1.We discussed in class how Federal Reserve Policy has changed dramatically in the last 10 years.
a) Let us go back 10 years to March, 2006. Below is the first line of the FOMC statement from March 28, 2006.
Release Date: March 28, 2006
For immediate release
The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 4-3/4 percent.
i) Explain exactly how monetary policy worked back in March of 2006. That is, who exactly decides on changing the target for the federal funds rate and what exactly is the federal funds rate? How does the federal funds market operate - what is it used for? What is the operational aspect of changing the target for the federal funds rate as above (this is in 2006!)?
ii) Now use a graph of the federal funds market and depict exactly how the Fed would successfully raise the target by 25 basis points to 4 3/4 %. Begin with conditions before the March 28, 2006 FOMC announcement and label as point A. Then show the change in conditions as point B. Assume that reserve demand is constant. Explain how and why your graph changes. What type of open market operations does the Fed need to conduct?
b) Now let's update to the present. As we know, the Fed 'got off the zero bound' in December 2015. How did they do this? How did the FOMC statement change relative to the 2006 statement. Be specific! What did the statement say exactly and how does this new monetary regime work exactly?.
c) The FOMC is contemplating another move at their April meeting and the decision whether to raise rates again depends critically on the labor market report released on Friday, April 1 (no fooling!) . Suppose that this report is extremely positive and thus, the Fed raises rates by another 25 basis points at their April 2016 FOMC meeting. How would they do this exactly and how and why would the federal funds rate change? How would the statement change? (more room on next page)
d) Now draw a graph with time on the horizontal axis and interest rates on the vertical axis - you need to have 3 different interest rates on the vertical axis (we did this in class). On the graph, clearly label the period of the 'zero bound', the period associated with the move in December of 2015, and the period after the hike at the April 2016 meeting (as assumed above). Make sure you label your graph completely including the horizontal axis representing time and the vertical axis representing interest rates.
2. We discussed the business cycle fact that government purchases is a pro-cyclical economic statistic.
a) First, explain how the real business cycle theorists explain the pro-cyclical behavior of government purchases. In the space below, draw three diagrams - a labor market diagram, a production function diagram, and an IS - LM - FE diagram. Start at point A and let G rise. Show and explain how each of your three diagrams are effected by the increase in G and label as point B. Be sure to explain how each of your diagrams are effected - the intuition of moving from points A to B. Do the real business cycle theorists believe that it is a good idea to fight recessions with expansionary fiscal policy as defined by increases in G? Why or why not? Explain.
b) Now explain how the New Keynesians explain the pro-cyclical behavior of government purchases. In the space below, draw a savings - investment diagram, an IS, LM, FE diagram, and an aggregate demand - aggregate supply diagram. Start at point A and allow the increase in G to move us to point B. Be sure to label all your diagrams completely. What does the power of this fiscal policy critically depend on. Be sure to mention the state of the economy in your discussion. Does investment get crowded out in this model and if so, what determines the degree of crowding out? Why do critics dislike the idea of crowding out so much, especially with regard to investment getting crowded out?