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Homework Assignment #3 – Econ 351 –Spring 2017 – YOU MUST USE THIS AS A TEMPLATE – PLEASE HIT ENTER TO MAKE ROOM FOR YOUR ANSWERS - ALSO PLEASE STAPLE, DUE, FRIDAY, APRIL 21, AT THE BEGINNING OF CLASS: NO LATE HWS ACCEPTED.
1) (40 points) For this question, we are going to focus on the risk structure of interest rates and the signal it sends as to the state of affairs in the credit markets. We are going to download and graph some data. In this exercise, we are using daily data. We can do this with two series, the rate on 3 month AA financial commercial paper and our friend, the 3 –month T-bill (daily). Note how we match maturities, critical when evaluating the risk structure of interest rates. Click Here for the commercial paper data and Here for the T-Bill data. Parse your data so that it begins in Jan 1998 and continues through to the present (we use the more recent data for the second part of this question. Make a third column and call it the spread (icp – iT-Bill). The spread is the signal!! The beginning of your worksheet should look like the one below:
3month commercial paper / 3M T-Bill / spread1998-01-01 / #N/A / #N/A / #N/A
1998-01-02 / 5.57 / 5.32 / 0.25
1998-01-05 / 5.53 / 5.23 / 0.3
1998-01-06 / 5.51 / 5.22 / 0.29
1998-01-07 / 5.48 / 5.23 / 0.25
1998-01-08 / 5.48 / 5.13 / 0.35
1998-01-09 / 5.42 / 5.05 / 0.37
1998-01-12 / 5.39 / 5.12 / 0.27
1998-01-13 / 5.37 / 5.17 / 0.2
1998-01-14 / 5.41 / 5.18 / 0.23
1998-01-15 / 5.41 / 5.13 / 0.28
a) (10 points) Note the relatively low spread during the beginning of 1998. What does a low spread indicate with regard to these credit markets? In your answer, be sure to explain what it would mean exactly if this spread was zero. Be sure to use interest rate and default risk in your answer.
b) (20 points total, 10 for graph and 10 for explanation) The Russian default occurred on August 17, 1998 Please graph the paper – bill spread from August 17, 1998 until November 30, 1998 (line graph using excel) and comment on the movement of the spread during this time period. Be sure to explain why the spread changed during this period and what signal it sent to policy makers. Was the movement in the spread due primarily to changes in the rate on commercial paper or changes in the rate on T-Bills or a little of both? Why would we expect the rate on the T-bill to move as it did during this crisis?
c) (10 points) On what day, during the fall of 1998 did the spread hit its highest point at what did the Fed do about it. Click Here for some help. In your answer, provide all the policy changes (as defined by changing the target for the federal funds rate) and the associated dates, conducted by the FOMC during the period from Sept. - Dec. 1998.
2) (40 points) THE BEGINNING OF THE GREAT RECESSION AND THE COLLAPSE OF LEHMAN BROTHERS. In this problem, we are going to let the data on the risk structure of interest rates, the daily data, identify the beginning of the Great Recession as well as identify the collapse of Lehman Brothers.
a) (10 points total, 5 for graph and 5 for explanation) August 9, 2007 was arguably the start of the financial crisis and ensuing Great Recession. In Ben Bernanke's Book titled 'The Courage to Act', he wrote about the FRBNY, the trading desk purchasing $24 Billion of US Government Securities on the morning of August 9. What happened on August 9, 2007? Click Here. The federal funds target was 5.25% on August 9 and the Fed injected the $24 Billion to maintain the federal funds target. In the space below, draw a reserve market diagram showing the conditions in the reserve market on August 8, 2007. Click Here for the data on the federal funds rate on August 8, 2007 and Here for reserve balances at the Fed. Label this point as point A on your diagram. We now update one week to August 15, 2007 (reserve data is weekly). Label these new conditions as point B on your diagram. Did the $ 24 billion in open market operations seem to work? Why is the difference in reserves between points A and B not $24 billion?
b) (10 points total: 5 points for graph and 5 points for explanation)Provide a graph of the paper – bill spread during the entire month of August 2007. Identify the date that this spread peaked and was the Fed and the FOMC doing anything about it – if so, what? Go Here for some help! Be sure to include all the Fed’s activity during August of 2007.
c) (10 points for graph and 10 points for explanation) We now consider the Lehman collapse – this occurred as you may know during September 2008. Provide a graph of the paper – bill spread during the entire month of September 2008 (again, use excel). Identify the date that this spread peaked and is this the date that Lehman went down? What else was happening during this week? Click Here for some help.
3) (30 points) After 'getting' off the zero bound in December of 2015, the Fed is poised to raise rates two more time this year. We have discussed various Taylor rule specifications. To answer this question, please use the data below: (please round all data to two decimal places)
Click Here for PCE overall (use most recent 12 month change)
Click Here for PCE core (minus food and energy) (use most recent 12 month change)
Click Here for the natural rate of unemployment (NAIRU) (use 2017 Q1)
Click Here for the actual rate of unemployment (use most recent)
Click Here for real GDP (use 2016 Q4)
Click Here for Real Potential GDP (use 2015 Q 3)
Let's pretend that you are hired to brief the FOMC during their March 14 - 15, 2017 meeting and you are responsible for informing the policy makers as to where policy is currently relative to various Taylor rule specifications. Assume it is the first day of the meeting (March 14). Click Here for the actual (effective) federal funds rate. Please show all work!!!
a) (10 points) Using the standard original Taylor Rule specification, what is the federal funds rate implied by this rule and is the Fed, as of March 14 hawkish or dovish relative to this rule. Be sure to give the actual funds rate as of March 14 in your answer.
b) (10 points) We now update to the present – use the most recent federal funds rate to answer parts b), c) and d). Using the Mankiw rule, what is the federal funds rate implied by this rule and is the Fed currently hawkish or dovish relative to this rule.
c) (10 points) Using the Chud Okun rule, what is the federal funds rate implied by this rule and is the Fed currently hawkish or dovish relative to this rule.
d)(10 points) We discussed how some economists have argued that the natural real rate of interest is lower than the Taylor assumed 2%. As evidence of this, we can look at the following graphic from " Rethinking the Widely Held 2% Inflation Target"
Using the original Taylor with the adjustment to the natural real rate of interest (assume it is now zero as in the graphic), calculate the implied funds rate from this modified Taylor rule. Is the Fed currently hawkish or dovish and how does your answer compare to your answers in parts a), b) and c) in this question?
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