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Please use a word processor such as Microsoft Word, Apple Pages or OpenOffice for your answers. If you have trouble editing the graphs, you can also sketch them on paper, take pictures of them and then insert the pictures in your file. Please make sure that the graphs are readable. Also please also print your file to pdf and attach both files (e.g. the Word file and the pdf file, which is just a print of the Word file). PDF is more stable and readable independently from the source file.

 

1) Suppose that the Fed purchases from bank B some bonds in the open market and that, before the sale of bonds, bank B had no excess reserves.

a) Describe what initially happens to the reserves of bank B.

b) If bank B does not want to hold excess reserves, what will it do with the additional money received from the sale of bonds to the Fed?

c) Why do we expect, at least in usual times, that the amount of checking deposits in the economy will go up? Describe briefly the various “rounds” of this process.

d) Now suppose that minimum required reserve ratio for banks is 1/10. Also suppose that banks hold no excess reserves and that currency in circulation is unchanged from the purchase of bonds. If the Fed buys $20 billions of bonds from bank B, what will be the increase in checking deposits?

 

2) Describe in one or two sentences what the Fed funds rate is.

b) Suppose that, some years from now, the Fed funds rate is 4% and that you are considering buying a car. You also intend to finance the purchase with a loan. Suppose that the Fed increases the Fed funds rate to 4.5% by selling bonds on the open market. Financially, is this a good news for you or  not? Explain why.

3) a) Suppose that the face value of a 1-year bond is $100 and that no coupons are paid during the year. Suppose also that the price of the bond is $96. What is the yield of this bond approximately?

b) Suppose that the face value of a 1-year bond is $100 and that no coupons are paid during the year. Suppose also that the yearly yield of this bond is 5%. What is approximately the price of the bond?

c) Suppose that the face value of a 2-year bond is $100 and that no coupons are paid during the two years. Suppose also that the yearly yield of this bond is 5%. What is approximately the price of the bond?

d) In b) and c) above the two bonds have different maturity but identical yield. Why do we usually think that the bonds with longer maturities will give higher yields?

 

4) a) Suppose that AD is strong because of high consumers and business optimism. For this reason, unemployment is below NAIRU. Represents this situation using an AS/AD graph (do not forget to distinguish between SRAS and LRAS).

b) The Fed is concerned that this overheated economy will put pressure on prices and lead to a too high level of inflation. For this reason the Fed wants to engage in contractionary monetary policy, reducing AD, and so output, thereby increasing unemployment. What do you expect the Fed will do, sell Treasury bonds or buy Treasury bonds?

c) Represent on a graph the effect of the Fed’s policy on the Fed funds rate. The graph should have the Fed funds rate on the vertical axis and it should clearly distinguish the old and the new equilbrium value of the Fed funds rate.

d) Which components of AD does the Fed try to affect and how?

 

5) a) Draw a supply-demand diagram of the foreign exchange market for the dollar (valued in “euros”). Who demands dollars? Who supplies dollars?

b) If, in more usual economic times (rather than a deep recession), the Fed were to announce an increase in the Fed funds rate, what would you expect to happen to the value of the dollar? Show your answer on the graph and briefly explain it.

 

6) a) U.S. payroll taxes were reduced in 2003. This reduction was temporary and due to expire at the end of 2010. In 2010 Congress decided to extend these cuts for two years. One of the rationale for this was that increasing taxes would have deepened the economic difficulties of the country. Make sense of this argument using the AS/AD framework (you can also use a graph here but you do not need to).

b) In 2012 the Congress made these tax cuts permanent except for high incomes (more than $400,000 per year if single and more than $450,000 per year if married) whose taxes were increased. Explain why supply-siders would disagree with increasing the taxes on high-income individuals.

Please use a word processor such as Microsoft Word, Apple Pages or OpenOffice for your answers. If you have trouble editing the graphs, you can also sketch them on paper, take pictures of them and then insert the pictures in your file. Please make sure that the graphs are readable. Also please also print your file to pdf and attach both files (e.g. the Word file and the pdf file, which is just a print of the Word file). PDF is more stable and readable independently from the source file.

 

1) Suppose that the Fed purchases from bank B some bonds in the open market and that, before the sale of bonds, bank B had no excess reserves.

a) Describe what initially happens to the reserves of bank B.

b) If bank B does not want to hold excess reserves, what will it do with the additional money received from the sale of bonds to the Fed?

c) Why do we expect, at least in usual times, that the amount of checking deposits in the economy will go up? Describe briefly the various “rounds” of this process.

d) Now suppose that minimum required reserve ratio for banks is 1/10. Also suppose that banks hold no excess reserves and that currency in circulation is unchanged from the purchase of bonds. If the Fed buys $20 billions of bonds from bank B, what will be the increase in checking deposits?

