Finance 462

Solutions to Problem Set #10

1)

a)      The increase in consumer confidence would most likely increase consumer spending.  As savings decreases, interest rates start to rise and money demand increases.  The extra demand for goods and services raises output and employment.  To return the economy to full employment (and prevent the eventual price increase), the fed would contract the money supply through an open market sale of securities.

b)      A decrease in the C/D ratio would lower the money supply (not M0, but all other measures).  The Fed would need to increase the money supply through an open market purchase or a lowering of the discount rate.

2)

a)      If the Fed targets the real interest rate, then money demand shocks are offset by changes in money supply. Since the shock causes money supply to change, but does not affect interest rates, output is unaffected.  By following an interest rate rule, output is unaffected by money demand shocks, and hence more stable than if the fed had no rule.

b)      When there are preference shocks (shifts in consumption or investment), the rule does not work very well. Suppose, for example, that a rise in consumer confidence lowers savings. Interest rates rise, money demand increases and employment/output increase (to match the higher demand).  The appropriate monetary response would be to increase the money supply to lower interest rates back to the target..  While this maintains a constant interest rate, it amplifies the increase real output. This makes output less stable. Note that this policy is not sustainable in the long run.  Output will eventually return to the full employment level at the higher interest rate.  If the fed were to try to maintain the lower interest rate, the result would be higher inflation.

3) A gold standard has two key components:  (a) to maintain a constant official price of gold (in the US the price was $35/oz).  Note that this is equivalent to defining a dollar in terms of a weight of gold ($1 = 1/35 = .0285oz of gold). (b) The government must maintain convertibility (anyone who wants can buy or sell gold to the government at the official price). 

a)      The Fed can only increase the money supply by purchasing assets. If the fed were to buy Treasuries, then the ratio of gold reserves to cash in circulation falls and convertibility comes into question.  If the fed buys gold, it bids up the price of gold (unless the supply of gold is increasing as well). Therefore, the money supply is linked to the amount of gold (which is relatively fixed).

b)      If new gold deposits are discovered, the fed would need to buy up the extra gold to keep the price at the pegged value Ė this releases currency into circulation which will stimulate the economy in the short run, but lead to inflation in the long run.

c)      If the reserve ratio drops too low, the public will suspect that the Fed will devalue the dollar by raising the price of gold (if gold sells for $40/oz, then $1 = 1/40 = .025oz of gold).  The higher gold price increases the value of the fedís reserves and, hence, raises the reserve ratio.  However, if the public expects devaluation, they will buy gold now in order to sell later at a higher price, which exacerbates the initial problem.

4) A currency peg is the same as a gold standard with two exceptions: (a) the reserve asset is the pegged currency (in the case of China , the reserve asset is dollars or dollar denominated assets). (b) Unlike gold, dollars are not in fixed supply, but are controlled by the fed.

a)      To keep the value of the dollar up, the Chinese must use Chinese currency to buy dollars.  This increases the Chinese money supply which will stimulate the Chinese economy in the short run but will be inflationary in the long run.

b)      If the value of the dollar reverses and starts to appreciate, the Chinese would have to sell dollars to maintain the peg.. As with the gold standard, the Chinese only have a finite supply of dollars.  When they run out, the ability to peg is eliminated.

5) This demand shock can be though of as a shift of the investment curve to the right or a shift in savings to the left.  This bids up interest rates and pushes the economy above full employment. Eventually, prices will rise which will bring the economy back to full employment and raise interest rates.

a)      With an interest rate target, the fed would match this increase in demand for credit with an equal increase in supply. That is, they would increase the money supply and over-stimulate the economy.

b)      During good times, banks will hold less excess reserves.  This drop in excess reserves will increase the multiplier which will increase M1. The fed would need to offset this by decreasing the monetary base.

c)      If the fed were following an inflation target, nothing would be required until prices start to rise.  At that point, the money supply would nee to be decreased.