Exam 3 money and banking

Do problem 6 on HW 6.

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c. Decrease in the interest paid on reserves.

A decrease in the interest paid on reserves will cause the horizontal portion of the demand curve to shift down. This will decrease the fed funds rate if the initial fed funds rate was equal to the initial interest on reserves (aka, if the lower bound on the fed funds rate is binding). Draw a graph: If the initial fed funds rate is not equal to the initial interest on reserves, then the decrease in the interest paid on reserves has no effect on the fed funds rate. Draw a graph:

Graph the effects of the following policy actions in the market for bank reserves. If more than one outcome is possible, draw a graph for each possible outcome and explain each outcome. a. Increase in reserve requirements.

An increase in the reserve requirement will increase demand for reserves. If the initial fed funds rate is between the discount rate and the interest on reserves, then the increase in the demand for reserves causes the fed funds rate to rise. Draw a graph: If the initial fed funds rate is equal to the discount rate, then the fed funds rate is unchanged (and still equal to the discount rate). Draw a graph: If the initial fed funds rate is equal to the interest on reserves, the increase in the demand for reserves may or may not have an effect on the fed funds rate. If the increase in demand is relatively small (pictured below as the shift from DRES to DRES'), the fed funds rate does not change. If the increase in demand is relatively large, (pictured below as the shift from DRES to DRES''), the fed funds rate will rise. Draw a graph:

a. An open market Sale

An open market sale will decrease the supply of non‐borrowed reserves (NBR) shifting the vertical portion of the supply curve to the left. If the initial fed funds rate is between the discount rate and interest on reserves, then the fed funds rate will rise. Draw a graph: If the initial fed funds rate is equal to the discount rate, then the fed funds rate is unchanged (and still equal to the discount rate). Draw a graph: If the initial fed funds rate is equal to the interest on reserves, the decrease in the supply of reserves may or may not have an effect on the fed funds rate. If the decrease in the supply is relatively small (pictured below as the shift from SRES to SRES'), the fed funds rate does not change. If the decrease in the supply is relatively large, (pictured below as the shift from SRES to SRES''), the fed funds rate will rise. Draw a graph:

"Because government policymakers do not consider inflation desirable, their policies cannot be the source of inflation." Is this statement true, false, or uncertain?

False. Policy can be inflationary in the short run if it increases aggregate demand and can be inflationary in the long run if it is used to keep output above potential output.

Suppose the economy is at a long‐run equilibrium with inflation equal to the central bank's target when financial frictions increase. a. Use a graph of the AD‐AS model to illustrate the short‐run effects of this shock. Label the initial equilibrium point 1 and the new short‐run equilibrium point 2. What happens to output, inflation, and unemployment?

Graph:

e. Illustrate the effect of the policy action in your graph from part a. (You can also draw a second graph if you want.) Label the new long‐run equilibrium point 4.

Graph:

When aggregate output is below potential output, what happens to the inflation rate over time? Why? Assume a constant aggregate demand curve.

If aggregate output is below potential output, inflation will fall over time. When Y<YP, a negative output gap exists. This implies there is a lot of slack in the labor market and a lot of surplus labor. In response to the large amount of surplus labor, wage growth will fall over time. This leads to an increase in the short‐run aggregate supply curve which causes inflation to fall.

d. Compare and contrast your answers from part b and c.

If the Fed focuses on inflation stabilization, it is able to stabilize both output and inflation in the long run. However, if they focus on output stabilization, they will not be able to hit their inflation target in the long run.

f. Compare and contrast the long‐run outcomes under do policy action (part b) and policy action (part e).

If the economy self‐corrects, inflation is permanently lower and, although output returns to potential in the long run, the recovery of output may take many years. In contrast, if the Fed intervenes inflation can be stabilized at the target rate and output returns to potential output (and may recovery faster than if the economy was allowed to self‐correct).

If large budget deficits cause the public to think there will be higher inflation in the future, what is likely to happen to the short‐run aggregate supply curve if budget deficits rise? Why?

If the public expects higher future inflation due to an increase in the budget deficit, the short‐run aggregate supply curve will fall. When people expect higher future inflation, workers will negotiate higher wages in order to preserve their purchasing power. This increase in wage growth increases firms' costs of production; the resulting fall in profits reduces firms' willingness to produce goods and services SRAS decreases

c. Now suppose the Fed does take correction action. Given the short‐run equilibrium from part a, what is the appropriate open market operation the central bank should conduct? What is the effect of this action on interest rates?

