Economics 470/570 - Monetary Theory and Policy

Midterm 2

Economics 470/570
Winter 2005 (worth 1 point)
Midterm #2

Part I - Definitions. Define each of the following (3 points each, 18 points total).

1. Autonomous expenditures

2. Crowding out

3. Inflationary and recessionary gaps

4. Policy ineffectiveness proposition

5. Menu costs

6. Wealth effect

Part II - Short Answer. Answer THREE of the following questions (9 points each, 27 points total).

1. What is the expenditure multiplier? Why is it useful?

2. When is money demand more sensitive to changes in the interest rate, at full employment or in a recession? Explain.

3. Use the IS-LM model to show that the model is classical in the LR, i.e. that (a) output does not change in the LR, (b) monetary shocks do not affect the real interest rate in the LR, (c) real shocks do affect the real interest rate in the LR.

4. Derive the SRAS and LRAS curves for the New Classical model.

Part III – Essays and problems. Answer THREE of the following questions (18 points each, 54 points total)

1. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as investment becomes less sensitive to the interest rate. Explain the result intuitively.

2. (a) What is a liquidity trap and how does it arise? Explain your answer intuitively and graphically. Is the economy more likely to be in a liquidity trap near full employment or in a recession? Explain. (b) Explain and show graphically using the IS-LM model how the economy can become stuck in a liquidity trap with output less than its full employment level. How can wealth effects overcome this problem?

3. Explain the activist and non-activist positions on the use of government policy to stabilize macroeconomic variables such as real output. What problems are encountered in the pursuit of activist policies? Are there substantial differences for monetary and fiscal policy?

4. Suppose the monetary authority wants to reduce the inflation rate. Compare the costs (in terms of output) of reducing inflation in the traditional Keynesian, New Classical, and New Keynesian models. Be sure to cover both an expected and an unexpected change in policy. Why is the credibility of policymakers important?

[Midterm 2 Solution]

Midterm 1

Economics 470/570
Winter 2005 (worth 1 point)
Midterm #1

Part I - Definitions. Define each of the following (3 points each, 18 points total).

1. Direct and indirect finance

2. Federal Funds rate

3. Bank Reserves

4. Monetary Base

5. Defensive and Dynamic Open Market Operations

6. Output gap

Part II - Short Answer. Answer THREE of the following questions (9 points each, 27 points total).

1. Who is on the FOMC? What does the FOMC do?

2. Write down the government budget constraint and explain each term.

3. (a) Explain why the demand curve for reserves slopes downward. (b) Explain the shape of the supply curve for reserves.

4. What is the Taylor rule? How is it used? How well does it predict Fed policy?

Part III – Essays and problems. Answer THREE of the following questions (18 points each, 54 points total)

1. How independent is the Fed? What factors contribute to independence? What factors work against independence? Discuss arguments for and against the independence of the Fed.

2. Show the t-accounts and the balance sheet for the following series of transactions. (i) Open a bank with 5 million dollars, put 2 million into buildings and equipment. (ii) Put 1 million of the cash into T-bills. (iii) Deposit .5 million into regional Fed bank. (iv) Collect 1.5 million in deposits from other banks. (v) Let the required reserve ratio be 10% and show what happens if the bank loans out all excess reserves.

3. What is meant by the phrase lender of last resort? Why is this important? Explain and show graphically how the Fed uses discount rate policy to act as a lender of last resort and how this limits the amount the federal funds rate can increase.

4. (a) State Say’s law. What is the significance of this in terms of government stabilization policy? Explain why Malthus does not believe in Say’s law. How does classical interest theory answer address Malthus’ criticism of Say’s law? (b) Explain why the investment function slopes downward and the saving function slopes upward.

[Midterm 1 Solution]

Final Exam

Economics 470/570
Winter 2005
Final Exam

Part I - Definitions. Define each of the following (2 points each, 12 points total).

1. Liquidity

2. Discount window and Discount rate

3. Velocity of money

4. Policy effectiveness

5. Monetary shock and Real shock

6. Natural rate hypothesis

Part II - Short Answer. Answer FOUR of the following questions (7 points each, 28 points total).

