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1.1 Monetary policy aims to advance the economic well-being of the country’s citizens. Economic well-being is typically determined by the quantity and quality of goods and services that individuals can enjoy. Congress authorized the Fed to pursue the goals of price stability, maximum employment, and moderate long-term interest rates. Price stability ensures moderate long-term interest rates, so the three goals reduce to the dual mandate of price stability and maximum employment.

1.2 The Fed seeks to reduce cyclical unemployment. The Fed does not seek to reduce the unemployment rate to zero because the tools of monetary policy are aimed at affecting economic conditions throughout the economy and are ineffective in reducing the levels of frictional and structural unemployment.

1.3 Interest rates represent the cost of borrowing by firms and households. Fluctuating interest rates make investment decisions by firms and households more difficult because the cost of borrowing becomes more uncertain.

1.4 Excess fluctuations in the foreign exchange value of the dollar would make it difficult to know the cost of your products abroad, the cost of imported intermediate goods used in making your products, and the dollar value of your firm’s foreign assets.

1.9 If the exchange rate between the Japanese yen and the U.S. dollar changes from ¥85 ’ $1 to ¥95 ’ $1, the U.S. dollar would have appreciated (it will take more yen to buy one U.S. dollar) and U.S. industries will be less competitive relative to Japanese industries. The appreciation of the dollar makes U.S. exports more expensive in terms of yen and Japanese imports to the United States cheaper in terms of dollars.

2.1 Open market operations is the Fed’s most important traditional monetary policy tool.

2.2 The federal funds rate is the interest rate that banks charge each other on very short-term loans, whereas the discount rate is the interest rate that the Federal Reserve charges banks on loans. Since 2003, the discount rate has been higher than the federal funds rate.

2.3 As the federal funds rate increases, the opportunity cost to banks of holding excess reserves increases because the return they could earn from lending out those reserves goes up. The demand curve for reserves becomes perfectly elastic at the interest rate the Fed pays on banks’ reserve balances because if the federal funds rate fell below this level, banks could borrow in the federal funds market and earn a higher interest rate on their reserve balances at the Fed. So, competition among banks will keep the federal funds rate from falling below the interest rate the Fed pays on banks’ reserve balances.

2.4 The supply of reserves is determined by the Fed supplying nonborrowed reserves through open market operations and borrowed reserves in the form of discount loans. The discount rate sets a ceiling on the federal funds rate, causing the supply curve for reserves to become horizontal. Banks would not pay a higher interest rate to borrow from other banks than the discount rate they can pay to borrow from the Fed.

2.5 a. A decrease in the required reserve ratio will decrease the demand for reserves because banks would need to hold fewer reserves. The demand curve will shift to the left from D1 to D2.

[pic]

b. A decrease in the discount rate from id1 to id2 would lower the interest rate at which the supply curve for reserves becomes horizontal. As shown on the graph below, the horizontal section of the supply curve shifts down from S1 to S2.

[pic]

c. A decrease in the interest rate paid on reserves from irb1 to irb2 would lower the interest rate at which the demand curve becomes horizontal. As shown on the graph below, the horizontal section of the demand curve shifts down from D1 to D2.

[pic]

d. An open market sale of government securities would decrease the supply of reserves, shifting the supply curve to the left from S1 to S2.

[pic]

2.6 The graph on the left below shows that to lower its target for the federal funds rate from [pic] to [pic], the Fed can conduct an open market purchase of securities. In the graph, the open market purchase shifts the supply curve for reserves to the right from S1 to S2. In the graph, we assume that in addition to lowering its target for the federal funds rate, the Fed reduces the discount rate from id1 to id2. As a result, the horizontal section of the supply curve for reserves shifts down.

The graph on the right below shows that to raise its target for the federal funds rate from [pic] to [pic], the Fed can conduct an open market sale of securities. In the graph, the open market purchase shifts the supply curve for reserves to the left from S1 to S2. In the graph, we assume that in addition to increasing its target for the federal funds rate, the Fed increases the discount rate from id1 to id2. As a result, the horizontal section of the supply curve for reserves shifts up.

[pic]

2.7 a. To raise the federal funds rate, the Fed would sell securities, which shifts the supply curve for reserves to the left from S1 to S2. The equilibrium federal funds rate rises from 2.00% to 2.25%. At the same time, the Fed raises the discount rate from 2.50% to 2.75%, as shown by the horizontal section of the supply curve shifting up.

