Question.105 - 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.
Answer Below:
1a) According to the Fed reserve requirements, all the banks have to keep a certain percentage of the public deposits in the form of government bonds and securities. These appear as reserves on the liabilities side of the bank’s balance sheet. Barring this amount of funds, the banks can use the balance of the public deposits to make loans and earn interest. When Fed purchases the bonds from bank B it creates additional reserve equaling the amount paid by the fed to the bank. Since, the bank did not have any excess reserves earlier i.e. it had employed all the lendable portion of the reserves in the form of loans; it will now have additional reserve to make loans and thereby earn additional interest. Hence, buying of bonds by Fed leads to creation of additional reserves with bank B. 1b) When the Fed purchases bonds from bank B, it reduces the government securities held by bank B and simultaneously increases its reserves. Since, the bank had no additional reserves previously, hence, selling of bonds to Fed results in additional reserves. As the bank does not want to hold the additional reserves, it will use it to make loans to individuals or businesses and earn more interest. As the increase in reserves had been due to sale of bonds b the bank and not through accumulation of public deposits, hence, bank B will be able to use the entire amount of the bonds transaction to make loans. If the banks increased its reserves through raising of public deposits then it would have been bound to keep a certain portion of the raised deposits in the form of non lendable reserves. 1c) Checkable deposits are those deposits in financial institutions against which checks or drafts can be written. When, Fed bus bonds from the open market then it creates additional cash with the small businesses, public and the local banks. These individuals, small businesses and the local banks then uses the additional cash balance to add to their existing checkable deposits are to create new checkable deposits with the financial institutions. Such action results in increase in the deposits of these financial institutions. Since, the deposits of the financial institution increases, hence, the will create additional reserves for the new deposits and the rest of the deposits will be used b them to make loans to businesses or individuals. Hence, purchase of bonds in the open market leads to creation of money supply in the market. 1d) 2a) Fed fund rate is the rate at which the credit worth financial institutions’ lend fund to other credit noted financial institution overnight in order to fulfill the mandatory reserve requirement to be held at the federal accounts of such banks. It is the base rate of interest for the financial institutions as it represents the cost of overnight borrowed funds of the financial institutions. 2b) Fed fund rate is the primary or the base rate as it represents the cost of overnight funds obtained b a financial institution and this cost of funds is then transferred to the loans made b these financial institutions to other smaller institutions, banks or individuals. This rate is set b the Federal Open Market Committee as a form of monetary tool to maintain the money supply in the economy. When the FOMC increases the fed fund rate, it results in higher cost of funds for the borrowing financial institutions. Hence, an increase of 0.5% of the fed fund rate increases the base rate b 0.5% and it gets transferred to the prevailing borrowing rate in the market. So, increase in the fed fund rate is financially a bad news for individuals or businesses seeking loan. 3a) Face value of bond = $100 Price of the bond = $96 Coupons = 0 In the absence of coupon payments the formula for the price of the bond is as follows: Price of bond = Face Value/ (1+r) ^t Where, r= yield to maturity per period and t= the bond maturity period Hence, according the given problem: 96 = 100/ (1+r) ^1 Or, r= 4.17% app. 3b) Face value of the bond = $100; coupons = 0; tenure = 1 year; yearly yield = 5%. This implies: Price of bond = Face Value/ (1+r) ^t Where, r= yield to maturity per period and t= the bond maturity period Hence, according the given problem: Or, price = 100/ (1+.05) ^1 = $05.24 app. 3c) face value of bond= $100; years to maturity = 2; yearly yield= 5%; coupon= 0. Price of bond = Face Value/ (1+r) ^t Where, r= yield to maturity per period and t= the bond maturity period Hence, according the given problem: Or, price = 100/ (1+.05) ^2 = $90.703 app. 3d) Bonds with longer maturities tend to have higher yield as in the long run the risk in the changes in the expectations associated with inflation and interest rates are higher as compared to short term. When expectations for an increase in inflation rates rise, it results in the increase in the interest rates. These rates are the prevailing rates at which the bonds are discounted for its cash flows (it is the r in our formula used in the above problems). Hence, an increase in interest rate in the long run will result in increase in the yield of the bonds and decrease in the prices of bonds as bond prices are inversely related and the long run yield curve is the graphical representation of the inflation/interest rate expectations. 4a) Look at the diagrams below In the above graph the aggregate demand has increased from AD1 to AD2 thereb increasing the price tp P3. This increase in the demand increases the employment level in the econom in the short run and the unemployment rate decreases lower than the non accelerating rate of unemployment which explains that with a stable rate of inflation, the unemployment rate will be consistent. But, in the short run when the increase in the aggregate demand has et not affected an increase in the wages, the unemployment rate falls below the NAIRU as depicted in the graph below. Here the unemployment rate has fallen to U2 from the non accelerating rate of unemployment of U1. In the long run however, the wages increases thereby leading to increase in the unemployment rate back to U1 but at higher wages. 