03 Jun Question Part 1: 70 points total 1) (25 points total) We are going back to the fall of 1998, back in the ‘midst’ of the new economy.
Question
Part 1: 70 points total
1) (25 points total) We are going back to the fall of 1998, back in the ‘midst’ of the new economy.
The Us economy weathered the E. Asian quite well and the US economy , by almost all accounts,
was performing brilliantly. In August of 1998, Russian defaulted on all the debt held by foreign
investors. This "shock" rattled financial markets so much that the Fed went into action and
lowered short term interest rates 3 times in a seven week period. In what follows, we are going to
model this 7 weeks period using our new acquired reserve demand / reserve supply diagram.
In order to do this problem correctly, we need to go back to 1998 and ‘fetch’ the three relevant
FOMC statements. To help you along, I provide the links for you below.
Statements (1998) September 29 October 15 November 17
Note importantly, we are modeling the behavior of the federal funds rate during this period. The
forecasted reserve demand at this time is given below. For simplicity, this reserve demand
function is stable (constant) throughout this exercise.
Rd = 900 – 100 iff
a) (10 points for correct and completely labeled diagram) In the space below, draw a
reserve demand / reserve supply diagram depicting as point A, the conditions before the
FOMC meeting in September, 1998. Note, you need to use the prevailing federal funds
target and solve for the appropriate reserve supply. You will be adding points B, C, and D
to this diagram.
b) (5 points) Now show as point B, the conditions shortly after the FOMC meeting on
September 29, 1998. Please show work.
c) (5 points) Explain exactly how the Fed (the FOMC in Washington DC) changes
conditions in the federal funds market. Be sure to refer this particular case, the movement
from point A to point B.
Now add to your diagram as point C, the conditions in the federal funds market shortly
after the statement in October and point D, the conditions in the federal funds market
following the FOMC meeting in November (the points for this part are included in the
points for the complete and correctly labeled diagram.
d) (5 points) Now label points B, C, and on the diagram below.
2) (45 points total) In this problem, we are going to use the money market to model two real world
events:
i) a portfolio shock to money demand and ii) a shock to the money multiplier.
Suppose you have the following information:
Original money demand function:
Md = P X [ 200 + .5 Y – 200 i]
where P = 1 (P remains constant in this problem), Y = 1600, M s = 600, MB = 400 MM=1.5
a) (5 points) Solve for the nominal interest rate ( i ) that clears the money market.
b) (10 points for correct and completely labeled diagram) In the space below, draw a money
demand / money supply diagram depicting these initial conditions.
c) (5 points) We now experience a portfolio shock to money demand so that the new money
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