1. Show that the Fed cannot simultaneously control bank reserves and the federal funds rate and therefore cannot adopt both as operating targets.

2. What is the difference between real and nominal interest rates? How do the ex-ante and ex-post real interest rates differ?

3. Derive the IS curve graphically and explain intuitively why the IS curve slopes downward.

4. Use the fixed wage AD-AS model to show the SR and LR adjustment to AD shocks.

5. How does the New Keynesian model differ from the traditional Keynesian and New Classical models?

Part III – Essays and problems. Answer FOUR of the following questions (15 points each, 60 points total)

1. What are the functions of money, i.e. why does money exist? Relative to a barter economy, what problems are overcome by the use of money?

2. Describe the three tools available to the Fed for controlling the money supply. How do defensive and dynamic open-market operations differ? How do primary, seasonal, and secondary credit differ? What are the advantages and disadvantages of each tool

3. Discuss the transactions, precautionary, and speculative motives for holding money in Keynes liquidity preference theory. When all three motives are put together, what theory of money demand emerges?

4. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as money demand becomes less sensitive to the interest rate. Explain the result intuitively.

5. Compare and contrast the effects of an expected increase or decrease in the money supply on prices and output in the traditional Keynesian, New Classical, and New Keynesian models.

Homework 10

Economics 470/570
Winter 2005
Review Question Set for Week #10

Definitions

Menu costs

Short Answer

1. How does the New Keynesian model differ from the traditional Keynesian and New Classical models?

2. Derive the SRAS and LRAS curves for the New Keynesian model.

Essay

1. Compare and contrast the effects of an unexpected increase or decrease in the money supply on prices and output in the traditional Keynesian, New Classical, and New Keynesian models.

2. Compare and contrast the effects of an expected increase or decrease in the money supply on prices and output in the traditional Keynesian, New Classical, and New Keynesian models.

3. Suppose the monetary authority wants to reduce the inflation rate. Compare the costs (in terms of output) of reducing inflation in the traditional Keynesian, New Classical, and New Keynesian models. Be sure to cover both an expected and an unexpected change in policy. Why is the credibility of policymakers important?

 

Homework 9

Economics 470/570
Winter 2005
Review Question Set for Week #9

Definitions

Policy ineffectiveness proposition

Rational expectations

Natural rate hypothesis

Activist/non-activist

Data lag

Recognition lag

Legislative lag

Implementation lag

Effectiveness lag

Short Answer

1. Derive the SRAS and LRAS curves for the New Classical model.

2. How does the New Classical model differ from the traditional Keynesian model?

 

Essay

1. Explain the activist and non-activist positions on the use of government policy to stabilize macroeconomic variables such as real output. What problems are encountered in the pursuit of activist policies? Are there substantial differences for monetary and fiscal policy?

2. Derive the short-run and long-run Phillip's curves from the fixed wage AD-AS model. Explain why the short-run Phillip’s curve shifts when inflationary expectations change.

3. Use the Phillip’s curve to explain why credibility of the monetary authority is important for fighting inflation.

4. Explain why only unexpected changes in policy can affect real output in the short-run and neither expected nor unexpected money can affect real output in the long-run in the New Classical model.

Homework 8

Economics 470/570
Winter 2005
Review Question Set for Week #8

Definitions

Liquidity trap

Monetary shock

SRAS

Full employment

Wealth effect

Real shock

LRAS

Inflationary and recessionary gaps

Short Answer

1. Use the IS-LM model to show that velocity is constant in the classical version of the model, but not in the Keynesian version.

2. Use the IS-LM model to show and explain how price adjustments return the economy to full employment when output differs from its full employment level.

3. Use the IS-LM model to derive the AD curve. Explain intuitively why the AD curve slopes downward.

4. Use IS-LM and AD diagrams to show how the AD curve shifts when there is a shift in either the IS or LM curve due to any factor except changes in price and income.

5. Use the IS-LM model to show that the model is classical in the LR, i.e. that (a) output does not change in the LR, (b) monetary shocks do not affect the real interest rate in the LR, (b) real shocks do affect the real interest rate in the LR.

6. Explain why the SRAS curve (assuming fixed wages in the SR) slopes upward. Explain why the curve shifts when the fixed wage is reset.

