Chapter 12 - Monetary Policy and the Federal Reserve

CHAPTER 12 MONETARY POLICY AND THE FEDERAL RESERVE

Answers to Review Questions
1. In no particular order: A higher real interest rate increases the reward for saving; if people save more in response to a higher real interest rate, than they are necessarily consuming less. A higher real interest rate makes it more costly to finance consumer durables and housing, reducing spending on those items. Firms will purchase fewer new capital goods when the real interest rate is high because the cost of borrowing (or the opportunity cost of retained earnings) used to finance capital goods purchases is high. Thus a higher real interest rate is likely to reduce both consumption and investment spending, both of which are components of planned aggregate expenditures. Learning Objective: 12-02 AACSB: Analytic Blooms: Understand

2. The Fed is likely to respond to a recessionary gap with an expansionary monetary policy intended to stimulate planned aggregate expenditure. The first step is an openmarket purchase of government bonds, which puts additional money into circulation and lowers the nominal interest rate. The lower nominal interest rate results in a lower real interest rate in the short run since inflation is slow to change. The lower real interest rate stimulates both consumption and investment spending, leading to an increase in planned aggregate expenditure. Finally, the increase in planned aggregate expenditure raises short-run equilibrium output since output equals planned aggregate expenditure in the short run. Learning Objective: 12-02 AACSB: Analytic Blooms: Analyze

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Chapter 12 - Monetary Policy and the Federal Reserve

3. If the Federal Reserve takes a contractionary policy action (such as an open-market sale of government bonds), we would expect the Federal Reserve to raise nominal (and therefore real interest rates in the short run) by reducing the money supply. An increase in the real interest rate will reduce autonomous expenditures in the economy, leading to a reduction in short-run equilibrium output. The Fed would most likely undertake such a policy in order to bring the economy back to full employment when it was experiencing an expansionary gap. Learning Objective: 12-02, 12-03 AACSB: Analytic Blooms: Analyze

4. Equilibrium in the market for money is shown in Figure 23.6. The nominal interest rate is determined at the intersection of the downward-sloping demand for money curve and the vertical supply curve for money (as established by the Fed). The Fed can affect the nominal interest rate by changing the supply of money and thus shifting the supply curve of money (see Figure 23.7.) An increase in the supply of money shifts the vertical supply curve for money to the right, lowering the nominal interest rate, while a reduction in the money supply shifts the supply curve to the left and raises the nominal interest rate. The real interest rate is the nominal interest rate minus the rate of inflation; this is the Fisher effect we discussed in Chapter 17. Because the rate of inflation adjusts relatively slowly, the Fed can control the real interest rate in the short run. However, in the long run the Fed cannot control the real interest rate; rather, in the long run the real interest rate is determined by the equality of saving and investment (see Figure 19.7.) Learning Objective: 12-04 AACSB: Analytic Blooms: Analyze

5. In an open-market purchase of bonds, the Fed uses newly created money to buy government bonds from the public. This action lowers the nominal interest rate, as can be seen in two ways: First, the purchase of bonds raises the demand for and hence the price of bonds. Since bond prices are inversely related to nominal interest rates, an increase in bond prices is equivalent to a decline in interest rates. Second, an increase in the money supply shifts the money supply curve to the right, lowering the nominal interest rate that clears the market for money. In economic terms, people are willing to hold more money only if the opportunity cost of doing so which is the nominal interest rate declines.

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Chapter 12 - Monetary Policy and the Federal Reserve

Learning Objective: 12-04 AACSB: Analytic Blooms: Analyze

Answers to Problems
1. The Federal Reserve is a government agency; it cannot make a profit. The Fed focuses on promoting public goals such as economic growth, low inflation, and the smooth operation of financial markets. The Fed also has the power to control and regulate banks in order to prevent bank panics, while also having the power to make Learning Objective: 12-01 AACSB: Reflective Thinking Blooms: Remember

2. Adding monetary policy to the basic Keynesian model: a. Planned aggregate expenditure (PAE) is given by

PAE C I p G NX PAE [2600 .8(Y 3000) 10,000r ] (2000 10,000r ) 1800 0 PAE 4000 20,000r .8Y
Since r =0.10, then

