Problem Set 4
1. John Taylor has suggested the following rule as a policy guide for the Federal Reserve
federal funds rate
* real rate
expected inflation rate
target inflation rate
Okun’s law 2(*)
* natural rate of unemploment
Suppose that the real rate is 2%, expected rate of inflation is 1.5 %, current unemployment rate is 5.5%, and the natural rate of unemployment is estimate to be 6%. According to the Taylor model, what federal funds rate would achieve a target inflation rate of 2%? Suppose with a global savings glut we assume a real rate of zero, what the nominal federal funds rate associated with a 2% inflation target? Still assuming a zero real rate, what happens to the nominal federal funds rate if the Fed tries to achieve a target inflation rate of 3%?
2. Suppose the Fed does an overnight repo in the amount of $20 million with a primary dealer. Illustrate this transaction with the T-accounts below.
3. Arrange the items listed below into a correct Federal Reserve balance sheet; i.e., lists the assets and liabilities.
Net portfolio holdings of Maiden Lane LLC
Deferred availability cash items
Reverse repurchase agreements
Gold certificate account
Federal Reserve notes
Central bank liquidity swaps
Items in process of collection
Term deposits held by depository institutions
Net portfolio holdings of TALF LLC
Federal agency debt securities
U.S. Treasury, General Account
Capital paid in
Treasury Notes and Bonds
Federal Reserve notes
Special drawing rights (SDRs)
4. Indicate the effect of each of the following changes on bank reserves (+ = increase and – = decrease).
Increase in Federal Reserve Notes Outstanding
Decrease in foreign deposits
Increase in Treasury cash holdings
Decrease in primary credit
Decrease in Treasury bills
Increase in agency securities
Increase reverse repos
Increase in secondary credit
Increase in Treasury deposits
5. Suppose the Federal Reserve instructs the Trading Desk to purchase $1 billion of securities. Show the result of this transaction on the balance sheets of the Federal Reserve System and commercial banks. What happens to the liquidity of the banking system?
6. Suppose the Federal Reserve instructs the Trading Desk to sell $850 million of securities. Show the result of this transaction on the balance sheets of the Federal Reserve System and commercial banks. What happens to the liquidity of the banking system?
7. A recent headline in Reuter’s read as follows:
China’s central bank on Sunday cut the amount of cash that banks must hold as reserves, the second industry-wide cut in two months …
The People’s Bank of China (PBOC) lowered the reserve requirement ratio (RRR) for all banks by 100 basis points to 18.5 percent, ….
Explain what impact this policy change would have on the balance sheet of PBOC and the commercial banks.
8. Using the Federal Reserve Statistical Release (H.4.1) classify the sources of reserves, uses of reserves and the net change in reserves.
If the reserve requirement is 10%, by how much will deposits increase as a result of this transaction? If the demand for money was assumed to be constant, what is your prediction about the level of interest rates?