Exam 2 –Econ 304 – Chuderewicz – Spring 2017
Name ______ABBREVIATED _KEY______Last 4 (PSU ID) ______
Section: Please Check:
Section 001 - 010Sparks10:10 am ______
Section 002 - 121Sparks 11:15am ______
PLEASE PUT THE FIRST TWO LETTERS OF YOUR LAST NAME ON TOP RIGHT HAND CORNER OF THIS COVER SHEET – ONLY NON-PROGRAMMABLE CALCULATORS ALLOWED. THANKS AND GOOD LUCK!!!
Total Points for exam = 240
Test time = 120 minutes
One minute for every two points
To help with time management if spreading time evenly
Question #1 = 25 points.....12 minutes
Question #2 =30 points ...... 15 minutes
Question #3 = 40 points.... 20 minutes
Question #4 = 45 points ...22minutes
Question #5 = 30 points..... 15 minutes
Question #6 = 30 points.... 15 minutes
Question #7 = 40 points ...20 minutes
Please answer all questions. You must show all work or points will be taken off.
1.(25 points) Suppose you are the manager the trading desk back when the fed was in the old system of targeting the federal finds rate. It is morning and your staff estimates reserve demand to be
Rf = 75 - 5 iff and the target for the funds rate is 3% (use 3 in calculations)
assuming you have perfect control over the amount reserves.
a)(5 points) How many reserves are needed to hit the target established by the FOMC (all numbers are in $ billion)?
SET RS = RD ...... RS = 75 - 5 (3) ..... RS = 60
b)(5 points) How do you control the amount of reserves in the system? Be specific. Who do you deal with?
OMO - THE BUYING AND SELLING OF GS - WE (THE FRBNY) DEALS WITH PRIMARY DEALERS
In the space below, draw a graph of the reserve market and label this as point A.
10 points for correct and completely labeled graph
The next morning, your staff realizes that a shock occurred overnight and they now estimate reserve demand to be:
Rf = 70 - 5 iff and the target for the funds rate is still 3%
c) (5 points) What do you instruct the desk (the traders) to do and how would they do it? Depict this new point as point B.
RS = 70 - 5 (3) ..... RS = 55
CONDUCT 5 BILLION IN OPEN MARKET SALES
2.(30 points total)
a) (10 points) Why did the Fed need to create the reverse repo (RRP) facility exactly? Why does it play such an important role in the conduct of monetary policy?
b) (10 points) You were studying with a friend and you were discussing the Ben Bernanke with the fire hose full of reserves analogy. Your friend was arguing that the retention pond that collects all, or pretty much all the excess reserves that the Bernanke Fed injected into the economy (through 3 rounds of quantitative easing) was equivalent to the reverse repo facility. That is, the reverse repo facility was created to capture these excess reserves. Was your friend right or wrong? If wrong, please correct him/her.
c)(10 points) Right now, the cap on the reverse repo facility is $ 2 Trillion dollars. Suppose the Fed is considering lowering the cap. what are the advantages and disadvantage (pros and cons) of lowering the cap?
3. (40 points) Use the graphic below (from an MP4) to answer the following questions.
a) (10 points) In the graphic we see "Sold 320b." What did the Fed sell and why did they sell it, and who did they sell it to?
THE FED SOLD GS, $320B TO PRIMARY DEALERS VIA OPEN MARKET OPERATIONS. THE FED SOLD THESE GS TO STERILIZE (OFFSET) OTHER OPERATIONS SUCH AS DIRECT BANK LENDING THAT INCREASED THE AMOUNT OF RESERVES IN THE SYSTEM .....SO THE RESERVE SUPPLY REMAINED CONSTANT SO THE FEDERAL FUNDS RATE STAYED AT IT'S TARGET
b) (10 points for filling in T-accounts below and 10 points for explanation) Using the T-accounts below, show how the Fed's and Dealers #1 and #2 balance sheet changed when they sold 320b. Assume they lent to dealer #1 (direct bank lending) and sold to Dealer #2. What has happened to the Fed's balance sheet with regard to size and composition?
write your explanation below:
c)(10 points) In the graphic, we see 1.77 Trillion. Where did the 1.77 Trillion come from, what was it used for, and where did in eventually end up and why?
4. (45 points) Using the graphic below, answer the following questions:
a)(10 points) The graphic above shows what happened to the federal funds rate between Wednesday March 15 and Thursday, March 16, 2017. Explain why the federal funds rate was .66% on Wednesday, March 15. Be sure to explain exactly what determines the precise value of the federal funds rate. (more space for your answer on next page)
b)(10 points) Suppose that you were in charge of writing the statement and the implementation note that was released at 2 pm Wednesday, March 15, 2017. In the space below write the portion of the statement that would tell the public about the change in monetary policy starting with....(you should mention 3 different interest rates)..Today, the FOMC decided to.....
c)(10 points) Now explain why the federal funds rate changed the way it did. Why would we expect this jump to be immediate? Make sure you use the word arbitrage in your answer and explain exactly what is happening in the federal funds market. Refer to the trading desk at the NY Fed (with the phones on it).
d) )(10 points) Now draw a graph of the this development with interest rates on the vertical axis and time on the horizontal axis. Just include the data for this particular week only (from March 13 - March 17).
e) (5 points) What has happened to the cost of arbitrage before and after the Fed made their move?
