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BE 562 Problem Set 2 Prof. Margaret Levenstein Due February 11, 2014 100 points

1. (16 points) Consider an economy characterized by the following C = 1000 + .75(Y T) G = 2000 T = 2000 NX = 0 Ip = 2000 80 r. Use the information above to answer the questions below. a. What is the multiplier for this economy? b. What is Ap? c. If the Federal Reserve sets the money supply so that r = 3.0%, what is Y? d. Illustrate your answer to part c in an IS-LM diagram. (Note, you do not have enough information to draw the LM curve with precision. Draw a standard LM curve that is consistent with your answers above.) 2. (16 points) Consider an economy like that described in problem 4 above. The government is concerned about unemployment and decides to increase G from 2000 to 2200. a. What is the multiplier now? b. What is Ap now? c. Show the impact of the increase in government spending on an ISLM diagram, assuming that the Federal Reserve did not change the money supply. d. Explain in words what happened to Y? To r ? (You do not have enough information to compute Y and r.)

3. (8 points) Suppose that the money demand equation for an economy is given by: MD = Y (.25 r) D where M is the quantity of money demanded, Y is GDP, and i is the nominal interest rate. Let Y = 100. a. If the Federal Reserve supplies money, Ms = 20, what is the equilibrium interest rate (i.e. what r will equate the supply and demand for money)? b. If the Federal Reserve wants to increase r by 10 percentage points (e.g. from 2% to 12%), at what level should it set the supply of money? 4. (12 points) In this question you define and measure the money multiplier. a. Define the money multiplier b. Use the St. Louis Federal Reserve Banks on-line data program ( to calculate and graph the money multiplier for the U.S. economy from 1984 to the present. c. Explain in words what happened to the money multiplier during the Great Recession and why this occurred. 5. (12 points) Use the St. Louis Federal Reserve Bank website (FRED) to compare the Federal Reserves target Fed Funds rate and the effective daily rate from 1995 (when the Fed started regularly announcing its target interest rate) until the end of 2008 (when the Federal Reserve announced a target spread of between zero and 0.25%). a. Graph the two rates and the difference between the two rates. b. What was the average daily difference between the two rates? c. What was the maximum daily difference and when did it reach that maximum? 6. (12 points) Use the Federal Reserve Boards statistical release H.6 Money Stock Measures to answer the questions below. a. What was the change in M2 during December 2013? b. What actions could the Federal Reserve Open Market Operations desk have taken to cause this change in the money supply? c. Show the effect of such actions on an ISLM diagram, indicating the impact of the policy on interest rates and GDP. d. In fact, U.S. interest rates were fairly constant over this period. What actions (by private parties) could explain this? Illustrate your answer on an IS-LM diagram.

7. (4 points) The CBO is currently projecting that the U.S. governments expenditures on interest payments on the federal debt will equal $237B in 2014 ( Using the ISLM model, explain the impact that these expenditures have on the IS curve? On GDP?

8. (20 points) At the conclusion of its January 29, 2014 meeting of the Federal Open Market Operations Committee, the FOMC announced that Beginning in February, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $30 billion per month rather than $35 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $35 billion per month rather than $40 billion per month. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. ( (20 points) a. What is the Federal Funds Rate? b. How, specifically, will the Federal Reserve purchas[e] additional agency mortgage-backed securities at a pace of $30 billion per month. What is the impact on the money supply of such purchases? c. On a standard ISLM diagram, show the impact of these securities purchases by the Federal Reserve. d. In words, tell me the predicted impact of these purchases on interest rates and GDP. e. Explain how what you report in part b is consistent with a policy that will keep the target range for the for the federal funds rate at 0 to percent.