978-1259285295 Chapter 18 Solution Manual Part 1

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Chapter 18

Monetary Policy:

Stabilizing the Domestic Economy

Conceptual and Analytical Problems

1. Suppose, one morning, the Open Market Trading Desk drastically underestimates the demand

for reserves when deciding the quantity of reserves to supply to the market. Based on

analysis of the market for bank reserves, explain why the market federal funds rate will not

exceed the discount rate regardless of the size of the gap between estimated and actual

reserve demand. (LO2)

Answer: If the actual demand for reserves were larger than the estimated demand, the actual

reserve demand curve would be farther to the right than the estimated demand curve. If the

gap is large enough, the demand and supply curves for reserves would intersect on the

2. Consider a situation where reserve requirements are binding and the Federal Reserve decides

to reduce the requirements. How would the Open Market Trading Desk act to maintain the

interest rate target, assuming the demand for excess reserves remains unchanged? (LO2)

Answer: If required reserves fell with no change in desired excess reserves, then overall

3. Suppose the Federal Reserve did not pay interest on excess reserves. How would the reserve

demand curve differ from that in Figure 18.2? (LO1)

Answer: Instead of becoming flat at the deposit rate, the reserve demand curve would

continue to slope downward until it hits the horizontal axis at zero, at which point it would

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4. * In a graph of the market for bank reserves, show how the Federal Reserve limits deviations

of the market federal funds rate from its interest rate target under the channel system. Next,

show how the Open Market Trading Desk would implement a decision by the FOMC to raise

the target federal funds rate. Assume that the Fed alters the discount and deposit rates to

maintain fixed spreads between them and the target federal funds rate. (LO1)

Answer: In the graph, the initial target interest rate, discount rate, and deposit rate are

indicated, with the initial equilibrium at point A. Were the reserve demand curve to shift

sufficiently rightward to intersect the horizontal portion of the reserve supply curve, banks

To implement a higher target for the federal funds rate, the Open Market Trading Desk would

carry out open market sales, shifting the supply of reserves to the left (see the arrows in the

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5. From 1979 to 1982, the FOMC used money growth as an intermediate target. To do so, the

committee instructed the Open Market Trading Desk to target the level of reserves in the

banking system. What was the justification for doing so? Explain why the result was

unstable interest rates. Would you advocate a return to reserve targeting? Why or why not?

(LO2)

Answer: In 1979, the Fed had to reduce inflation. It would not have been politically

acceptable for the Fed to explicitly raise interest rates to the level required to bring down

6. Federal Reserve buying of mortgage-backed securities is an example of a targeted asset

purchase. Explain how the Fed’s actions are intended to work. (LO2)

Answer: The Fed wishes to stimulate the housing market. Housing prices and activity

collapsed in the 2007-2009 episode, serving as a key driver of the crisis. By purchasing

7. The strategy of inflation targeting, which seeks to keep inflation close to a numerical goal

over a reasonable horizon, has been referred to as a policy of “constrained discretion.” What

does this mean? (LO2)

Answer: Under inflation targeting, central banks conduct policy to attain the inflation goal.

However, the targets may specify an acceptable range around the central target. In addition,

8. The charge given by Congress to the Federal Reserve is to “promote effectively the goals of

maximum employment, stable prices, and moderate long-term interest rates.” Discuss

whether the Taylor rule conforms to this mandate. (LO3)

Answer: The mandate given to the Federal Reserve by Congress is embedded in the Taylor

rule. First, if the inflation target π*, is low, the inflation gap term satisfies the “stable price”

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9. Discuss the coefficients on the inflation gap and output gap terms in the Taylor rule given in

equation (1). If you could change the relative importance of the coefficients, what would you

choose? (LO3)

Answer: The coefficients on the inflation gap and output gap terms express the “weights” the

policy maker assigns to each of the objectives. A relatively higher weight on the inflation gap