7. Use the fixed wage AD-AS model to show the SR and LR adjustment to AD shocks.

Essay

1. Explain and show graphically using the IS-LM model that wage stickiness can impede the economy’s return to full employment.

2. What is a liquidity trap and how does it arise? Explain your answer intuitively and graphically. Is the economy more likely to be in a liquidity trap near full employment or in a recession? Explain.

3. Explain and show graphically using the IS-LM model how the economy can become stuck in a liquidity trap with output less than its full employment level. How can wealth effects overcome this problem?

4. Explain and show graphically using the IS-LM model that when investment is highly insensitive to changes in interest rates, the automatic adjustment mechanism that returns the economy to full employment can break down.

5. In the classical version of the IS-LM model, show that (a) fiscal policy is ineffective, and (b) monetary policy is fully effective. In what sense is the result for monetary policy inconsistent with the classical view?

6. In the Keynesian liquidity trap version of the IS-LM model, show that, when the economy is in the liquidity trap, (a) monetary policy is ineffective, and (b) fiscal policy is fully effective. Show that the results (a) and (b) also hold in the Keynesian vertical IS version of IS-LM model.

7. Is the private sector inherently stable, i.e. does the economy self correct quickly when there are inflationary or recessionary gaps? Discuss using graphs where appropriate. Is there a role for stabilization policy?

Homework 7

Economics 470/570
Winter 2005
Review Question Set for Week #7

Definitions

IS curve

LM curve

Policy effectiveness

Crowding out

Short Answer

1. Derive the LM curve graphically and explain intuitively why the LM curve slopes upward.

2. Explain why the LM curve is vertical when money demand is unaffected by changes in the interest rate (as in the classical model). More generally, explain why the LM curve is steeper when money demand is less sensitive to the interest rate.

3. Derive the IS curve graphically and explain intuitively why the IS curve slopes downward.

4. Explain why the IS curve is steeper when the sensitivity of investment to the interest rate falls.

5. When is investment more sensitive to changes in the interest rate, at full employment or in a recession? Explain.

6. When is money demand more sensitive to changes in the interest rate, at full employment or in a recession? Explain.

7. Is there any difference between using a tax cut to stimulate output rather than increasing government spending? Explain.

Essay

1. What factors cause the LM curve to shift? In what direction do they shift the LM curve? Show the shifts graphically using money demand - money supply and LM curve diagrams.

2. Show graphically and explain intuitively how the slope of the LM curve changes when the responsiveness of money demand to the interest rate (|L_R|) increases.

3. What factors cause the IS curve to shift? In what direction do they shift the IS curve? Show the shifts graphically using 45 degree line and IS curve diagrams.

4. Show graphically and explain intuitively how the slope of the IS curve changes when the responsiveness of investment to the interest rate (|IR|) increases.

5. Consider points above or below the LM curve. Explain why there is excess demand or excess supply at each point and the forces that cause i to change so as to restore equilibrium. Next, consider points above or below the IS curve. Explain why there is excess demand or excess supply at each point and the forces that cause y to change so as to restore equilibrium. Use these results to explain why the IS-LM model is stable.

6. Show graphically and explain intuitively how an increase in (a) the money supply, and (b) government spending affects income and the interest rate in the IS-LM model.

7. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as investment becomes less sensitive to the interest rate. Explain the result intuitively.

8. Use the IS-LM model to examine how the relative effectiveness of monetary and fiscal policy changes as money demand becomes less sensitive to the interest rate. Explain the result intuitively.

Homework 6

Economics 470/570
Winter 2005
Review Question Set for Week #6

Definitions

Consumption, disposable income, MPC and MPS

Investment

Government spending

Aggregate demand or expenditures

Autonomous expenditures

Expenditure multiplier

Transactions, precautionary, and speculative demand for money

Liquidity preference

Autonomous money demand

Short Answer

1. Explain why investment is negatively related to the interest rate.

2. Explain why setting income equal to expenditures is equivalent to setting saving equal to investment.

3. What is the expenditure multiplier? Why is it useful?

4. Show the money demand curve graphically. Show how the money demand curve shifts when income increases.

Essay

1. What does the 45 degree line diagram show? Show the equilibrium on the 45 degree line diagram and explain how the economy moves to equilibrium if output differs from its equilibrium value. How will the equilibrium level of output change if there is a change in autonomous consumption, investment, government spending, or taxes? Explain. How will income change if the interest rate falls?

