Exam 2 –Econ 304 – Chuderewicz –Fall 2017
Name ______Last 4 (PSU ID) ______
Section: Please Check:
Section 001 - 112 Chambers 9:05 am ______
Section 002 - 112 Chambers 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 = 285
Test time = 120 minutes
To help with time management if spreading time evenly
Question #1 = 25 points.....10 minutes
Question #2 =40 points ...... 17 minutes
Question #3 = 40 points.... 17 minutes
Question #4 = 40 points ...17minutes
Question #5 = 50 points..... 21 minutes
Question #6 = 40 points.... 17 minutes
Question #7 = 50 points ...21 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 = 60 - 5 iff and the target for the funds rate is 2% (use 2 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)?
b)(5 points) How do you control the amount of reserves in the system? Be specific. Who do you deal with?
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 2%
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.
2.(40 points total)
a) (10 points) Explain why the interest rate on reverse repos serves as the lower bound for the federal funds rate. Lower bound for who exactly?? Be sure to explain why the federal funds rate will never ever go below the rate on reverse repos. Why would we expect the federal funds rate to not hit the lower bound?
b) (10 points) Discuss the advantages and disadvantages of having a large cap and large access regarding the reverse repo facility. Be as specific as possible.
c) (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 explaining what the retention pond is and how it differs from the reverse repo facility.
d)(10 points) Suppose you were the Fed Chairperson and you were giving a testimony in front of Congress. During the question and answer period following your testimony a senator was criticizing you, and the Fed in general, for paying taxpayer money to private money market funds. What is this senator talking about (why are these taxpayer funds?) and what would be your defense for paying these private market funds taxpayer money? Defend the Fed!
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? Refer to the reserve market and the federal funds target at the time and why was it so important to conduct these sales.
b) (20 points total: 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. (40 points) Let's pretend that we are in the future and the target range of the federal fund rate is between 2.75% and 3%. The FOMC meets and decides that the economy needs a boost and thus decides to lower the target range by 50 basis points (.50%). The new range is now between 2.25% and 2.50%. This pretend date is October 31, 2020 (for the purposes of labeling your graph and referencing this date in your essay below).
a)(15 points for correct and completely labeled graph) In the space below, depict what happens in the overnight lending markets by drawing a graph consistent with the conditions prior to the FOMC announcement and then after the announcement. Be sure to mark the date of this change as October 31, 2020. Be sure to have three interest rates on your graph and please label the cost of arbitrage (on your graph).
15 points for correct and completely labeled diagram
b)(15 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 explain exactly what is happening in the federal funds market. Refer to the trading desk at the NY Fed (with the phones on it). At what value will the federal funds rate settle at?
c)(10 points) Suppose that you were in charge of writing the statement and the implementation note that was released on October 31, 2020. 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.....
5. (50 points) The "dot plots" below are from the projection materials from 2 different FOMC meetings.
a)(5 points) One of the dot plots above is from a recent FOMC meeting and the other is from about 5 years ago. Which dot plot is recent and which dot plot is from about 5 years ago. How can you tell which is which?
b)(10 points) From the article titled: "Yellen Says Fed May Need to Use Unconventional Policy Again Some Day" Janet Yellen was quoted:
The “probability that short-term interest rates may need to be reduced to their effective lower bound at some point is uncomfortably high, even in the absence of a major financial and economic crisis."
Explain why the probability of returning to the zero bound is uncomfortably high. Use the reference from the article, 2 % is not enough, referring to what the Fed did to the federal funds target, on average, to fight the most previous 3 US recessions. Which dot plot is Janet Yellen referring to?
c)(10 points) The article 2 % is not enough suggests a fix to this "uncomfortably high probability of returning to the zero lower bound." Explain the fix making sure you refer to the title of the article: 2% is not enough ...... 2% of what??? Use the Taylor Rule / Fisher equation to support your answer.
d)( 25 points total) Janet Yellen was quoted earlier this month by saying "That is because the neutral rate of interest—the inflation-adjusted interest rate that is consistent with the economy expanding at its full potential without overheating—“is much lower than in previous decades,”
d) i) (5 points) What does Janet mean when she says: The inflation-adjusted interest rate? How is this neutral inflation-adjusted interest rate estimated?
d) ii) (20 points total: 10 for graph(s), 10 for explanation) Explain why this rate: "is much lower than in previous decades,” Draw diagram(s) to support your answer - be sure to explain exactly what is going on and refer to your diagram(s).....i.e..... explain exactly why this rate is much lower than in previous decades. Make sure refer to the speech made by Ben Bernanke regarding the current account. (more room for your answer next page).
6. (40 points total)
a) (10 points correct and completely label diagram)Currently, the federal funds rate is 1.15 % and the rate of PCE inflation is 1.6%. Given that λ, the coefficient in front of inflation in the MP curve is .50, draw the current MP curve in the space below and label it as MP11/1/17. We know that in the long run, inflation will be 2% and we also know that the natural 'equilibrium' real rate of interest is 1%. Add this MP curve to your diagram and label it as MPlong run. Be sure to label your diagram completely.
b)(10 points) We discussed the Andy Capp comic below in class. We argued that before the financial crisis / Great Recession Andy Capp would not have had a problem getting a loan. Update to the present and he has zero probability of obtaining a loan (as in comic below). How do we model this change in lending conditions in our macro model? What is it referred to in our model? Write down the relevant equation to support your answer.(more room for your answer next page)
write your answer here:
c) (10 points) Given the change in lending conditions above - how would our model be effected? Without drawing graphs.... how would the MP curve be effected? How would the IS curve be effected? How would the AD curve be effected? Be sure to differentiate between shifts vs. movements along these three curves.
d)(10 points) According to our discussion and the research on the effectiveness of forward guidance, what did we learn from our recent experience while at the zero bound? Provide an argument that the Fed blew it (screwed up) with their forward guidance. If we get to the zero bound, what do you imagine the forward guidance might be from the Fed, given the results of the research?
7) (50 points) Problem:
The IS curve is given by: Y = 17 - r
The MP curve is given by: MP: r = 1 + .5π
a) (5 points) Solve for the AD curve.
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.
20 points for completely labeled graphs
Suppose the MP curve changes and is now: MP: r = -2 + .5π
b) (10 points) Why would the MP curve change the way it did? Give some real world examples. Does the change in the MP curve have anything to do with inflation?
c) (5 points) Assuming inflation is 2%, calculate the new r and Y (show work) and update your graphs above account for the MP shock - label as point C (again, when inflation is 2%).
d)(10 points) What determines how powerful this change in monetary policy in with regard to influencing output (Y)? Be very specific!
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