In order to stabilize output and return inflation back to target, the Fed should pursue expansionary monetary policy. They can achieve this via an open market purchase which will cause interest rates to fall.

"The federal funds rate can never be above the discount rate." Is this statement true, false, or uncertain? Explain your answer.

In theory, this is true. The discount rate should act as an upper bound in the federal funds market because if the fed funds rate ever went above the discount rate, banks would not borrow in the fed funds market, but only borrow from the discount window (which would eventually drive the fed funds rate down). However, in practice, the fed funds rate does rise above the discount rate due to perceived stigma of borrowing from the discount window. Banks may prefer to pay a higher federal funds rate than potentially signal to other banks that they are in a weak financial position.

d. In words, what is the effect of the policy action on aggregate demand? Make sure to specify what components of aggregate demand are affected, how they are affected and why.

Lower interest rates will make borrowing cheaper and saving less attractive. This will result in an increase in consumption and investment which will increase AD and shift it to the right.

c. A new productivity enhancing technology is widely developed.;

Permanent positive supply shock: a new, better technology will increase potential output, shifting LRAS to the right. Simultaneously, since the new technology is likely to decrease production costs, short‐run AS also increases shifting the to the right. Output rises and inflation falls in the short run. Long run: the economy is in a negative output gap. This causes wage growth to fall short‐run AS increases until the economy has return to a long‐run equilibrium. Inflation is lower, and output has increased to the new higher level of potential output. Draw Graph:

Are there any "good" supply shocks? Explain your answer.

Permanent supply shocks can be considered "good" shocks since they lead to a permanent increase in output and a permanent decrease in inflation and unemployment

Classify each of the following as a supply shock or demand shock. Explain why the relevant curve will be affected and how. Then, beginning from a long‐run equilibrium, use a graph of the AD‐AS model to show the effects on inflation and output in the short run and in the long run. Label the initial equilibrium point 1, the new short‐run equilibrium point 2, and the new long‐run equilibrium point 3. Assume there is no policy intervention by the Federal Reserve. a. Increase consumer confidence results in higher consumer spending.

Positive demand shock: since consumption is part of AD, an increase in consumer spending will increase AD and shift it to the right. Inflation and output rise in the short run. Long run: the economy is in a positive output gap. This causes wage growth to rise short‐run AS decreases until the economy has return to a long‐run equilibrium. Inflation is higher, but output has returned to potential output. Draw Graph:

Suppose the economy is at a long‐run equilibrium with inflation equal to the central bank's target when the price of steel increases. a. What happens in the short and long run if the Federal Reserve does not take any action?

Short run: this is a temporary negative supply shock. In the short run, short‐run AS decreases causing output to fall and inflation to rise. Long run: without any intervention from the Fed, in the long run wage growth will fall in response to the negative output gap, causing short‐run AS to increase until the economy is back at a long‐run equilibrium. In the long run, there is no effect on output or inflation.

b. What should the Fed do if they want to stabilize inflation after the shock? What happens in the short and long run as a result?

Short run: this is a temporary negative supply shock. In the short run, short‐run AS decreases causing output to fall and inflation to rise. To stabilize inflation the Fed should pursue contractionary monetary policy. This will decrease AD and cause inflation to fall back to target, but will also cause output to fall even further below potential output. Long run: the economy is still in a negative output gap. In the long run wage growth will fall in response to the negative output gap, causing short‐run AS to increase. This pushes inflation back down below the Fed's target. In response, the Fed should pursue expansionary policy, increasing AD. This causes inflation to rise back up to target and output to rise back to potential output. Thus, in the long run, the Fed can stabilization output back to potential output and hit their inflation target if they focus on stabilizing inflation.

c. What should the Fed do if they want to stabilize output after the shock? What happens in the short and long run as a result?

Short‐run: this is a temporary negative supply shock. In the short run, short‐run AS decreases causing output to fall and inflation to rise. To stabilize output the Fed should pursue expansionary monetary policy. This will increase AD and cause output to increase back to potential output and inflation to rise. Long run: in the long run, the Fed has returned output to potential output but inflation is now permanently higher.

Identify three factors than can shift the aggregate demand curve to the right and three different factors that can shift the aggregate demand curve to the left. Explain why they shift the curve.