[pic]

b. Banks’ increased demand for reserves shifts the demand curve to the right from D1 to D2. To offset the effect of the increase in demand on the equilibrium federal funds rate, the Fed would engage in an open market purchase of securities. The open market purchase shifts the supply curve to the right from S1 to S2, leaving the equilibrium federal funds rate unchanged at [pic].

[pic]

c. An increase in the required reserve ratio would increase the demand for reserves. To offset the effect of this increase, the Fed would engage in an open market purchase of securities. The graph is the same as for part (b) above.

3.1 An open market sale of Treasury securities decreases the price of Treasury securities, thereby increasing the yield on Treasury securities. Because the sale of Treasury securities reduces reserves, the sale decreases the monetary base and the money supply.

3.2 Open market operations have the advantages over other policy tools of control, flexibility, and ease of implementation. The Fed initiates open market operations and completely controls the volume of open market purchases and sales. Open market operations are flexible because the Fed can make both large and small open market operations, and the Fed can easily implement open market operations by the trading desk placing buy or sell orders with primary dealers.

3.3 To stimulate the economy, the Fed had already pushed the federal funds rate to near zero by December 2008. But the economy continued to struggle and the Fed wanted to put further downward pressure on long-term interest rates. Given that it could not push the federal funds rate any lower than zero, the Fed moved to purchase mortgage-backed securities and long-term Treasury securities to further reduce long-term interest rates, such as the mortgage interest rate.

3.4 Before 1980, only member banks of the Federal Reserve System could receive discount loans. After 1980, all depository institutions could receive discount loans. During the financial crisis of 2007–2009, the Fed’s discount lending expanded to include temporary lending facilities that made loans to primary dealers (investment banks and large securities firms), financial firms with mortgage-backed securities, nonfinancial corporations that issue commercial paper, and investors who purchase asset-backed securities.

4.1 The Fed often faces the key tradeoff between price stability and maximum employment. For example, in attempting to achieve high economic growth or high employment, the Fed needs to pursue an expansionary monetary policy, but this same policy could cause higher inflation.

4.2 The two timing difficulties the Fed faces in using its monetary policy tools are the information lag and the impact lag. The information lag is the Fed’s inability to observe instantaneously changes in GDP, inflation, or other economic variables. The impact lag is the time required for monetary policy changes to affect output, employment, or inflation.

4.3 The following is a list of targets, or variables, that the Fed can influence directly. The targets are listed from the most influence to the least influence:

Policy tools (Fed has most influence),

Policy instruments

Intermediate targets

Policy goals (Fed has least influence)

4.4 The Taylor rule is a monetary policy guideline economist John Taylor developed to help analyze how the Fed chooses the target for the federal funds rate. The Taylor rule serves as a summary measure of Fed policy and can be compared to the Fed’s actual target for the federal funds rate to assess whether Fed policy is more expansionary or more contractionary than is indicated by economic conditions.

4.5 The Bank of Canada uses inflation targeting and a focus on the exchange value of the Canadian dollar. The Bank of England uses inflation targeting. The Bank of Japan has not adopted a formal inflation target, but does emphasize price stability, and has begun to focus on the expected inflation rate one or two years ahead. The European Central Bank has an inflation target and attaches a significant role to the monetary aggregate M3.

4.6

a. M2 is an intermediate target.

b. The monetary base is an intermediate target.

c. The unemployment rate is a policy goal.

d. Open market purchases are a policy tool.

e. The federal funds rate is an operating target.

f. Nonborrowed reserves are an operating target.

g. M1 is an intermediate target.

h. Real GDP growth is a policy goal.

i. The discount rate is a policy tool.

j. The inflation rate is a policy goal.

4.7 If the Fed uses the federal funds rate as a policy instrument, then increases in the demand for reserves will lead to an increase in the level of reserves. In the graph that follows, this result is shown by the supply curve shifting to the right from S1 to S2 as the demand curve shifts to the right from D1 to D2, while the target for the federal funds rate remains unchanged at [pic]

Conversely, if the Fed uses the level of reserves as a policy instrument, then in the graph below, the Fed will keep the supply of reserves constant at S1 when the demand curve shifts to the right from D1 to D2. As a result, the equilibrium federal funds rate increases from [pic] to [pic] .

[pic]

4.11 Using the equation found on page 474 of the text, the Taylor rule federal funds rate target ’ 2% + 2% + 0.5(1.2% – 2%) + 0.5((5.9%) ’ 0.65%. This Taylor rule federal funds rate target exceeds the Fed’s actual target range of 0.00 to 0.25%.

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