 

2) Describe in one or two sentences what the Fed funds rate is.

b) Suppose that, some years from now, the Fed funds rate is 4% and that you are considering buying a car. You also intend to finance the purchase with a loan. Suppose that the Fed increases the Fed funds rate to 4.5% by selling bonds on the open market. Financially, is this a good news for you or  not? Explain why.

3) a) Suppose that the face value of a 1-year bond is $100 and that no coupons are paid during the year. Suppose also that the price of the bond is $96. What is the yield of this bond approximately?

b) Suppose that the face value of a 1-year bond is $100 and that no coupons are paid during the year. Suppose also that the yearly yield of this bond is 5%. What is approximately the price of the bond?

c) Suppose that the face value of a 2-year bond is $100 and that no coupons are paid during the two years. Suppose also that the yearly yield of this bond is 5%. What is approximately the price of the bond?

d) In b) and c) above the two bonds have different maturity but identical yield. Why do we usually think that the bonds with longer maturities will give higher yields?

 

4) a) Suppose that AD is strong because of high consumers and business optimism. For this reason, unemployment is below NAIRU. Represents this situation using an AS/AD graph (do not forget to distinguish between SRAS and LRAS).

b) The Fed is concerned that this overheated economy will put pressure on prices and lead to a too high level of inflation. For this reason the Fed wants to engage in contractionary monetary policy, reducing AD, and so output, thereby increasing unemployment. What do you expect the Fed will do, sell Treasury bonds or buy Treasury bonds?

c) Represent on a graph the effect of the Fed’s policy on the Fed funds rate. The graph should have the Fed funds rate on the vertical axis and it should clearly distinguish the old and the new equilbrium value of the Fed funds rate.

d) Which components of AD does the Fed try to affect and how?

 

5) a) Draw a supply-demand diagram of the foreign exchange market for the dollar (valued in “euros”). Who demands dollars? Who supplies dollars?

b) If, in more usual economic times (rather than a deep recession), the Fed were to announce an increase in the Fed funds rate, what would you expect to happen to the value of the dollar? Show your answer on the graph and briefly explain it.

 

6) a) U.S. payroll taxes were reduced in 2003. This reduction was temporary and due to expire at the end of 2010. In 2010 Congress decided to extend these cuts for two years. One of the rationale for this was that increasing taxes would have deepened the economic difficulties of the country. Make sense of this argument using the AS/AD framework (you can also use a graph here but you do not need to).

b) In 2012 the Congress made these tax cuts permanent except for high incomes (more than $400,000 per year if single and more than $450,000 per year if married) whose taxes were increased. Explain why supply-siders would disagree with increasing the taxes on high-income individuals.

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1a) According xxxxxxx the Fed xxxxxxx requirements, all xxxxxxx xxxxxxx have xxxxxxx keep a xxxxxxx percentage of xxxxxxx public xxxxxxx xxxxxxx the form xxxxxxx government bonds xxxxxxx securities. These xxxxxxx as reserves xxxxxxx the liabilities xxxxxxx of the xxxxxxx xxxxxxx sheet. xxxxxxx this amount xxxxxxx funds, the xxxxxxx can xxxxxxx xxxxxxx balance of xxxxxxx public deposits xxxxxxx make loans xxxxxxx earn interest.

  xxxxxxx Fed purchases xxxxxxx bonds from xxxxxxx xxxxxxx it xxxxxxx additional reserve xxxxxxx the amount xxxxxxx by xxxxxxx xxxxxxx to the xxxxxxx Since, the xxxxxxx did not xxxxxxx any excess xxxxxxx earlier i.e. xxxxxxx had employed xxxxxxx xxxxxxx lendable xxxxxxx of the xxxxxxx in the xxxxxxx of xxxxxxx xxxxxxx will now xxxxxxx additional reserve xxxxxxx make loans xxxxxxx thereby earn xxxxxxx interest. Hence, xxxxxxx of bonds xxxxxxx xxxxxxx leads xxxxxxx creation of xxxxxxx reserves with xxxxxxx B.

