Finance 462

Problem Set #10

1)      Suppose that the Federal Reserve is following a policy of maintaining full employment and prices are fixed in the short run. How would the Fed respond to the following events?

a)      An increase in consumer confidence

b)      A drop in the currency to deposit ratio.

2)      Suppose that the Fed strictly follows a rule of keeping the interest rate constant at 4% per year.

a)      If the economy is hit by money demand shocks only, how will money supply respond to money demand shocks? Will the rule make output more or less volatile than if money supply were constant? Will the central bank be able to follow its rule in the long run?

b)      Assume the country is hit by demand shocks only. How will the money supply behave? Will output be more or less volatile?

3)      From as early as 1834 until 1971, US monetary policy was based on a gold standard (this standard was put on hold during wartime).  Initially, the official price of gold was set at $20.67 an ounce, but was raised to $35 in 1934.

a)      Explain how the gold standard restricted the ability of the central bank to alter the money supply.

b)      Suppose new gold deposits are discovered.  How would the Fed need to respond? What would the economic impact be?

c)      A problem with the gold standard (as is the case with any policy rule) is that it is subject to speculative attacks.  Why is this? (I.e. suppose that the reserve ratio drops to low.  How will the public respond?)

4)      Currently, the Chinese monetary policy is based on pegging the Yuan to the dollar. (Currently, the price of the Yuan is pegged at $8.28). 

a)      Given the current world decline of the dollar, explain how the Bank of China must respond to maintain the peg.  What impact will this have on the Chinese economy?(Hint: this is just like the gold standardÖthe commodity is now the dollar)

b)      Suppose that the dollar reverses course and begins to appreciate against the Yuan.  What impact will this have on the bank of China ?  Can they maintain a peg indefinitely against an appreciating dollar?

5)      During the late 90ís, we a large increase in private investment as firms capitalized on the productivity gains of IT capital.  Assume this to be a demand shock (i.e., productive capacity hasnít increased yet.)

a)      How would the fed need to respond if they were following an interest rate target?

b)      How would the fed respond if they were following a money target?

c)      How would the fed respond if they were following an inflation target?