Download Quiz 5 Answers

QUIZ 5: Macro – Winter 2011
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You must always show your thinking to get full credit.
Question 1
Which of the following situations move the LM curve? Explain what happens in the
money market first and then how the LM shifts. (3 pts. each)
i.
The war payments to France from Germany increased France’s wealth stock (W).
What happened to France’s LM curve?
As W increases, the transaction motive for liquidity demand shifts the Ld curve up
and to the right in the money market. This will increase the equilibrium real interest
rates for every level of Y. Hence the LM curve will shift up and to the left.
ii.
The Mexican Central Bank increases money supply M.
As M increases, the real money supply shifts to the right in the money market. This
will decrease the equilibrium real interest rates for every level of Y. Hence the LM
curve will shift down and to the right.
iii.
The future inflation rate of the US is revised downwards (e declines).
As e decreases, the nominal interest rate goes down for every level of r. This means
that individuals will be more willing to hold money, since it is less costly for them in
terms of forgone returns. The Ld curve moves up and to the right in the money
market. This will increase the equilibrium real interest rates for every level of Y.
Hence the LM curve will shift up and to the left.
iv.
The price level decreases in Japan. What happens to Japan’s LM curve? [How
real money supply moves?].
As P decreases, Ms/P increases and the real money supply shifts to the right in the
money market. This will decrease the equilibrium real interest rates for every level
of Y. Hence the LM curve will shift down and to the right.
v.
The liquidity of non-monetary assets of an economy decreases.
As monetary and non-monetary assets are worse substitute in terms of liquidity in
performing transactions, the transaction motive for liquidity demand shifts the Ld
curve up and to the right in the money market. This will increase the equilibrium
real interest rates for every level of Y. Hence the LM curve will shift up and to the
left.
Question 2
Some of the following statements are true and others are false. Explain. A statement
should be considered false if one or more sentences are false; true otherwise. (2 pts. each)
i.
The Federal Reserve System is the monetary policy authority of the United
States. The chairman of the Fed is currently Ben Bernanke. However, it is the
Federal Open Market Committee that decides through voting the policy
action.
This statement is true in all its parts.
ii.
The Fed currently targets the M1 monetary aggregate, which includes
currency and checking deposits. That is, the level of money supply.
This statement is false. Although the Fed has target monetary aggregates in the past
(1979-1982 under Chairman Paul Volcker), right now The Fed targets the fed funds
rate. A nice resource on this difference is here:
http://www.frbsf.org/education/activities/drecon/2003/0301.html
Just to summarize. The Fed obtains its monetary policy goals in one of two ways:
1. Targeting the quantity of money (commonly measured by the monetary
aggregates: M1, M2 and M3)
2. Targeting the price of money (more precisely the price of reserves, commonly
known as the "federal funds rate"). Through the fractional reserve requirement and
the money multiplier, a higher amount of reserves implies a higher amount of
money. If it costs more to banks to borrow reserves in order to increase deposits, the
total amount of money supply in the economy decreases.
iii.
The Fed funds rate is the overnight interest rate that private banks charge to
each other when borrowing and lending Fed funds, that is reserves.
This statement is true in all its parts. That is the market where fed funds are
traded (the Open Market) and where the Fed Open Market Committee directs
its actions (that are executed by the Trading Desk of the New York regional
Fed).
iv.
Reserves are a liability of private banks and an asset of the central bank.
This statement is false in all its parts. Reserves are a liability of the Central Bank
and an asset of private banks in the economy. To see it clearly consider that
reserves are vault cash and deposits by private banks at the central bank.
v.
The central bank affects money supply by increasing the reserves
requirements of private banks. Particularly, the central bank can increase
money supply by decreasing the reserve-deposit ratio, hence increasing the
money multiplier.
This statement is true in all its parts.
Question 3
Please explain below how an open market operation of the Fed works and what are the
consequences for money supply. (10 pts.)
The FOMC, through the Trading Desk at the Federal Reserve Bank of New York,
conducts open market operations that target a particular degree of tightness or ease
in reserve market conditions by affecting the supply of fed funds. Since the fed
funds rate is effectively the price of reserves when the Fed exchanges government
securities for fed funds it will decrease the fed funds rate. In order to tighten its
policy instead the Fed can sell government securities in exchange of fed funds, thus
reducing reserves and increasing the fed funds rate.
Question 4
In the Business Week reading “What the Fed Can’t Do” Harvard economist Robert Barro
makes the point that the Fed cannot influence what? (5 pts.)
The Fed cannot influence the real interest rate in the economy according to
economist Robert Barro. That rate is influenced by saving, consumption and
investment decisions that are mostly driven by long-run prospects of the economy
(think about long-term real interest rates, say 2, 5, 10 years maturities).
This is in contrast with the view that “Changes in the federal funds rate, the interest
rate or "price" of overnight loans between commercial banks, may fluctuate day by
day and between different banks. But, the general level of the federal funds rate
affects the prime rate and other interest rates offered to bank customers, and in
turn either encourages or discourages new borrowing, investment, and economic
growth.” [This quote is from the San Francisco Fed, but similar arguments are
made in your readings on the Economist].
The two views can be reconciled by the fact that the second statement is probably
right for consumption and investment decisions related to a short-run horizon and
the first one for those related to a long-run horizon. We will see more of this in class.