Macroeconomics Study Set 62

Business

Quiz 13 :

Monetary Policy: Conventional and Unconventional

Quiz 13 :

Monetary Policy: Conventional and Unconventional

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Show the balance sheet changes that would take place if the Federal Reserve Bank of New York purchased an office building from Citigroup for a price of $100 million. Compare this effect to the effect of an open-market purchase of securities shown in Table₁. What do you conclude Table₁ img
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Balance sheets of Citigroup and Federal Reserve Bank
Assume that Federal Reserve Bank in New York purchased an office building from Citigroup for a price of $100 million. The effect of purchasing a new building on the balance sheet is shown in Table (1).
Table - 1
img Note: Figures highlighted in yellow indicate change in balance sheet due to purchase of building worth
$100 million.
In Table (1), as the Federal Reserve Bank purchases a building worth $100 million, the Federal Reserve Bank's liability increased to $100 million more.
Hence, the Federal Reserve Bank purchases a treasury bill worth $100 million and transfers it to the Citigroup.
It is evident from Table (1) that whatever the Federal Reserve Bank has to pay, it pays by purchasing from the open market.

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Explain how your answers to Test Yourself Question 5 would differ if banks decided to hold onto the $5 billion in new reserves as excess reserves. Reference Test Yourself Question 5 Explain what a $5 billion increase in bank reserves will do to real GDP under the following assumptions: a. Each $1 billion increase in bank reserves reduces the rate of interest by 0.5 percentage point. b. Each 1 percentage point decline in interest rates stimulates $30 billion worth of new investment. c. The expenditure multiplier is two. d. The aggregate supply curve is so flat that prices do not rise noticeably when demand increases.
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a. Increase in bank reserve by $1 billion reduces the interest rate by 0.5
Assume that each $1 billion increase in bank reserve reduces the rate of interest by 0.5 percentage point. In such a condition, holding $5 billion bank reserves will keep the interest rate down by 0.25 percentage point.
Keeping the rate of interest down will induce consumption and investment to increase. As a result, the real GDP will increase. Hence, holding $5 billion bank reserves will positively affect the real GDP.
b. One percent decrease in interest rates stimulates investment by $30 billion
Assume that each 1-percentage point decline in rate of interest will increase the new investment by $30 billion. Holding $5 billion bank reserves will keep the rate of interest up. Hence, higher rate of interest will discourage the investor to invest.
The decrease in investment will cause the real GDP to decrease. Hence, holding bank reserves by $5 billion will negatively affect the real GDP.
c. Expenditure multiplier is two
Assume that expenditure multiplier is two. In such a condition, holding bank reserve by $5 billion will reduce the liquidity of money in the market; this in turn reduces consumption. Hence, holding bank reserve by $5 billion will reduce the real GDP.
d. Supply curve is flat
Assume that supply curve is flat; it means prices do not respond for any change in demand.
Holding bank reserves by $5 billion will reduce the demand for goods and services in the market. Since the supply curve is so flat, the reduction of demand will affect output rather than price.
In a flat supply curve, holding bank reserves by $5 billion will reduce the real GDP.

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From September 2007 through December 2008, the Fed believed that interest rates needed to fall and took steps to reduce them, eventually cutting the federal funds rate from 5.25 percent to nearly zero. How did the Fed reduce the federal funds rate Illustrate your answer on a diagram.
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Decreasing federal funds rate
When the Federal Bank purchases high amount of treasury bills in the open market, it leads to an increase of excess reserves in the market. This in turn increases the money supply in the economy. The increase in money supply increases the gap between demand and supply for bank reserves, which in turn reduces the interest rate. Here, the interest rate refers to the federal funds rate
Graphical representation
The following graph illustrates how the Federal Bank reduces federal funds rate.
img Figure - 1
In the above figure, X axis measures the amount of bank reserves and Y axis measures the interest rate, which is referred to as federal funds rate.
The economy is in equilibrium at point e where the demand for bank reserves and supply of bank reserves intersect each other. At point e, the federal fund rate is 5.25 and the amount of bank reserves is r. When the Federal Bank purchases treasury bills from the market, the supply curve shifts from S to
img . This shift in supply curve increases the excess supply of market reserves shown by the dotted arrow mark. This higher excess reserve reduces the interest rate to nearly zero.

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Suppose there is $120 billion of cash and that half of this cash is held in bank vaults as required reserves (that is, banks hold no excess reserves). How large will the money supply be if the required reserve ratio is 10 percent 12 1 2 percent 16 2 3 percent
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Suppose the Fed purchases $5 billion worth of government bonds from Bill Gates, who banks at the Bank of America in San Francisco. Show the effects on the balance sheets of the Fed, the Bank of America, and Gates. (Hint: Where will the Fed get the $5 billion to pay Gates ) Does it make any difference if the Fed buys bonds from a bank or an individual
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Once the federal funds rate reached (approximately) zero, which happened in December 2008, what options were still open to the Fed. What did it actually do (Note: This may be a good question to discuss with your instructor.)
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What are some reasons behind the worldwide trend toward greater central bank independence Are there arguments on the other side
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Why does a modern industrial economy need a central bank
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Treasury bills have a fixed face value (say, $1,000) and pay interest by selling at a discount. For example, if a one-year bill with a$1,000 face value sells today for $950, it will pay $1,000 - $950 = $50 in interest over its life. The interest rate on the bill is therefore $50/$950 = 0.0526, or 5.26 percent. a. Suppose the price of the Treasury bill falls to $925. What happens to the interest rate b. Suppose, instead, that the price rises to $975. What is the interest rate now c. (More difficult) Now generalize this example. Let P be the price of the bill and r be the interest rate. Develop an algebraic formula expressing r in termsof P. ( Hint: The interest earned is $1,000 - P. What is the percentage interest rate ) Show that this formula illustrates the point made in the text: Higher bond prices mean lower interest rates.
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Explain what a $5 billion increase in bank reserves will do to real GDP under the following assumptions: a. Each $1 billion increase in bank reserves reduces the rate of interest by 0.5 percentage point. b. Each 1 percentage point decline in interest rates stimulates $30 billion worth of new investment. c. The expenditure multiplier is two. d. The aggregate supply curve is so flat that prices do not rise noticeably when demand increases.
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Explain why the quantity of bank reserves supplied normally is higher and the quantity of bank reserves demanded normally is lower at higher interest rates.
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Explain how your answers to Test Yourself Question 5 would differ if each of the assumptions changed. Specifically, what sorts of changes in the assumptions would weaken the effects of monetary policy Reference Test Yourself Question 5 Explain what a $5 billion increase in bank reserves will do to real GDP under the following assumptions: a. Each $1 billion increase in bank reserves reduces the rate of interest by 0.5 percentage point. b. Each 1 percentage point decline in interest rates stimulates $30 billion worth of new investment. c. The expenditure multiplier is two. d. The aggregate supply curve is so flat that prices do not rise noticeably when demand increases.
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From 2003 to 2011, the federal government's budget deficit rose sharply because of tax cuts and increased spending. If the Federal Reserve wanted to maintain the same level of aggregate demand in the face of large increases in the budget deficit, what should it have done What would you expect to happen to interest rates
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(More difficult) Consider an economy in which government purchases, taxes, and net exports are all zero. The consumption function is C = 300 + 0.75 Y and investment spending ( I ) depends on the rate of interest ( r ) in the following way: I = 1,000 - 100 r Find the equilibrium GDP if the Fed makes the rate of interest (a) 2 percent ( r = 0.02), (b) 5 percent, and (c) 10 percent.
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Explain why both business investments and purchases of new homes rise when interest rates decline.
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