual funds are also popular because they don’t require the
investor to closely monitor the portfolio or have expertise in the many stocks and bonds in the
portfolio.
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