02 Jun Question 1) (15 points) Assume that the central bank pays an interest
Question
1) (15 points) Assume that the central bank pays an interest on the excess reserves and thediscount rate is above the federal funds rate. “An open market purchase of bonds by the Fedalways decreases the federal funds rate”. Is this statement true, false or uncertain. Explain clearlyusing the supplydemand analysis of the market for reserves.
2) (30 points total) Using the supply and demand analysis of the market for reserves, indicatewhat happens to the federal funds rate, borrowed reserves, and nonborrowed reserves, holdingeverything else constant, under the following situations.
a) (5 points) The economy is surprisingly strong, leading to an increase in the amount ofcheckable deposits.
b) (5 points) Banks expect an unusually large increase in withdrawals from checking depositaccounts in the future.
c) (5 points) The Fed raises the target federal funds rate.
d) (5 points) The fed raises the interest rate on reserves above the current equilibrium federalfunds rate.
e) (5 points) The fed reduces reserve requirements.
f) (5 points) The Fed reduces reserve requirements, and sterilizes this by conducting an openmarket sale of securities.
3) (15 points) If the Fed has an interest rate target, why will an increase in the demand for
reserves usually lead to a rise in the money supply? Use a graph of the market for reserves to
explain.
4) (25 points total)
a) (5 points) In the formula we derived in class for IS curve, we assumed that the net exports isnot a function interest rate. Now suppose that the net exports, NX, is an inverse function ofinterest rate, that is, , where and are constant parameters. Derive the IS curve again (therelationship between r and y in which goods market is in equilibrium).
b) Consider an economy described by the following:
The notation is the same as one used in class (specially for MP curve: ).
b1) (5 points) Derive expressions for IS, MP and AD curves.
b2) (5 points) Assume that inflation is 1% (). What is the real interest rate, equilibrium level ofoutput, consumption, planned investment and net exports?
b3) (5 points) Suppose the Fed increases to . Calculate the new level of interest rate, equilibriumlevel of output, consumption, planned investment, and net exports.
c) (5 points) Considering the output, consumption, planned investment, and net exports all decreased, why might the Fed choose to increase ?
5) (20 points total) Classify each of the following as a supply or demand shock. Use a graph to
show the effects on inflation and output in the short run and the long run.
a) (5 points) Financial frictions increase.
b) (5 points) Households and firms become more optimistic about the economy.
c) (5 points) Favorable weather produces a record crop of wheat and corn in the Midwest.
d) (5 points) Steel workers go on strike for 4 weeks.
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