 

1b) xxxxxxx xxxxxxx Fed purchases xxxxxxx from bank xxxxxxx it reduces xxxxxxx government securities xxxxxxx by bank xxxxxxx and simultaneously xxxxxxx xxxxxxx reserves. xxxxxxx the bank xxxxxxx no additional xxxxxxx previously, xxxxxxx xxxxxxx of bonds xxxxxxx Fed results xxxxxxx additional reserves. xxxxxxx the bank xxxxxxx not want xxxxxxx hold the xxxxxxx xxxxxxx it xxxxxxx use it xxxxxxx make loans xxxxxxx individuals xxxxxxx xxxxxxx and earn xxxxxxx interest. As xxxxxxx increase in xxxxxxx had been xxxxxxx to sale xxxxxxx bonds b xxxxxxx xxxxxxx and xxxxxxx through accumulation xxxxxxx public deposits, xxxxxxx bank xxxxxxx xxxxxxx be able xxxxxxx use the xxxxxxx amount of xxxxxxx bonds transaction xxxxxxx make loans. xxxxxxx the banks xxxxxxx xxxxxxx reserves xxxxxxx raising of xxxxxxx deposits then xxxxxxx would xxxxxxx xxxxxxx bound to xxxxxxx a certain xxxxxxx of the xxxxxxx deposits in xxxxxxx form of xxxxxxx lendable reserves.

 

1c) xxxxxxx xxxxxxx are xxxxxxx deposits in xxxxxxx institutions against xxxxxxx checks xxxxxxx xxxxxxx can be xxxxxxx When, Fed xxxxxxx bonds from xxxxxxx open market xxxxxxx it creates xxxxxxx cash with xxxxxxx xxxxxxx businesses, xxxxxxx and the xxxxxxx banks. These xxxxxxx small xxxxxxx xxxxxxx the local xxxxxxx then uses xxxxxxx additional cash xxxxxxx to add xxxxxxx their existing xxxxxxx deposits are xxxxxxx xxxxxxx new xxxxxxx deposits with xxxxxxx financial institutions. xxxxxxx action xxxxxxx xxxxxxx increase in xxxxxxx deposits of xxxxxxx financial institutions. xxxxxxx the deposits xxxxxxx the financial xxxxxxx increases, hence, xxxxxxx xxxxxxx create xxxxxxx reserves for xxxxxxx new deposits xxxxxxx the xxxxxxx xxxxxxx the deposits xxxxxxx be used xxxxxxx them to xxxxxxx loans to xxxxxxx or individuals. xxxxxxx purchase of xxxxxxx xxxxxxx the xxxxxxx market leads xxxxxxx creation of xxxxxxx supply xxxxxxx xxxxxxx market.

 

1d)

 

 

 

 

2a) Fed xxxxxxx rate is xxxxxxx rate at xxxxxxx the credit xxxxxxx financial institutions’ xxxxxxx fund to xxxxxxx xxxxxxx noted xxxxxxx institution overnight xxxxxxx order to xxxxxxx the xxxxxxx xxxxxxx requirement to xxxxxxx held at xxxxxxx federal accounts xxxxxxx such banks. xxxxxxx is the xxxxxxx rate of xxxxxxx xxxxxxx the xxxxxxx institutions as xxxxxxx represents the xxxxxxx of xxxxxxx xxxxxxx funds of xxxxxxx financial institutions.

 

2b) xxxxxxx fund rate xxxxxxx the primary xxxxxxx the base xxxxxxx as it xxxxxxx xxxxxxx cost xxxxxxx overnight funds xxxxxxx b a xxxxxxx institution xxxxxxx xxxxxxx cost of xxxxxxx is then xxxxxxx to the xxxxxxx made b xxxxxxx financial institutions xxxxxxx other smaller xxxxxxx xxxxxxx or xxxxxxx This rate xxxxxxx set b xxxxxxx Federal xxxxxxx xxxxxxx Committee as xxxxxxx form of xxxxxxx tool to xxxxxxx the money xxxxxxx in the xxxxxxx When the xxxxxxx xxxxxxx the xxxxxxx fund rate, xxxxxxx results in xxxxxxx cost xxxxxxx xxxxxxx for the xxxxxxx financial institutions. xxxxxxx an increase xxxxxxx 0.5% of xxxxxxx fed fund xxxxxxx increases the xxxxxxx xxxxxxx b xxxxxxx and it xxxxxxx transferred to xxxxxxx prevailing xxxxxxx xxxxxxx in the xxxxxxx So, increase xxxxxxx the fed xxxxxxx rate is xxxxxxx a bad xxxxxxx for individuals xxxxxxx xxxxxxx seeking xxxxxxx Face value xxxxxxx bond = xxxxxxx Price xxxxxxx xxxxxxx bond    = xxxxxxx Coupons                    = xxxxxxx the absence xxxxxxx coupon payments xxxxxxx formula for xxxxxxx price of xxxxxxx xxxxxxx is xxxxxxx follows:

Price of xxxxxxx = Face xxxxxxx (1+r) xxxxxxx xxxxxxx r= yield xxxxxxx maturity per xxxxxxx and t= xxxxxxx bond maturity xxxxxxx according the xxxxxxx problem:

96 = xxxxxxx xxxxxxx ^1

Or, xxxxxxx 4.17% app.