2. Discuss the transactions, precautionary, and speculative motives for holding money in Keynes liquidity preference theory. When all three motives are put together, what theory of money demand emerges?

3. Explain intuitively and use a money demand – money supply diagram to show how the interest rate changes if (a) the nominal money supply increases, (b) the price level increases, (c) real income increases, and (d) an increase in autonomous money demand.

4. According to Baumol, the transactions demand for money depends upon the interest rate as well as nominal income. Explain why the transactions demand for money depends upon the interest rate. Why is this important?

Homework 2 Update

Economics 470/570
Winter 2005
Review Question Set for Week #2

[ADDS PAGE NUMBERS FROM MISHKIN’S TEXT]

Definitions

FOMC [341]

FAC [345]

Discount window [359]

Discount rate [359]

Member bank [340]

Federal Funds rate [393]

Short Answer

1. What are the three types of financial intermediaries? What types of firms are in each category? [34-37]

2. Briefly describe the major functions of Federal Reserve district banks. [339]

3. Who is on the FOMC? What does the FOMC do? [341-344]

Essay

1. What are the reasons for regulating financial markets? Discuss the types of regulations that have been imposed on financial markets. [37-40]

2. Describe the structure of Federal Reserve districts and Federal Reserve banks. [336-340]

3. Describe the structure and function of the Board of Governors of the Federal Reserve System. [340-341]

4. How has the power structure of the Federal Reserve System shifted over time? [344-346]

5. How independent is the Fed? What factors contribute to independence? What factors work against independence? Discuss arguments for and against the independence of the Fed (we will discuss this part of the question next class). [346-349, 352-354]

 

Homework 1 Update

Economics 470/570
Winter 2005
Review Question Set for Week #1

[ADDS PAGE NUMBERS FROM MISHKIN'S TEXT]

Definitions

Medium of exchange/Double coincidence of wants [45-47]

Unit of account/Multiplicity of prices [45-47]

Store of value/Liquidity [45-47]

Financial intermediary [29]

Direct and indirect finance [23-25]

Liquidity [47]

Short Answer

1. How is money measured? Why is there more than one definition of the money supply? [51-55]

2. How do bonds and equities differ? Which is more risky? [25-26]

3. How do bond and equity markets differ? How do primary and secondary markets differ? How do money and capital markets differ? [25-28]

4. Explain how secondary markets determine the price of new securities and why they make new securities easier to sell. How do over-the-counter markets and organized exchanges differ? [26-27]

5. List and briefly describe the various money market instruments.

http://wps.aw.com/wps/media/objects/744/761962/appendixes/ch02appendix.pdf

6. List and briefly describe the various capital market instruments.

http://wps.aw.com/wps/media/objects/744/761962/appendixes/ch02appendix.pdf

Essay

1. Why study of money? Why study banking? Why study financial markets? [3-13]

2. What are the functions of money, i.e. why does money exist? Relative to a barter economy, what problems are overcome by the use of money? [45-48]

3. Describe the main function of financial markets. Explain how direct finance and indirect finance differ. Among households, government, business, and the foreign sector, who are the biggest borrowers/lenders? [29-32 plus class notes]

4. How do financial intermediaries, through their ability to pool resources promote more efficient use of financial resources? Be sure to cover risk pooling, the pooling of small investors, and pooling over time in your answer.

5. How do financial intermediaries reduce default risk, transactions costs, and matching costs? [29-32 plus class notes for both 4 and 5]

Homework 5

Economics 470/570
Winter 2005
Review Question Set for Week #5

Definitions

Monetary aggregate

Velocity of money

Output gap

Short Answer

1. Show that if the Fed controls either the federal funds rate or bank reserves, then the variance of the other variable increases.

2. Can the Fed control bank reserves exactly? Explain. Why is this important?

3. What is the Taylor rule? How is it used? How well does it predict Fed policy?

4. What is meant be the phrase “money is a veil” in the classical model? What is the role of money in the classical model?