PAE 2000 .8Y

b. Algebraically, short-run equilibrium occurs where Y = PAE:

Y 2000 .8Y 0.2Y 2000 Y 10,000

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Chapter 12 - Monetary Policy and the Federal Reserve

The equilibrium short-run output level is 10,000. In table form, Output (Y) 9,500 9,600 9,700 9,800 9,900 10,000 10,100 10,200 Planned Aggregate Expenditure (PAE) 9,600 9,680 9,760 9,840 9,920 10,000 10,080 10,160

Y-PAE -100 -80 -60 -40 -20 0 20 40

From the table, short-run equilibrium output is also 10,000 since this is the only output level where Y = PAE. c. The figure below illustrates this equilibrium graphically (note that the axes begin with 9500, not 0, in this figure).

Learning Objective: 12-02 AACSB: Analytic Blooms: Apply

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Chapter 12 - Monetary Policy and the Federal Reserve

3. a. The economy is currently experiencing a recessionary gap, since Y = 10,000 < Y* = 12,000. To determine the real interest rate that the Federal Reserve should set to bring the economy to equilibrium at full employment (Y*), note that in equilibrium, Y = PAE. We can therefore use the equilibrium condition, Y = PAE, along with the expenditure line to fine the interest rate the Fed should choose. First, substitute Y* = 12,000 for Y in this equilibrium condition, we have Y* = PAE or 12,000 = PAE. Second, we showed in problem 1 that PAE is given by:
PAE 4000 20,000r .8Y

So, when Y = Y* = 12,000,

12,000 4000 20,000r .8(12,000) 12,000 13,600 20,000r 1,600 r 0.08 20,000

Thus, the Fed needs to lower the real interest rate from 10% to 8% to bring the economy to equilibrium at full employment. Alternately, we can use the multiplier and the PAE expression to solve this problem. First, note that to bring the economy to equilibrium at full employment, output must rise by 2,000 from its current level of 10,000 (from Problem 1). With a multiplier of 5, this means that autonomous planned aggregate expenditures (PAE) must rise by 400 (2,000/5). To increase autonomous expenditures, the Federal Reserve must reduce the real interest rate. But, by how much should the Fed cut the real interest rate? The PAE expression indicates that for each 1% drop in interest rates, PAE will increase by 200. Thus, to raise PAE by 400, the Fed will need to reduce real interest rates by 2%, from 10% to 8%. b. In this case the economy is experiencing an expansionary gap, so output must fall by 1,000 to bring the economy to equilibrium at full employment. With a multiplier of 5, this means that PAE must fall by 200. To reduce autonomous expenditures, the Federal Reserve must raise the real interest rate. The PAE expression indicates that for each 1% rise in interest rates, PAE will fall by 200. Thus, to reduce PAE by 200, the Fed will need to raise real interest rates by 1%, from 10% to 11%. You can verify this by plugging r =0.11 into the PAE expression to find that PAE = 9,000.

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Chapter 12 - Monetary Policy and the Federal Reserve

c. When the real interest rate, r, equals 0.08 (8%) and Y = Y* = 12,000,
C 2600 .8(12 ,000 3000 ) 10 ,000 (0.08 ) 9000 I p 2000 10 ,000 (0.08 ) 1200 S Y * C G 12 ,000 9,000 1,800 1200

National saving equals planned investment when the economy is in equilibrium at potential output, consistent with equilibrium in the market for saving. Learning Objective: 12-02 AACSB: Analytic Blooms: Apply

4. Closing the output gap: a. Planned aggregate expenditure (PAE) is given by

PAE C I p G NX PAE [14,400 .5(Y 8000) 40,000r ] (8000 20,000r ) 7800 1800 PAE 28,000 60,000r .5Y
b. To determine the real interest rate that the Federal Reserve should set to bring the economy to equilibrium at full employment, Y*. We need to find the real interest rate at which PAE = Y*. Substituting Y* = 40,000 in this expression, we have 40,000 = PAE. Thus: 40,000 28,000 60,000r .5(40,000) 40,000 48,000 60,000r 8,000 60,000r 8,000 r 0.133 60,000 The Fed therefore needs to set the real interest rate equal to 13.3% to bring the economy to equilibrium at full employment. Learning Objective: 12-02 AACSB: Analytic Blooms: Apply