 

3b)  xxxxxxx value of xxxxxxx bond xxxxxxx xxxxxxx coupons = xxxxxxx tenure = xxxxxxx year; yearly xxxxxxx = 5%. xxxxxxx implies:

Price of xxxxxxx = Face xxxxxxx xxxxxxx ^t

  xxxxxxx r= yield xxxxxxx maturity per xxxxxxx and xxxxxxx xxxxxxx bond maturity xxxxxxx according the xxxxxxx problem:

Or, price xxxxxxx 100/ (1+.05) xxxxxxx = $05.24 xxxxxxx face value xxxxxxx xxxxxxx $100; xxxxxxx to maturity xxxxxxx 2; yearly xxxxxxx 5%; xxxxxxx xxxxxxx Price of xxxxxxx = Face xxxxxxx (1+r) ^t

  xxxxxxx r= yield xxxxxxx maturity per xxxxxxx and t= xxxxxxx xxxxxxx maturity xxxxxxx according the xxxxxxx problem:

Or, price xxxxxxx 100/ xxxxxxx xxxxxxx = $90.703 xxxxxxx Bonds with xxxxxxx maturities tend xxxxxxx have higher xxxxxxx as in xxxxxxx long run xxxxxxx xxxxxxx in xxxxxxx changes in xxxxxxx expectations associated xxxxxxx inflation xxxxxxx xxxxxxx rates are xxxxxxx as compared xxxxxxx short term. xxxxxxx expectations for xxxxxxx increase in xxxxxxx rates rise, xxxxxxx xxxxxxx in xxxxxxx increase in xxxxxxx interest rates. xxxxxxx rates xxxxxxx xxxxxxx prevailing rates xxxxxxx which the xxxxxxx are discounted xxxxxxx its cash xxxxxxx (it is xxxxxxx r in xxxxxxx xxxxxxx used xxxxxxx the above xxxxxxx Hence, an xxxxxxx in xxxxxxx xxxxxxx in the xxxxxxx run will xxxxxxx in increase xxxxxxx the yield xxxxxxx the bonds xxxxxxx decrease in xxxxxxx xxxxxxx of xxxxxxx as bond xxxxxxx are inversely xxxxxxx and xxxxxxx xxxxxxx run yield xxxxxxx is the xxxxxxx representation of xxxxxxx inflation/interest rate xxxxxxx at the xxxxxxx below

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http://tutor2u.net/economics/content/diagrams/nairu1.gif

 

4c)  xxxxxxx xxxxxxx of the xxxxxxx fund rate xxxxxxx determined through xxxxxxx demand for xxxxxxx b the xxxxxxx as fed xxxxxxx xxxxxxx is xxxxxxx cost of xxxxxxx funds by xxxxxxx institutions xxxxxxx xxxxxxx overnight basis. xxxxxxx Fed sells xxxxxxx bonds in xxxxxxx open market, xxxxxxx small businesses, xxxxxxx and oublic xxxxxxx xxxxxxx their xxxxxxx portion of xxxxxxx from the xxxxxxx which xxxxxxx xxxxxxx use in xxxxxxx the bonds. xxxxxxx will in xxxxxxx cause the xxxxxxx to either xxxxxxx the public xxxxxxx xxxxxxx reserves xxxxxxx b calling xxxxxxx and principal xxxxxxx loans xxxxxxx xxxxxxx shortage of xxxxxxx for the xxxxxxx Thus demand xxxxxxx reserves will xxxxxxx created b xxxxxxx banks who xxxxxxx xxxxxxx more xxxxxxx to maintain xxxxxxx reserve requirements xxxxxxx such xxxxxxx xxxxxxx push the xxxxxxx fund rate xxxxxxx creating a xxxxxxx fed fund xxxxxxx equilibrium. As xxxxxxx in the xxxxxxx xxxxxxx the xxxxxxx for reserve xxxxxxx increase from xxxxxxx 1 xxxxxxx xxxxxxx rate i(ff) xxxxxxx a level xxxxxxx at interest xxxxxxx i2 (ff).

