Homework Exercises 5

Chapter 10 problems
1. Unemployment us a bad thing, and the government should make every effort to eliminate it. Do you agree or disagree? Explain your answer. Disagree. Some unemployment is beneficial to the economy because the availability of vacant jobs makes it more likely that a worker will find the right job and that the employer will find the right worker for the job. 2. Which goals of the Fed frequently conflict? The goal of price stability often conflicts with the goal of high economic growth and employment and interest-rate stability. When the economy is expanding along with employment, inflation may rise. In order to pursue the goal of price stability, the Fed may have to pursue a contractionary and anti-inflationary policy that conflicts with the goal of high employment and economic growth. Similarly when the central bank wants to pursue tight monetary policy and raise interest rates in order to contain inflation, this pursuit of the goal of price stability may conflict with the goal of interest-rate stability. 3. If the demand for reserves did not fluctuate, the Fed could pursue both a non-borrowed reserves target and an interest-rate target at the same time. Is this statement true, false or uncertain? Explain your answer. True. In such a world, hitting a nonborrowed reserves target would mean that the Fed would also hit its interest rate target, or vice versa. Thus the Fed could pursue both a nonborrowed reserves target and an interest rate target at the same time. 4. Classify each of the following as either an operating target or an intermediate target, and explain why. a. The three-month Treasury bill rate. The three-month Treasury bill rate can be thought of as either an operating target or an intermediate target. It can be an operating target because it is a variable that can be affected directly by the tools of the Fed (open market operations, in particular). It can be an intermediate target because it has some direct effect on economic activity. b. The monetary base The monetary base is an operating target because it can be directly affected by the tools of the Fed and is only linked to economic activity through its effect on the money supply. c. M2 M2 is an intermediate target because it is not directly affected by the tools of the Fed and has some direct effect on economic activity.

5. Which procedures can the Fed use to control the three-month Treasury bill rate? Why does control of this interest rate imply that the Fed will lose control of the money supply? The Fed can control the interest rate on three-month Treasury bills by buying and selling them on the open market. When the bill rate rises above the target level, the Fed would buy bills, which would bid up their price and lower the interest rate to its target level. Similarly, when the bill rate falls below the target level, the Fed would sell bills to raise the interest rate to the target level. The resulting open market operations would of course affect the money supply and cause it to change. The Fed would be giving up control of the money supply to pursue an interest-rate target. 6. If the Fed has an interest-rate target, why will an increase in the demand for reserves lead to a rise in the money supply? The increase in the demand for reserves shifts the reserves demand curve to the right would raise interest rates. In order to prevent this, the Fed will buy bonds to increase the supply of reserves. The open market purchase will then cause the monetary base and the money supply to rise. 7. Interest rates can be measured more accurately and more quickly than the money supply. Hence an interest rate is preferred over the money supply as an intermediate target. Do you agree or disagree? Explain your answer. Disagree. Although nominal interest rates are measured more accurately and more quickly than the money supply, the interest rate variable that is of more concern to policymakers is the real interest rate. Because the measurement of real interest rates requires estimates of inflation, it is not true that real interest rates are necessarily measured more accurately and more quickly than the money supply. Interest-rate targets are therefore not necessarily better than money supply targets. 8. Compare the monetary base to M2 on the grounds of controllability and measurability. Which to do you prefer as an intermediate target? Why? The monetary base is more controllable than M2 because it is directly controlled by the tools of the Fed. It is measured more accurately and quickly than M2 because the Fed can calculate the base from its own balance sheet data, while it constructs M2 numbers from surveys of banks, which takes some time to collect and are not always that accurate. Even though the base is a better intermediate target on the grounds of measurability and controllability, it is not necessarily a better intermediate target because its link to economic activity may be weaker than that between M2 and economic activity. 9. Discounting is no longer needed because the presence of the FDIC eliminates the possibility of bank panics. Is this statement true, false or uncertain? Explain your answer. False. The FDIC would not be effective in eliminating bank panics without Fed discounting to troubled banks in order to keep bank

failures from spreading. In addition the FDIC only has approximately 1% of the total deposits in its insurance fund. Significant issues across banks might deplete this fund. Finally not all deposit accounts are insured. 10. The benefits of using Fed discount operations to prevent bank panics are straightforward. What are the costs? The costs are that banks that deserve to go out of business because of poor management may survive because of Fed discounting to prevent panics. This might lead to an inefficient banking system with many poorly run banks. 11. What are the benefits of using a nominal anchor for the conduct of monetary policy? A nominal anchor helps promote price stability by tying inflation expectations to low levels directly through its constraint on the value of money. It can also limit the time-inconsistency problem by providing an expected constraint on monetary policy. 12. Give an example of the time-inconsistency problem that you experience in your everyday life? All sorts of answers are possible 13. What incentives arise for a central bank to fall into the time-inconsistency trap of pursuing overly expansionary monetary policy? Central bankers might think they can boost output or lower unemployment by pursuing overly expansionary monetary policy even though in the long run this just leads to higher inflation and no gains on the output or unemployment front. Alternatively, politicians may pressure the central bank to pursue overly expansionary policies. 14. What are the advantages of monetary targeting as a strategy for the conduct of monetary policy? Monetary targeting has the advantage that it enables a central bank to adjust its monetary policy to cope with domestic considerations. Furthermore, information on whether the central bank is achieving its target is known almost immediately. 15. What is the big if necessary for the success of monetary targeting? Does the experience with monetary targeting suggest that the big if is a problem? Monetary targeting only works well if there is a reliable relationship between the monetary aggregate and inflation, a relationship that has often not held in different countries. 16. What methods have inflation-targeting central banks used to increase communication with the public and increase the transparency of monetary policy making? Inflation-targeting central banks engage in extensive public information campaigns that include the distribution of glossy brochures, the publication of Inflation Report-type documents, making speeches to the public, and continual communication with the elected government.

