Name:______________________

EC 391 Midterm #2

Short Answer
1) What is the difference between a credit driven asset price bubble and an irrational
exuberance asset price bubble.

2) What are the benefits and disadvantages of the unconventional monetary policy tool of
forward guidance?

3) What are the advantages and disadvantages of an inflation-target law?

Analytical Questions
1) Demand and Supply of Reserves: For each of the following graph the initial eq. and the
effect of the policy change. Describe the change of the equilibrium federal funds rate.

a) Suppose the discount rate is equal to the initial federal funds rate. Graph a decrease in
the discount rate.

b) Suppose the initial federal funds rate is between the discount rate and interest rate paid on
reserves. Graph a decline in demand for reserves.

c) Suppose the discount rate is equal to the initial federal funds rate. Graph an increase in
the discount rate. Does borrowed reserves increase or decrease?

d) Suppose the initial federal funds rate is between the discount rate and interest rate paid on
reserves. Graph a decline in the interest rate paid on reserves.
2) IS/MP Algebra
! = # + % + & + '(
# = # + )*+ ! − -
% = % − / 0 + 1
&=&
'( = '(
0 = 0 + 23 + 4(! − ! 6 ) --(MP Curve)

a) Intuitively explain each element of the MP curve equation.

b) Solve for the IS curve?

c) Solve for the AD curve?

3) IS-MP-AS/AD Graphs
a. In the 1990’s the United States experienced permanent technology shocks and
accommodating monetary policy. Drawing the IS, MP and AS-AD graphs
describe this story. Assume the macroeconomy was initially at a long-run
equilibrium.

b. The economy experienced a positive output gap for most of the decade. What
would we expect to see happen to the expected inflation rate because of this?

i. What if the short run aggregate supply curve did not depend on the output
gap (low gamma), would this accelerate or decelerate the answer you gave
in part b.
Multiple Choice

1) The opportunity cost of holding excess reserves is the federal funds rate
A) minus the discount rate.
B) plus the discount rate.
C) plus the interest rate paid on excess reserves.
D) minus the interest rate paid on excess reserves.

2) When the federal funds rate equals the interest rate paid on excess reserves
A) the supply curve of reserves is vertical.
B) the supply curve of reserves is horizontal.
C) the demand curve for reserves is vertical.
D) the demand curve for reserves is horizontal.

3) Monetary policy is considered time-inconsistent because
A) of the lag times associated with the implementation of monetary policy and its effect
on the economy.
B) policymakers are tempted to pursue discretionary policy that is more contractionary in
the short run.
C) policymakers are tempted to pursue discretionary policy that is more expansionary in
the short run.
D) of the lag times associated with the recognition of a potential economic problem and
the implementation of monetary policy.

4) Because prices are sticky in the short-run, when the Federal Reserve raises the federal funds
rate
A) nominal interest rates fall.
B) real interest rates rise.
C) inflation falls.
D) real interest rates fall.

5) The monetary policy (MP) curve indicates the relationship between
A) the Federal Funds Rate and the real interest rate.
B) the Federal Funds Rate and the inflation rate.
C) the inflation rate and the expected inflation rate.
D) the real interest rate the central bank sets and the inflation rate.

6) True or False: Every time the IS curve shifts, the AD curve shifts in the same direction?
A) True
B) False

7) Everything else held constant, an increase in financial frictions ________ aggregate
________.
A) increases; demand
B) decreases; demand
C) decreases; supply
D) increases; supply


8) Everything else held constant, an increase in net taxes will cause the IS curve to shift to the
________ and aggregate demand will ________.
A) right; increase
B) right; decrease
C) left; increase
D) left; decrease

9) Everything else held constant, if firms expect an increase in inflation, ________ aggregate
supply ________.
A) long-run; increases
B) long-run; decreases
C) short-run; decreases
D) short-run; increases

10) Using the Gordon growth model, a stock's current price will increase if
A) the dividend growth rate increases.
B) the growth rate of dividends falls.
C) the required rate of return on equity rises.
D) the expected sales price rises.