 

5b) xxxxxxx the fed xxxxxxx rate is xxxxxxx b xxxxxxx xxxxxxx the interest xxxxxxx in the xxxxxxx rises. Such xxxxxxx in the xxxxxxx arte in xxxxxxx US economy xxxxxxx xxxxxxx foreign xxxxxxx as their xxxxxxx would yield xxxxxxx returns xxxxxxx xxxxxxx interest rates. xxxxxxx demand for xxxxxxx will increase xxxxxxx the euro xxxxxxx dollar exchange xxxxxxx to increase. xxxxxxx xxxxxxx that xxxxxxx will strengthen xxxxxxx euro and xxxxxxx more xxxxxxx xxxxxxx be required xxxxxxx buy 1 xxxxxxx In the xxxxxxx graph, the xxxxxxx curve for xxxxxxx has shifted xxxxxxx xxxxxxx indicate xxxxxxx in demand xxxxxxx dollars in xxxxxxx European xxxxxxx xxxxxxx to increase xxxxxxx interest rates.

As seen xxxxxxx the above xxxxxxx the increase xxxxxxx xxxxxxx for xxxxxxx has made xxxxxxx demand curve xxxxxxx dollars xxxxxxx xxxxxxx from D0 xxxxxxx D1 and xxxxxxx the exchange xxxxxxx from P0 xxxxxxx P1 which xxxxxxx the new xxxxxxx xxxxxxx equilibrium.

6a) xxxxxxx reduction of xxxxxxx payroll taxes xxxxxxx the xxxxxxx xxxxxxx done to xxxxxxx people with xxxxxxx annual income xxxxxxx $50,000 per xxxxxxx to sustain xxxxxxx the recession xxxxxxx xxxxxxx an xxxxxxx in their xxxxxxx This provided xxxxxxx consumers xxxxxxx xxxxxxx funds during xxxxxxx recession and xxxxxxx them carry xxxxxxx consumption expenditures. xxxxxxx helped the xxxxxxx to reduce xxxxxxx xxxxxxx in xxxxxxx aggregate demand xxxxxxx the economy xxxxxxx helped xxxxxxx xxxxxxx loans to xxxxxxx their interest xxxxxxx debt. Repayment xxxxxxx interest and xxxxxxx infused money xxxxxxx the banking xxxxxxx xxxxxxx hence xxxxxxx the market. xxxxxxx lower taxes xxxxxxx in xxxxxxx xxxxxxx tax revenues xxxxxxx the government xxxxxxx the government xxxxxxx on the xxxxxxx security services xxxxxxx The lower xxxxxxx xxxxxxx also xxxxxxx lower taxes xxxxxxx b the xxxxxxx and xxxxxxx xxxxxxx in lower xxxxxxx costs. Lower xxxxxxx costs would xxxxxxx the employers xxxxxxx cut their xxxxxxx during recession xxxxxxx xxxxxxx the xxxxxxx from further xxxxxxx of unemployment. xxxxxxx would xxxxxxx xxxxxxx maintaining the xxxxxxx supply in xxxxxxx economy through xxxxxxx of workers. xxxxxxx reduction of xxxxxxx taxes by xxxxxxx xxxxxxx was xxxxxxx a view xxxxxxx stimulate demand xxxxxxx money xxxxxxx xxxxxxx the economy xxxxxxx on the xxxxxxx hand it xxxxxxx have saved xxxxxxx economy from xxxxxxx unemployment and xxxxxxx xxxxxxx Payroll xxxxxxx affect the xxxxxxx or moderate xxxxxxx groups xxxxxxx xxxxxxx form a xxxxxxx share of xxxxxxx salaries and xxxxxxx (as per xxxxxxx tax rates xxxxxxx on the xxxxxxx xxxxxxx and xxxxxxx limits). Hence, xxxxxxx taxes comprise xxxxxxx smaller xxxxxxx xxxxxxx the annual xxxxxxx of the xxxxxxx income level xxxxxxx Also, the xxxxxxx income level xxxxxxx earns their xxxxxxx xxxxxxx generally xxxxxxx higher share xxxxxxx profits and xxxxxxx gains, xxxxxxx xxxxxxx there are xxxxxxx payroll taxes xxxxxxx Hence, changes xxxxxxx the payroll xxxxxxx hardly impact xxxxxxx higher income xxxxxxx xxxxxxx

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