17. Why might inflation targeting increase support for the independence of the central bank to conduct monetary policy? Sustained success in the conduct of monetary policy as measured against a pre-announced and well-defined inflation target can be instrumental in building public support for a central banks independence and for its policies. Also, inflation targeting is consistent with democratic principles because the central bank is more accountable. 18. Because the public can see whether a central bank hits its monetary targets almost immediately, whereas it takes time before the public can see whether an inflation target is achieved, monetary targeting makes central banks more accountable than inflation targeting does. Is this statement true, false or uncertain? Explain your answer. Uncertain. If the relationship between monetary aggregates and the goal variablesay, inflationis unstable, then the signal provided by the monetary aggregates is not very useful and is not a good indicator of whether the stance of monetary policy is correct. 19. Because inflation targeting focuses on achieving the inflation target, it will lead to excessive output fluctuations. Is this statement true, false or uncertain? Explain your answer. False. Inflation targeting does not imply a sole focus on inflation. In practice, inflation targeters do worry about output fluctuations, and inflation targeting may even be able to reduce output fluctuations because it allows monetary policymakers to respond more aggressively to declines in demand because they dont have to worry that the resulting expansionary monetary policy will lead to a sharp rise in inflation expectations. 20. A central bank with a dual mandate will achieve lower unemployment than a central bank with a hierarchical mandate in which price stability takes precedence. Is this statement true, false or uncertain? False. There is no long-run trade-off between inflation and unemployment, so in the long run a central bank with a dual mandate that attempts to promote maximum employment by pursuing inflationary policies would have no more success at reducing unemployment than one whose primary goal is price stability.

Chapter 10 Quantitative Problems

1. Consider a bank policy to maintain 12% of deposits as reserves. The bank currently has $10m in deposits and $400,000 in excess reserves. What is the required reserve on a new deposit of $50,000? The bank policy is to maintain 12% of deposits as total reserves. The excess reserves of $400,000 is 4% of 10m. The total reserves is 12% which equals the required reserves plus the excess reserves. Thus the required reserves are 8%. Thus the required reserves on a $50,000 deposit is $4,000.

2. Estimates of unemployment for the upcoming year have been developed as follows. What is the expected unemployment rate? What is the standard deviation? Economy Probability Unemployment Rate (%) Bust .15 20 Average .5 10 Good .2 5 Boom .15 1 One can set up the problem as follows:
Economy Bust Average Good Boom Probability 0.15 0.5 0.2 0.15 Sum Unemployment Rate Expectation 20% 10% 5% 1% 0.03 0.05 0.01 0.0015 0.0915 Squared Deviation 0.001765838 0.000036125 0.000344450 0.000996338 0.00314275

Thus the expected unemployment rate is 9.15% and the standard deviation is the square root of the squared deviation or 5.6%. 3. The Federal Reserve wants to increase the supply of reserves, so it purchases 1m USD worth of bonds from the public. Show the effect of this open market operation using T-accounts.
Banking System Assets Reserves $1 million Liabilities Checkable Deposits $1 million

Federal Reserve System Assets Securities $1 million Reserves Liabilities $1 million

4. Use T-accounts to show the effect of the Federal Reserve being paid back a $500K discount loan from a bank.
Banking System Assets Reserves $500,000 Liabilities Discount Loans $500,000

Federal Reserve System Assets Discount Loans $500,000 Reserves Liabilities $500,000

5. The short-term nominal interest rate is 5%, with an expected inflation of 2%. Economists forecast that next years nominal rate will increase by 100 basis