10. Use the following Taylor rule to calculate what would happen to the real interest rate if actual

and expected inflation increased by 3 percentage points. (LO3)

Target federal funds rate = 2 + current inflation + ½(inflation gap) +½(output gap)

Answer: Target federal funds rate = 2 + current inflation + ½(inflation gap) +½(output gap)

To calculate the impact on the real interest rate, we can use the Fisher equation

11. *The Taylor rule in Problem 19 is thought to be a reasonably good description of policy

behavior in the United States in the absence of unusual financial market conditions or

deflationary worries. Taking into account what you know about the policy goals of the ECB

and that the average economic growth rate tends to be lower in Europe than in the United

States, how would you amend the Taylor rule to better approximate policymaking behavior

by the ECB? (LO3)

Answer: You should amend both the constant term and the weights on the inflation and

output gaps to better fit the ECB.

The constant term in the Taylor rule is a measure of the risk-free interest rate over the long

run. That rate is typically at or below the economy’s growth rate. Given that economic

The ECB has a hierarchical mandate where price stability is accorded greater importance that

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12. Go to the Web site of the Federal Reserve Board at www.federalreserve.gov and find the

section describing monetary policy tools. Which unconventional tools employed during the

financial crisis of 2007-2009 has the Fed stopped using? What do you think determined the

order in which various facilities were shut down? Which, if any, of the tools still remain in

operation? (LO4)

Answer: On www.federalreserve.gov/monetarypolicy/expiredtools.htm the Fed reports that

the following policy tools have expired as of 2013: (1) the Money Market Investor Funding

The order in which the facilities shut down reflects the sequence in which the problems they

13. *Use your knowledge of the problems associated with asymmetric information to explain

why, prior to the change in the Federal Reserve’s discount lending facility in 2002, banks

were extremely unlikely to borrow from the facility despite funds being available at a rate

below the target federal funds rate? (LO1)

Answer: Participants in the federal funds market do not have full information about each

other, so signals about the well-being of borrowers played a very important role. If a bank

14. The ECB pays a market-based interest rate on required reserves and a lower rate on excess

reserves. Explain why the system is structured this way. (LO1)

Answer: Paying a market-based interest rate on required reserves reduces the costs to banks

of holding reserves. Paying interest on excess reserves helps sets a floor under the overnight

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15. Based on the liquidity premium theory of the term structure of interest rates, explain how

forward guidance about monetary policy can lower long-term interest rates today. Be sure to

account for both future short-term rates and for the risk premium. How does the effectiveness

of forward guidance depend on its time consistency? (LO4)

Answer: The liquidity premium theory expresses the long-term interest rate as the sum of

average expected future short-term rates and a liquidity risk premium:

int=i1t+i1, t+1

e+…+i1, t+n−1

n+rpn

When credible, forward guidance influences expectations about future short-term rates. For

example, if policymakers credibly express intent to keep interest rates low for several years,

16. With the policy interest rate at zero, how might a central bank counter unwanted deflation?

(LO4)

Answer: Several unconventional policy options exist, including forward guidance,

quantitative easing and targeted asset purchases. These can be used individually or in

17. *Outline and compare the ways in which the Federal Reserve and the ECB added to or

adjusted their monetary policy tools in response to the financial crisis of 2007-2009 and

subsequent financial crisis in the euro area. (LO2)

Answer: The Federal Reserve set up a host of lending facilities such as the Term Auction

Facility, the Primary Dealer Credit Facility and the Commercial Paper Funding Facility (see

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In both crises, the ECB used dollar liquidity swaps from the Fed to provide dollar funding to

euro-area banks. In the latter part of 2008, the ECB switched from using variable rate tenders

to fixed rate tenders for its main refinancing operations. Over time, it widened markedly the

range of acceptable collateral and lengthened the term of key refinancing arrangements to as

long as three years. By early 2013, most of its liquidity supply was longer term. The ECB

Unlike the Fed, the ECB generally has not provided forward guidance regarding the future

level of the policy rate.

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