5. What is the difference between real and nominal money? Do changes in nominal money also change real money in the classical model? Explain.

6. What is the difference between real and nominal interest rates? How do the ex-ante and ex-post real interest rates differ?

7. Represent the classical model using an AD-AS diagram and show that changes in money, government spending, and taxes do not affect real output. What is the AD curve in the classical model?

Essay

1. Explain the reasons for the Fed’s decision to adopt an interest rate target rather than a monetary aggregate target.

2. State Say’s law. What is the significance of this in terms of government stabilization policy? Explain why Malthus does not believe in Say’s law. How does classical interest theory answer address Malthus’ criticism of Say’s law?

3. Explain classical interest theory. Be sure to explain why the investment function slopes downward and the saving function slopes upward.

4. Explain the quantity theory of money. Explain the Cambridge approach and illustrate that it leads to the same identity as the quantity theory. What assumptions are imposed to arrive at a theoretical statement?

5. What is the money demand function in the classical model? What factors determine velocity? How do these factors affect money demand?

Homework 4

Economics 470/570
Winter 2005
Review Question Set for Week #4

Definitions

Monetary Base

Borrowed and Non-borrowed reserves

Operating targets

Intermediate targets

Monetary Policy Goals

Defensive and Dynamic Open Market Operations

Primary, Secondary, and Seasonal Credit

Short Answer

1. Derive the deposit and money multipliers when people hold currency and when banks hold excess reserves. Are the multipliers larger or smaller than the simple multiplier, i.e. when currency held and excess reserves are both zero? Explain.

2. Suppose that the required reserve ratio is 20%, the currency to deposit ratio is .25, the excess reserve to deposit ratio is .05, and the monetary base is 1,000. (a) Find the money supply. (b) Let open market operations increase the monetary base by 200. Use the money multiplier to find the new value of the money supply.

3. Using t-accounts, show that the Fed can increase the monetary base by (a) making discount loans to banks, (b) an open market purchase of government bonds from banks, or (c) an open market purchase of government bonds from an individual.

4. (a) Explain why the demand curve for reserves slopes downward. (b) Explain the shape of the supply curve for reserves.

5. Show that the Fed cannot simultaneously control bank reserves and the federal funds rate and therefore cannot adopt both as operating targets.

Essay

1. Suppose that a bank has $100,000 in excess reserves. Assuming that the required reserve ratio is 20%, use t-accounts to illustrate the multiple deposit creation process. Use this to obtain the simple deposit multiplier. Why are the deposit multiplier and the money multiplier the same when there is no currency and when banks loan out all excess reserves?

2. Explain how and why the money multiplier changes when (a) the required reserve ratio increases, (b) the currency to demand deposit ratio increases, and (c) the excess reserve to demand deposit ratio increases. Who determines each of these quantities?

3. What is meant by the phrase lender of last resort? Why is this important? Explain and show graphically how the Fed uses discount rate policy to act as a lender of last resort and how this limits the amount the federal funds rate can rise.

4. Describe the three tools available to the Fed for controlling the money supply. How do defensive and dynamic open-market operations differ? How do primary, seasonal, and secondary credit differ? What are the advantages and disadvantages of each tool?

5. What are the tools, operating targets, intermediate targets, and goals of Federal Reserve Policy? How are they related?

Homework 3

Economics 470/570
Winter 2005
Review Question Set for Week #3

Definitions

Asset

Liability

Demand Deposit

Bank Reserves

Reserve Requirement

Required Reserves

Excess Reserves

Short Answer

1. Write down the government budget constraint and explain each term.

2. Why is a demand deposit an asset for an individual, but a liability of the bank?

Essay

1. Show the t-accounts and the balance sheet for the following series of transactions. 

(i) Open a bank with 10 million dollars, put 3 million into buildings and equipment.

(ii) Put 2 million of the cash into T-bills.

(iii) Deposit 1.5 million into regional Fed bank.

(iv) Collect 4 million in deposits from other banks.

(v) Let the required reserve ratio be 20% and show what happens if the bank loans out all excess reserves.