points, but inflation will fall to 1.5%. What is the expected change in real interest rates? nominal rate = real rate + expected inflation Year 1: 5% = real rate + 2%, or the real rate = 3% Year 2: 6% = real rate + 1.5%, or the real rate = 4.5% Real rates have increased by 150 basis points. For problems 6-8 recall from introductory macroeconomics that the money multiplier = 1/(required reserve ratio). 6. If the required reserve ratio is 10%, how much a new $10,000 deposit can a bank lend? What is the potential impact on the money supply? The bank must retain $10,000 10%, or $1,000 of the new deposit. The remaining $9,000 can be lent to, for example, mortgage borrowers, commercial borrowers, etc. Since the reserve requirement is 10%, the potential money multiplier is 1/0.10 or 10. The $10,000 deposit can potentially increase the money supply by $100,000. 7. A bank currently holds $150,000 in excess reserves. If the current reserve requirement is 12.5%, how much could the money supply change? How could this happen? The money supply could increase if the bank lent its excess reserves. Since the reserve requirement is 12.5%, the potential money multiplier is 1/0.125, or 8. If the bank lends all of the excess reserves, the money supply could increase by $150,000 8 $1,200,000. 8. The trading desk at the Federal Reserve sold $100,000,000 in T-bills to the public. If the current reserve requirement is 8.0%, how much could the money supply change? Since the reserve requirement is 8.0%, the potential money multiplier is 1/0.08, or 12.5. The sale of T-bills will act to decrease the money supply. The contraction will be on the order of $100,000,000 12.5 = 1,250,000,000. However, if there are excess reserves in the system, it may not be this high.

Chapter 10 Additional Problems

1. Define Monetary Base, M1 and M2. The monetary base is all cash in circulation outside of the Federal Reserve plus bank reserves held at the Federal Reserve. M1 is a measure of money supply and includes all cash outside of the banking industry plus demand deposits/checking accounts/checkable deposits/reservable deposits. M2 = M1 + savings accounts + money market accounts + small size time deposits. 2. Assume Fred has $500 in cash and that this is the entire monetary base. Assume that the reserve requirement for banks is 5% and that reserves are taken on checking accounts but not money market accounts. a. What is the current level for M1 and M2? M1 and M2 are $500.

b. If Fred deposits the $500 into his checking account what happens to M1 and M2? What are the required reserves? How much of the cash can the bank leave in its own vault? M1 and M2 are unchanged at $500. The required reserves are $25. The bank can leave $475 in its vault. c. The bank where Fred has a checking account would like to extend a loan to another customer, Sue. How large a loan can the bank extend? After the loan what happens to the Monetary Base, M1 and M2? If the bank deposits the proceeds of the loan into Sues checking account what are the required reserves of the bank? The bank can lend $475 to Sue. The Monetary base will be unchanged at $500, M1 will be 975 and M2 will be 975. The required reserves will be $48.75 d. If both Fred and Sue want to withdraw their money at the same time this would cause a run on the bank. What options does the bank have? The bank can borrow cash from another bank. The bank can borrow reserves from another bank through the Fed Funds market. The bank can borrow from the Federal Reserve. The bank can sell the loan to another bank for cash. The bank can recall the loan from Sue. 3. If excess reserves have increased by 100,000 dollars and the required reserve ratio is 5% then what is the most that M1 can increase? 100,000/0.05 = 5,000,000 4. What is the money multiplier? The following graph shows the Monetary Base, M1 and M2. Given a reason that might explain why M1 and the Monetary Base lines crossed in 2008.
12000.0 10000.0 8000.0 6000.0 4000.0 2000.0 0.0 Jan-00
BASE M1 M2

Nov-01

Sep-03

Jul-05

May-07

Mar-09

Jan-11

Source: Federal Reserve Bank of St. Louis/Board of Governors of the Federal Reserve System/Board of Governors of the Federal Reserve System/FRED

The money multiplier is defined to be M1/MB. The lines crossed in 2008 when the federal reserve started making large scale asset

purchases and started paying interest on reserves. This meant that banks were incentivized to keep excess reserves at the Fed rather than lending them out. Another explanation is that even though the Fed was significantly increasing the Monetary Base banks were risk adverse and did not want to lend the excess out. 5. Using T-Accounts show the effect of the Fed reserve buying $1,000 of T-bills from the Fred and Fred depositing the proceeds into his checking account at Bank A. What effect will this have on reserves both required and excess (assume a reserve ratio of 10%)? What effect will this have on the Monetary Base, M1 and M2? We can assume that the Fed Reserve had nothing prior to purchasing the Tbills. We can also assume that the banking system had no assets or liabilities and Fred simply had one asset the T-bill. Thus the before state looks like
Fred Assets T-bill $1,000 Banking System Assets Reserves 0 Liabilities Discount Loans Federal Reserve System Assets Discount Loans Reserves Liabilities 0 Liabilities

After the purchase of the T-bill we have required reserves of 10% and excess reserves of 90%. The check that was deposited into Freds checking account is from the Federal Reserves so all proceeds are deposited into the banks reserve account. The monetary base, M1 and M2 were all zero to begin with. After the operation they all increase to $1,000.
Fred Assets Checking $1,000 Banking System Assets Req. Reserves $100 Checking Liabilities 1,000 Liabilities

Exc. Reserves

$900 Federal Reserve System

Assets T-bills Reserves

Liabilities

6. In the previous problem if Bank A already had excess reserves at the Fed would Bank A expect to be able to lend any additional excess reserves to Bank B at a higher or lower rate than the rate seen before the Feds open market operation? The Federal Reserve has increased the amount of excess reserves in the system. This will push the fed funds rate down so Bank A would have expected to be able to lend excess reserves to Bank B at a higher rate before the open market operation.