Since aggregate demand = C + I + G + NX, an autonomous change in C, I, G, and/or NX will have an identical effect on AD. If interest rates rise, the cost of borrowing is higher and the return to saving is lower. This leads to lower consumption and investment which leads to a decrease in AD. If taxes rise, households have lower disposable income. This leads to lower consumption which leads to a decrease in AD. If financial frictions rises interest rates also tend to rise to compensate lenders for higher risk (simultaneously, the extent of credit rationing may rise). This leads to lower consumption and investment which leads to a decrease in AD.

b. Favorable weather produces a record high crop of grains in the United States.

Temporary positive supply shock: a record crop of grains will increase the short‐run AS, but because this does not represent a change in potential output it does not affect LRAS. AS shifts right; output rises and inflation falls in the short run. Long run: the economy is in a positive output gap. This causes wage growth to rise short‐run AS decreases until the economy has return to a long‐run equilibrium. Inflation is higher, but output has returned to potential output. Draw Graph:

Suppose the economy is at a long‐run equilibrium that is experiencing 4% inflation. How could the central bank effectively target a 2% inflation rate? Can they also target output? Draw a graph to illustrate.

The central bank should pursue contractionary policy in order to lower the rate of inflation. This entails conducting an open market sale in order to increase interest rates and decrease AD. This immediately decreases the rate of inflation, but also puts the economy in a negative output gap. In the long run, wage growth will fall in response to the negative output gap causing short‐run AS to increase. This adjustment continues until the economy has returned to potential output. While the central bank can target a specific rate of inflation in the long run, they cannot target output. Because of the economy's self‐correcting mechanism, output will return to potential output in the long run despite central bank policies. Draw graph

Why is it that a decrease in the discount rate does not normally lead to an increase in the federal funds rate? Use the supply and demand analysis of the market for reserves to explain.

The discount rate acts as an upper bound on the fed funds rate. However, most of the time the upper bound is not binding - that is, the equilibrium fed funds rate is below the discount rate. Therefore, if the Fed changes the discount rate there will be no effect on the fed funds rate. Only when the upper bound is binding (fed funds rate = discount rate) will a change in the discount rate have an effect on the fed funds rate. Draw out a graph

What factors shift the short‐run aggregate supply curve? What factors shift the long‐run aggregate supply curve?

The short‐run aggregate supply curve may be shifted by changes in commodity/input prices; changes in expected future inflation, and persistent output gaps. The long‐run aggregate supply curve depends on potential output. Potential output is the level of real GDP the economy would produce if all available resources are fully employed using the best available technology. Therefore, changes in potential output will shift the LRAS. Higher potential output (perhaps caused by better technology or an increase in capital or labor resources) increase LRAS and shift it to the right. Additionally, shocks that tend to increase or decrease LRAS had a similar effect on the SRAS. E.g., when technology improves, the costs of production tend to fall increase in SRAS

What is the zero lower bound on interest rates? How effective is conventional monetary policy when short‐ term interest rates are at the zero lower bound? How could a central bank use quantitative easing to stimulate the economy when it is at the zero lower bound?

The zero lower bound (ZLB) refers to the fact that nominal interest rates cannot go below 0%. If the economy is in a recession, conventional monetary policy would dictate lowering short‐term interest rates (the fed funds rate to be exact). However, if the fed funds rate is already 0% it cannot go any lower - interest rates cannot be negative because no lender would have an incentive to lend. Therefore, if we are at the ZLB, conventional monetary policy is ineffective. However, even if short‐term rates are at 0%, long‐term rates may still be positive. In this case, the Fed can use quantitative easing to attempt to lower long‐term interest rates. They do this by buying longer maturity assets. This increases the demand for longer maturity assets, pushing their price up and interest rates down. Lower long‐ term interest rates will further increase consumption and investment thereby furthering stimulating the economy.

In what way is a permanent supply negative supply shock worse than a temporary negative supply shock?

While both shocks will cause a decrease in output and an increase in inflation in the short run, in the case of a permanent negative supply shocks the effects are permanent. For a temporary negative supply shock, the effects on output and inflation wear off over time as the economy self‐corrects in the long run

b. Suppose the Fed does not take any corrective action. In words, what happens in the long run? Illustrate the long‐run transition in your graph. Label the new long‐run equilibrium point 3. (8 points)

Without any action by the Fed, wage growth will fall in the long run in response to the negative output gap the economy is experiencing at equilibrium 2. This cause short‐run AS to increase, shifting right until the economy is at a new long‐run equilibrium. Output has returned to potential, but inflation is permanently lower.