1. (3 points) Financial friction in the IS-MP model During the financial crisis
ID: 1156103 • Letter: 1
Question
1. (3 points) Financial friction in the IS-MP model During the financial crisis of 2007-2008, there was a substantial spread between the interest rate set by the Fed and the interest rate at which firms and households could borrow. Let R be the interest rate set by the Fed, and R-Rfbe the interest rate that firms and households face. We call f the degree of financial friction. (Note that the models we have encountered so far had f = 0). (a) Suppose there is a housing bubble that bursts. Depict the scenario in an IS-MP diagram assuming f-0. (b) Now suppose f>0 and suppose the Fed lowers the interest rate to R in (a). Show using the IS-MP diagram what the level of ouput will be. (This will depend on the value of f). (c) Argue why conventional monetary policy is ineffective when financial friction is se- vereExplanation / Answer
The difference between Fed behavior during the Bank Panics of 1930-1933 and the Financial Crisis of 2007-2008 is that the Fed (Points : 4)
was very active during the former crisis, while it was basically passive during the latter crisis. FALSE! It's actually the opposite, making (b) the answer:
stood idly by during the former crisis, but took dramatic actions during the latter crisis. CORRECT
was not yet in existence during the 1930s. - false, it was established in the 1910s under Pres. Wilson
was a much bigger institution in the 1930s than it is today. FALSE, our banking system has only grown!
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