1. (15 pts.)
Suppose the Fed wants to raise the nominal interest rate. Explain the three available mechanisms the Fed can use to achieve this goal. In your answer, use a graph of the money market to show how the Fed’s action translates into a higher nominal interest rate.
2. (10 pts.)
a. (6 pts.)
Explain the difference between the three Fed discount window programs.
b. (4 pts.)
Why does the Fed set the discount rate above the Fed Funds rate?
3. (25 pts.)
Suppose the Fed decides to sell $14 billion in Treasury bonds. Assume that the reserve requirement is 8%, banks hold 4% in excess reserves, but the public holds no cash.
What is the total increase or decrease in the money supply which would result from the Fed’s action? Explain your answer, and show your calculations.
4. (50 pts.)
Assume the public in the small country of Harvardia does not hold any cash. Commercial banks, however, hold 5% of their checking deposits as excess reserves, regardless of the interest rate.
a. (5 pts.)
Consider the balance sheet of one of several identical banks:
ASSETS LIABILITIES & NET WORTH
Reserves $ 400 Checking Deposits $2,000
Loans $1,600 Net Worth $ 0
What is the required reserve ratio?
b. (10 pts.)
If the total money stock (supply) is $100,000, find the total amount of reserves held in the banking system. Show your work. Use a diagram to show what the money supply curve looks like for this economy, fully labeled.
c. (10 pts.)
The Harvardia Central Bank decides that it wants to cut the money stock in half. It is considering an open market operation. How many dollars worth of bonds should the Central Bank buy or sell? Assume that excess reserves are 5% and the required reserve ratio is what you found in part a. Show your work.
d. (25 pts.)
Beginning from the money market equilibrium that prevailed before the open market operation, explain the effect of the Central Bank’s policy on the equilibrium interest rate. Will the interest rate change more if the money demand curve is steeper or flatter? Explain with reference to one well-labeled diagram.
(Hint: On one diagram, show both a steep and a flat money demand curve, along with one money supply curve. Then show what happens along the two curves as the money supply changes. To explain your result, think about what a steeper or flatter money demand curve implies about money demand.)