4b) in order to carry out a contractionary monetary policy the Fed will have to reduce the money supply from the market which can be done b selling of treasury bonds in the open market. When Fed sells government bonds in the open market, it will suck out money from the market which will in turn increase the interest rates and thereby inflation. Such higher cost of funds will reduce the aggregate demand and higher inflation will bring back the unemployment rate back at the non accelerating rate of unemployment. Thus, fall of unemployment rate below NAIRU is for a short span until inflation rectifies this rate. 4c) The equilibrium of the fed fund rate is determined through the demand for reserve b the banks as fed fund rate is the cost of borrowing funds by financial institutions on an overnight basis. When Fed sells government bonds in the open market, the small businesses, individuals and oublic will withdraw their that portion of deposits from the banks which they would use in purchasing the bonds. This will in turn cause the banks to either pay the public from the reserves or b calling ineterest and principal on loans thereby creating shortage of reserves for the banks. Thus demand for reserves will be created b the banks who will borrow more and to maintain their reserve requirements and such action will push the fed fund rate higher, creating a new fed fund rate equilibrium. As shown in the graph below, the demand for reserve will increase from level 1 at interest rate i(ff) to a level higher at interest rate i2 (ff). 4d) The contractionary monetary policy adopted b Fed will reduce money supply from the economy which will increase the base rate and therefore the market interest rate in the market. Such increase in the interest rate will make the public demand less loans from the banks also; the inflation rate will increase thereby increasing the cost of consumption. Hence, higher interest rates will curtail the consumption expenditure which is the most important component of aggregate demand. 5a) The exchange rate between two currencies is determined b the supply-demand equilibrium for the currency in the foreign exchange market. The dollars will be demanded in Europe by people of that country who wants to purchase US goods, bonds, shares, real assets and etc. The supply of dollars will be provided by those people of the country who wish to but imported goods, US people who want to buy bonds, shares and other real assets/. As shown below D$ show demand for dollar and DS showed the supply of dollars in terms of Euro. The demand and supply line intersect at the rate of Euro0.89/dollar. 5b) when the fed funds rate is increased b the Fed, the interest rate in the economy rises. Such increase in the interest arte in the US economy will attract foreign investors as their investments would yield higher returns on higher interest rates. Hence, demand for dollar will increase causing the euro per dollar exchange rate to increase. This implies that dollar will strengthen against euro and now more Euros will be required to buy 1 dollar. In the provided graph, the demand curve for dollar has shifted right to indicate increase in demand for dollars in the European market due to increase in interest rates. As seen in the above graph, the increase in demand for dollars has made the demand curve for dollars to shift from D0 to D1 and shifting the exchange rate from P0 to P1 which is the new exchange rate equilibrium. 6a) The reduction of the payroll taxes during the recession was done to help people with lower annual income of $50,000 per annum to sustain during the recession leading to an increase in their salary. This provided the consumers with additional funds during the recession and helped them carry out consumption expenditures. This helped the economy to reduce the decline in the aggregate demand in the economy and helped defaulters of loans to pay their interest and debt. Repayment of interest and debt infused money in the banking system and hence in the market. However, lower taxes resulted in loss of tax revenues for the government and the government spending on the social security services increased. The lower payroll tax also implies lower taxes paid b the employer and thereby resulting in lower wage costs. Lower wage costs would help the employers to cut their expenses during recession and save the economy from further threats of unemployment. This would result in maintaining the aggregate supply in the economy through retaining of workers. Hence, reduction of payroll taxes by the government was with a view to stimulate demand and money supply in the economy while on the other hand it would have saved the economy from further unemployment and reduced supply. 6b) Payroll taxes affect the lower or moderate income groups as the form a major share of their salaries and wages (as per the tax rates levied on the various wages and salary limits). Hence, such taxes comprise a smaller portion of the annual income of the higher income level groups. Also, the higher income level group earns their high income generally from higher share of profits and capital gains, over which there are no payroll taxes levied. Hence, changes in the payroll taxes hardly impact the higher income level group.More Articles From Economics
.ico)
.ico)
.ico)
.ico)