THE COST OF ARBITRAGE STAYED STEADY AT 9 BASIS POINTS (.09%)
5. (30 points) We discussed the quantity of money and the fact that money growth used to be used by the Fed as an intermediate target.
a)(10 points) Write down the quantity theory of money in percent change form with the assumption that the velocity of money is constant (same as in class). Why is it reasonable, under these conditions, to use money growth as an intermediate target? What should the growth rate of money be and why?
%ΔM + %ΔV = %ΔP + %ΔY
if V is constant (%Δ = 0) then
%ΔM = %ΔP + %ΔY
%ΔP is inflation and we want it to be 2%
%ΔY is real GDP growth and we want it somewhere around 3%
So let the money supply grow at 5% - this will satisfy dual mandate
b)(10 points) What are the characteristics of a good intermediate target? - feel free to use the diagram that we drew in class to help with your explanation.
THE FED MUST HAVE GOOD AND RELIABLE CONTROL OVER THE INTERMEDIATE TARGET (IT)
THE INTERMEDIATE TARGET MUST SHARE A CLOSE AND RELIABLE RELATIONSHIP WITH THE FED'S ULTIMATE OBJECTIVES (INFLATION AND REAL OUTPUT)
c)(10 points) Explain why the Fed abandoned using money as an intermediate target.
THEY LOST CONTROL OVER MONEY GROWTH - MAINLY DUE TO FINANCIAL INNOVATIONS
THE CONNECTION BETWEEN MONEY GROWTH AND THE FED'S ULTIMATE OBJECTIVES BROKE DOWN
6. (30 points) We introduced a model of aggregate demand and discussed some of foundations of the model.
We started with the following specification of the consumption function:
a) (5 points) What are the components underlying ?
a (wealth), af (expected wealth), yf (expected wealth), CC (consumer confidence)
b)(10 points) We discussed the sensitivity of consumption to changes in wealth where we broke wealth into two components: stock market wealth (WSM) and real estate wealth (WRE). Which form of wealth is consumption more sensitive to and why?
CONSUMPTION IS MORE SENSITIVE TO CHANGES IN REAL ESTATE WEALTH SINCE CHANGES IN REAL ESTATE WEALTH ARE PERCEIVED TO BE MORE PERMANENT THAN CHANGES IN STOCK MARKET WEALTH
c) (5 points) Given the Great Recession, do you think the difference in this sensitivity of consumption to these two forms of wealth got wider or narrower and why?
SINCE THE GREAT RECESSION WAS CAUSED IN PART BY HOUSING PRICES PLUMMETING (THE BUBBLE BROKE), WE WOULD THINK THAT THE DIFFERENCE WOULD NARROW....REAL ESTATE WEALTH IS NOT AS STABLE AS WE THOUGHT IT WAS.
d)(10 points) We also discussed the sensitivity of consumption to changes in r as is measured form the parameter c (at the end of consumption function). What determines the value of c and why is this value so important?
SAVERS AND BORROWERS - RECALL, SAVERS LIKE DAGWOOD CONSUME MORE WHEN RATES RISE AND CONSUME LESS WHEN RATES FALL
BORROWERS ON THE OTHER HAND CONSUME LESS WHEN RATES RISE AND MORE WHEN RATES FALL
THIS BLEND OF SAVERS AND BORROWERS SUGGEST THE PARAMETER c WOULD BE SMALL.....
THIS VALUE IS SO IMPORTANT BECAUSE IT MEASURES HOW SENSITIVE CONSUMPTION (70% OF THE ECONOMY) IS TO CHANGES IN r....ie., IT MEASURESHOW POWERFUL MONETARY POLICY IS WITH REGARD TO INFLUENCING CONSUMPTION.
7) (40 points) Problem:
The IS curve is given by: Y = 18 - r
The MP curve is given by: MP = 1 + .5π
a) (5 points) Solve for the AD curve.
Y = 18 - [1 + .5π]
Y = 17 - .5π
In the space below, draw the MP curve, the IS curve, and the AD curve labeling as point A, where inflation is 2% and point B, where inflation is 3%. Be sure to label all the axes.
15 points for completely labeled graphs
Suppose the IS curve changes and is now: Y = 17 -r
b) (10 points) Name 3 reasons why the IS curve would change the way it did.
ANY 3
FROM C(BAR) FALL IN a, af, yf, CC.... also rise in T(bar)
FROM I(BAR) A RISE IN Pk, tau (τ), a fall in ITC, A or AS, ...also, higher financial frictions (f)
A FALL IN G(BAR) OR NX (BAR)
Update your graphs above account for the IS shock - label as point C, where inflation is 2%.
c)(10 points) What determines the slope of the IS curve and was is the slope of the IS curve so important from a policy perspective?
THE SENSITIVITY OF CONSUMPTION TO CHANGES IN r (c)
THE SENSITIVITY OF INVESTMENT TO CHANGES IN r (d)
THE SENSITIVITY OF NET EXPORTS TO CHANGES IN r (x)
THE SLOPE OF THE IS CURVE DETERMINES THE POWER OF MONETARY POLICY....THE FLATTER, THE MORE POWERFUL -
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