ISL244E MacroeconomicsProblem Session-4

byResearch Assistant Serkan Değirmenci (Ph.D. Candidate)

D202/05-07.03.2012

Today

• GNH (2009), Macroeconomics in Context- Chapter 11: Money and Monetary Policy

Review Questions (RQ): 5-6-7-8-9-10-11 (Page: 284-285)

Exercises (E): 9 (Page: 286-287)

Chapter 11: RQ-5 (Page: 284)• Draw up and explain the components of a

balance sheet for a private bank.• ANSWER: (Textbook: p. 265)

See Table 11.1.

Chapter 11: RQ-6 (Page: 284)• Draw up and explain the components of the

balance sheet of the Federal Reserve.• ANSWER: (Textbook: p. 267)

See Table 11.2.

Chapter 11: RQ-7 (Page: 284)• Show what happens to the Fed's balance

sheet and the balance sheet of a bank, when the bank sells bonds to the Fed.

• ANSWER: (Textbook: p. 268) See Table 11.3.

Chapter 11: RQ-8 (Page: 284)• Describe how a Fed open market purchase

leads to a sequence of loans and deposits, and thus a multiplier effect.

• ANSWER: (Textbook: p. 268-269)See Table 11.4 and related discussion.

Chapter 11: RQ-9 (Page: 284)• Describe two tools the Fed can use to affect

the money supply, other than open market operations.

• ANSWER: (Textbook: p. 269-270)Changes in required reserves and changes in the discount rate.

Chapter 11: RQ-10 (Page: 284)• Describe how a Fed open market purchase changes

the federal funds rate.• ANSWER: (Textbook: p. 271-272)

Increases reserves, which shifts out the supply of federal funds, lowering the equilibrium rate.

Chapter 11: RQ-11 (Page: 285)• What are two important factors affecting investment? Show

how they work using graphs.• ANSWER: (Textbook: p. 273-274-275)

Confidence and interest rates. See Figures 11.4 and 11.5.

Chapter 11: E-9 (Page: 286)• Suppose the nominal prime interest rate for a one-year loan in an economy is

currently 6 percent.a. If inflation is running at 1 percent per year, what is the current real interest rate?b. Suppose many people believe that the inflation rate is going to rise in the future-probably up to 2 percent to 3 percent or more within a few years. You want to borrow a sum of money for ten years, and are faced with deciding between1. a series of short-term, one-year loans. The interest rate on this year’s loan would be 6 percent, while future nominal interest rates are unknown. Or2. a ten-year fixed-rate loan on which you would pay a constant 6.25 percent per year. If you agree with most people and expect inflation to rise, which borrowing strategy do you expect might give you the better deal? Why? Explain your reasoning.c. Could your reasoning in part (b) help explain the pattern of interest rates shown in Figure 11.12? Explain.

Chapter 11: E-9 (Page: 286)-AnswerANSWER:a. r = i − π so r = 6% − 1% = 5% b. The question here is which choice is likely to give you a lower real interest rate, overall. - If you borrow for one year now at a 6% rate, you will be slightly better off over the next year with the short-term loan instead of the long term loan (since you pay 6% instead of 6.25%). - But if inflation rises in the future, when you go to find your next one-year loan you will probably find that lenders will have raised their nominal rates as well. If, instead, you choose the fixed-rate ten-year loan, then, by the equation re = i − πe your expected real interest rate over most of the ten years will be something below 5%--and perhaps substantially below:re = 6.25% − (expected inflation of 2-3% for most of the loan duration) = 4.25% or less, for most of the loan duration Since you believe inflation will rise substantially, you should probably "lock in" to a low nominal rate—and thus a low expected future real rate--by choosing the long term loan.

Chapter 11: E-9 (Page: 286)-Answer

ANSWER:c. Yes, this sort of reasoning could contribute to explaining that graph, which shows nominal short-term rates falling dramatically, while nominal long-term rates fall by much less. If people expect inflation to rise, they will be willing to "lock in" to long term rates even though the long-term rates haven't dropped as dramatically as the short-term rates.

to be continued…