Emergency please help! MONETARY TRANSMISSION MECHANISM PROBLEMS Where we have th

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Emergency please help!

MONETARY TRANSMISSION MECHANISM PROBLEMS

Where we have the following information:

• The money multiplier is 3.25, or is derived from the formula.

• Interest rates will change by 1.5% for each $65 billion change in the money supply.

• Investment will change by $122 billion for each 2% change in interest rates.

• Income will change by $7 for each $2 change in investment.

• The unemployment rate will change by .46% for each $150 billion change in income, up to a maximum short run change of +1.84%.

• If the change in income exceeds +$600 billion, the effects will be strictly inflationary (if income rises) or deflationary (if income falls). For each additional $150 billion in income, the inflation rate will change by 2.1%.

1. What will be the impact on income, unemployment and inflation if the Fed buys $15 billion worth of bonds?

2. What will be the impact on income, unemployment and inflation if the Fed sells $25 billion worth of bonds?

3. If the Fed wants to raise income by $350 billion, how much should it buy/sell in Treasury bonds?

4. If the Fed wants to lower the unemployment rate by 1%, how much should it buy/sell in Treasury bonds?

5. Recalculate problem #1 where the required reserve ratio is 15%, the desired excess reserve ratio is 5% and the currency ratio is 75%. Let your calculated impact on income and unemployment be the Fed’s targets.

a. Let’s begin this problem again, except that there has been increased pessimism in the market and the following changes have occurred that the Fed didn’t count on, as follows:

• the desired excess reserve ratio rises to 50%.

• the desired currency ratio rises to 100%

• interest only changes by .75% for each $65 billion change in the MS

• investment only changes by $66 billion for each 2% change in interest

Calculate the effect of the Fed’s policy.

b. Clearly the Fed didn’t reach its target, so they try again, but with an increase amount of bond purchases of $85 billion. But, once again there has been increased pessimism in the market and the following changes have occurred that the Fed didn’t count on:

• the desired excess reserve ratio rises to 95%.

• the desired currency ratio rises to 125%

• interest only changes by .4% for each $65 billion change in the MS

• investment only changes by $36 billion for each 2% change in interest

Calculate the effect of the Fed’s policy.

c. That still didn’t work, so the Fed tries once again. This time they buy even more bonds: $250 billion! Well, that should do the trick. Except now, there have been further changes, representing a wave of optimism, as follows:

• the desired excess reserve ratio falls to 15%.

• the desired currency ratio falls to 60%

• interest only changes by 1.5 % for each $65 billion change in the MS

• investment only changes by $122 billion for each 2% change in interest Calculate the effect of the Fed’s policy.

Explanation / Answer

(1)

When Fed buys bonds, money supply increases.

When Fed buys bonds worth $15 billion, increase in money supply = $15 billion x 3.25 = $48.75 billion

As money supply rises by $48.75 billion, interest rate falls by 1.5%.

As interest rate falls by 1.5%, Investment rises by $122 billion.

Increase in income = $122 billion x $7 / $2 = $427 billion

Decrease in unemployment rate = 0.46% x 3 = 1.38%

Since increase in income is less than $600 billion, Increase in inflation rate = 0

(2)

When Fed sells bonds, money supply falls.

When Fed sells bonds worth $25 billion, decrease in money supply = $25 billion x 3.25 = $81.25 billion

As money supply falls by $81.25 billion, interest rate rises by 2 x 1.5% = 3%.

As interest rate rises by 3%, Investment falls by $122 x 2 = $244 billion.

decrease in income = $244 billion x $7 / $2 = $854 billion

Inecrease in unemployment rate = 0.46% x 6 = 2.76%

Since upper limit is 1.84%, Increase in unemployment rate = 1.84%

Decrease in inflation rate = 2.1% x 2 = 4.2% (There are 2 brackets of $150 billion between $854 billion & $600 billion).

Note: First 2 questions are answered.

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