Part 1
1. (Federal Reserve System) What are the main powers and responsibilities of the Federal Reserve System? What are its two mandates and some of it's other goals?
The Federal Reserve System is authorized to ensure sufficient money and credit in the banking system that is needed to support a growing economy. The Fed also has the power to buy and sell government securities, such as bonds, to make loans to member banks, to clear in the banking system, and to require that member banks hold a reserve requirement equal to a portion of their deposit.
The Fed has the following goals in mind: economic growth, stable interest rates, stable financial markets, and stable exchange rates.
2. (Subprime Mortgages) What are subprime mortgages, and what role did they play in the financial crisis of 2008?
Subprime mortgages were loans to people who may have difficulty maintain the repayment schedule; borrowers were defined as having credit scores below 640. The crisis arose form packaging American subprime and American regular mortgages in to mortgaged back securities, and were sold in a market separate from traditional prime loans. These packaged mortgages were the basis asset-backed securities, so the likely rate of return looked excellent (since subprime lenders pay higher premiums, and the loans were anyway secured against saleable real-estate, and so, theoretically ‘could not fail'). Many mortgages had a low interest for the first year, but such borrowers began to default in large numbers. Property valuations fell and the rate of return on investment could not be estimated, and so investor confidence in these instruments collapsed, and all were considered to be almost worthless assets.
Part 2
1. (Money Creation) Show how each of the following would initially affect a bank's assets and liabilities.
a. Someone makes a $10,000 deposit into a checking account- It will increase liabilities.
b. A bank makes a loan of $1,000 by establishing a checking account for $1,000). Increase assets and liabilities.
c. The loan described in part (b) is spent - It will decrease assets and liabilities.
d. A bank must write off a loan because the borrower defaults- It will decrease assets and liabilities.
2. (Monetary Tools) What tools does the Fed have to pursue monetary policy. Which tool does it use the most?
a. The Fed buys and sells government securities, sets the discount rate (the rate charged by reserve banks for loans to member banks), and sets legal reserve requirements for member banks.
b. The Fed frequently buys and sells government bonds on the open market.
3. (Monetary Control) Suppose the money supply is currently $500 billion and the Fed wishes to increase it by $100 billion.
a. Given a required reserve ratio of 0.25, what should it do?
The Fed need to lower the reserve requirements, which will provide banks with more funds to lend and less to hold in reserve.
b. If it decided to change the money supply by changing the required reserve ratio, what change should it make? Why may the Fed be reluctant to change the reserve requirement?
The Fed should decrease the required reserve ratio. However, changes to the reserve requirement may disrupt the banking system.
Part 3
1. (Money Demand) Suppose that you never carry cash. Your paycheck $1,000 per month is deposited directly into your checking account, and you spend your money at a constant rate so that at the end of each month your checking account balance zero.
a. What is your average money balance during the pay period? $1,000.00
b. How would each of the following changes affect your average monthly balance?
i. You are paid $500 twice monthly rather than $1,000 each month. It would decrease the average monthly balance.
ii. You are uncertain about your total spending each month? Your average money balance will increase.
iii. You spend a lot at the beginning of the month (e.g. for rent) and little at the end of the month. Average monthly balance would will decline.
iv. Your monthly income increase. Your average monthly balance would increase.
2. (Market Interest Rate) With a diagram, show how the supply of money and the demand for money determine the rate of interest? Explain the shapes of the supply curve and the demand curve.
The demand curve slopes downward, as the lower the interest rate, the opportunity cost of holding onto money. The vertical supply curve assumes that the quantity of money is independent of the interest rate.
3. (Money Supply Versus Interest Rate Target) Assume that the economy's real GDP is growing.
a. What will happen to money demand over time? If the GDP is growing. The money demand will increase.
b. If the Fed leaves the money supply unchanged, what will happen to the interest rate overtime? Interest rates should remain unchanged.
c. If the Fed changes the money supply to match the change in money demand, what will happen to the interest rate over time? An increase in the money supply lowers the interest rate, while a decrease increase the interest rate.
d. What would be the effect of the policy described in part (c) on the economy's stability over the business cycle? If the Fed increases the money supply, eventually consumer spending will increase. However, the spending will result in price level increase.