Homework 2

Economics 470/570
Winter 2005
Review Question Set for Week #2

Definitions

FOMC

FAC

Discount window

Discount rate

Member bank

Federal Funds rate

Short Answer

1. What are the three types of financial intermediaries? What types of firms are in each category?

2. Briefly describe the major functions of Federal Reserve district banks.

3. Who is on the FOMC? What does the FOMC do?

Essay

1. What are the reasons for regulating financial markets? Discuss the types of regulations that have been imposed on financial markets.

2. Describe the structure of Federal Reserve districts and Federal Reserve banks.

3. Describe the structure and function of the Board of Governors of the Federal Reserve System.

4. How has the power structure of the Federal Reserve System shifted over time?

5. How independent is the Fed? What factors contribute to independence? What factors work against independence? Discuss arguments for and against the independence of the Fed (we will discuss this part of the question next class).

Homework 1

Economics 470/570
Winter 2005
Review Question Set for Week #1

Definitions

Medium of exchange/Double coincidence of wants

Unit of account/Multiplicity of prices

Store of value/Liquidity

Financial intermediary

Direct and indirect finance

Liquidity

Short Answer

1. How is money measured? Why is there more than one definition of the money supply?

2. How do bonds and equities differ? Which is more risky?

3. How do bond and equity markets differ? How do primary and secondary markets differ? How do money and capital markets differ?

4. Explain how secondary markets determine the price of new securities and why they make new securities easier to sell. How do over-the-counter markets and organized exchanges differ?

5. List and briefly describe the various money market instruments.

6. List and briefly describe the various capital market instruments.

Essay

1. Why study of money? Why study banking? Why study financial markets?

2. What are the functions of money, i.e. why does money exist? Relative to a barter economy, what problems are overcome by the use of money?

3. Describe the main function of financial markets. Explain how direct finance and indirect finance differ. Among households, government, business, and the foreign sector, who are the biggest borrowers/lenders?

4. How do financial intermediaries, through their ability to pool resources promote more efficient use of financial resources? Be sure to cover risk pooling, the pooling of small investors, and pooling over time in your answer.

5. How do financial intermediaries reduce default risk, transactions costs, and matching costs?

Syllabus for Winter 2005

Monetary Theory and Policy

Course: Economics 470/570
Professor: Mark Thoma
Office/Hours: PLC 471 on M/W 12:00-1:00 p.m.
Phone/Email: (541) 346-4673, [email protected]
Web Page: http://mthoma.uoregon.edu/Economics470/

Text: Principles of Money, Banking, and Financial Markets, 11^th edition, by Ritter, Silber, and Udell, Pearson Addison-Wesley.

Prerequisites: Economics 313 or the equivalent.

GTF, Office Hours, Location, and Email Address:

Beilei Cai T/Th 12:00-1:00 PLC 537 [email protected]

Tests: There will be two midterm exams and a comprehensive final. The midterms will be given Monday, January24th and Monday, February 21st, and the final exam will be given on Monday, March 14th at 10:15 a.m. No make-up exams will be given. If you cannot take the midterms and the final exam on the scheduled dates, please do not sign up for the class.

Homework: Problem sets will be assigned periodically. These are not graded, but it is strongly recommended that you do them.

Grading: Grades will be assigned according to your relative standing in the class. The midterms are worth 30% each and the final is worth 40%.

Tentative Course Outline:

Introduction

Introduction (ch. 1 )

The Role of Money in the Macroeconomy (ch. 2, 4, pgs. 63-64)

Banks and Other Intermediaries

Financial Intermediation class notes

Central Banking and the Conduct of Monetary Policy

Structure of Central Banks and the Federal Reserve System (ch. 17)

Bank Reserves and the Money Supply (ch. 18)

The Instruments of Central Banking (ch. 19)

Monetary Policy Strategy (ch. 21)

Monetary Theory

The Classical foundations (ch. 22)

The Keynesian Framework (ch. 23)

The IS-LM Model (ch. 24)

Short-Run Stabilization Policy (ch. 25)

The AS-AD Model and Stabilization Policy (ch. 26)

Rational Expectations: Theory and Policy Implications (ch. 27)

Empirical Evidence on Monetary Policy Effectiveness (ch. 28)