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Chapter 12 - Monetary Policy and the Federal Reserve

5. Understanding shifts in money demand: a. The money demand curve shifts to the right, as people demand more money for transactions purposes. b. If the Fed took no action, money supply would remain unchanged and the nominal interest rate would rise. c. During the Christmas season, the Fed provides increases in the money supply in order to accommodate increased shopping needs without an increase in the interest rate. Diagrammatically, the vertical money supply curve is shifted to the right enough to just offset the effect of the rightward demand shift on the nominal interest rate. Learning Objective: 12-03 AACSB: Analytic Blooms: Apply

6. Money demand and the benefits of holding money: Here is a table that shows Umas average money holdings and the extra benefit of holding money: Average money Total Extra holdings benefit benefit $500 $35 --$600 $47 $12 $700 $57 $10 $800 $65 $8 $900 $71 $6 $1,000 $75 $4 $1,100 $77 $2 $1,200 $77 0 Uma should compare the extra benefits from increasing her money holdings to her opportunity cost of holding more money, and increase her money holdings as long as the benefit of doing so exceeds the cost. The cost of holding an extra $100 is the interest that she could have earned in some alternative financial investment. So if the nominal interest rate is 9%, the cost of holding an extra $100 is 9% of $100, or $9 per year. The extra benefit of moving from $600 to $700 in money holdings exceeds $9 (see the table), but the extra benefit of moving from $700 to $800 in money is less than the cost. Thus, if the interest rate is 9%, Uma should hold $700. Similarly, if the interest rate is 5%, the cost of holding an additional $100 is $5, and Uma should hold $900 in money. Finally, at an interest rate of 3%, the cost of each extra $100 in money is $3, and extra benefits exceed costs up to a holding of $1000.

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Chapter 12 - Monetary Policy and the Federal Reserve

Learning Objective: 12-03 AACSB: Analytic Blooms: Apply

7. a. Lower commission charges reduce the cost of converting non-money assets, such as stocks and bonds, into money. People will tend to hold less money, knowing that it is relatively cheap to sell other assets to obtain money as needed to make transactions, so the economy-wide demand for money will decline (demand shifts left). b. People will start to charge their groceries instead of using money (cash or check). A checking balance is still necessary in order to pay the credit card bill at the end of the month, but the overall effect is likely to be to reduce the amount of money people need to hold on average over the month. The demand for money will therefore be lower than it was before grocery stores started accepting charge cards. c. If stocks become more risky, people will demand relatively more safe assets, money among them. The demand for money therefore will increase (demand shifts right). d. As in part a, if people can conveniently and cheaply convert non-money assets into money as needed for transactions, they will hold less money on average and the demand for money will decline. e. A boom period will lead to increased levels of GDP. An increase in GDP increases the demand for money. f. If citizens of a developing nation are worried about inflation or even confiscation of their domestic assets, they will probably choose to hold their wealth in the form of U.S. currency or bank deposits in U.S. banks. This will cause the total demand for U.S. money (including overseas demand) to increase. Learning Objective: 12-03 AACSB: Analytic Blooms: Analyze 8. How do the scenarios in problem 7 affect nominal interest rates? a. Assuming that the Fed does not change the money supply in response to the shift in money demand: i. The decline in money demand will cause the nominal interest rate to fall. ii. The decline in money demand will cause the nominal interest rate to fall. iii. The increase in money demand will cause the nominal interest rate to rise. iv. The decline in the demand for money will cause the nominal interest rate to fall. v. The increase in money demand will cause the nominal interest rate to rise. vi. The increase in money demand will cause the nominal interest rate to rise.

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Chapter 12 - Monetary Policy and the Federal Reserve

b. In order to keep the nominal interest from changing, the Fed needs to meet all instances of declines (shift to the left) in the demand for money with a reduction (shift to the left) in the supply for money. Likewise, should all instances of increased demand for money be met with an increase in the supply for money? Learning Objective: 12-03, 12-04 AACSB: Analytic Blooms: Analyze

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