Economics 304 Homework - Lesson 7 - The Fed and the Money Supply complete solution

Economics 304 Homework - Lesson 7 - The Fed and the Money Supply complete solution correct answer key

90 points total: Instructions: Please show all work or points will be taken off. Good luck!

1. (35 points total) In this problem, we are going to calculate the money multiplier one year prior to the Great Recession (12/2006) and compare it to the money multiplier five years hence (12/2011).  The implication as you may have guessed is that since the Fed has been paying interest on excess reserves (10/2008), the excess reserve to deposit ratio has risen which implies a lower money multiplier.[1]  To do so, we  will use the data from FRED (Federal Reserve Economic Data).  Note, after clicking on hyperlink, look to the upper left and click on "view data" to retrieve the data that you need to do the problem.  To make sure we are on the 'same page,' the amount of excess reserves in December, 2006 is $1.862 billion (we are using beginning of month data). 

Data you need for  problem 1:

Monetary Base

2006-12-01   837.701

2011-12-01  2603.613

Excess Reserves

12/06 1.862

12/11 1502.318

Currency

2006-12-01   749.5

2011-12-01   999.8

Required Reserves

2006-12-01   41.420

2011-12-01   96.514

Demand Deposits

2006-12-01   610.8

2011-12-01  1164.6

a) (10 points) Calculate the money multiplier for Dec 2006, one year prior to the Great Recession. Please show all work.

b) (10 points) Calculate the money multiplier for Dec 2011, five years hence and a little more than three years after the Fed got the authority to pay interest on excess reserves. Click Here for the press release.

c) (5 points) What is the percent change in the money multiplier in this five year period?

d) (10 points) Now consider the change in the monetary base during this same five year period and compare it to the change in excess reserves.  Is it a true statement to say most of the open market purchases that caused the monetary base to "blow up" ended up on bank's balance sheets as excess reserves.  Be very specific with your answer using actual numbers. Which change is bigger and why?? 

2. (35 points total) You are the director of monetary affairs at the Fed and you are in charge of keeping track of the money supply, making sure it does not fall, as it did in the Great Depression, but also making sure it does not ‘blow up’ as we know it might, knowing that the banks are sitting on piles and piles of excess reserves (see pic below).  You have the following initial conditions:

RR/D= .10

C = 400 b

D = 1000 b

ER = 500 b

a) (6 points)              i) Calculate the MB.

                                   ii) Calculate the money multiplier.

                                   iii) What is the money supply (use mm x MB to calculate this)?

Show work

Now  you know that if these banks get rid of their excess reserves all at once, the amount of open market sales that you need to conduct (to keep a handle on the money supply) will be massive and raise more than one eyebrow in Washington (from the politicians) as the infamous ‘exit strategy’ will be full speed ahead. The Fed’s treasured independence would be tested once again and you want to avoid that.  Suppose that you had major influence and convinced the banks that it would be much more stabilizing for all parties if they gradually lent out their excess reserves rather than lending them out all at once.  As such, you convince the banks to cut (lower) their excess reserve to deposit ratio in half (note: the ER/D ratio is cut in half not ER itself).  Assuming importantly that:

• The C/D and RR/D remain the same as in the initial conditions (they are stable)
• The monetary base does not change

b) (4 points) Repeat part a) except for part i).

c) (5 points) Given that 10% is the optimal growth rate of the money supply (from its initial value in part a), what type and how many open market operations do you need to conduct to achieve this target, given what happened to the money supply in part b)?  Assume importantly that the money multiplier is stable at its new level (after the banks cut E/D in half, i.e., part b).

We now pretend that this crisis is well behind us and now it is time to go back to targeting the funds rate. You are facing the following conditions:

Reserve Market

Initial Conditions

rr/D= .10

C = 200 b

D = 1000 b

ER = 00

M = C + D

d)  (5 points)  If Rd = 400 – 100 iff, given the information above, what is the market clearing federal funds rate?  This happens to be the fed funds target.

Show work.

e) (5 points) Suppose two things happen simultaneously:1) reserve demand is increasing and is now expected to be:   Rd = 500 - 100 iff  and 2) Chairman Bernanke calls you up and wants you to increase the funds rate by 150 basis points (one and one half percentage points) beyond its equilibrium value in part d).  What type and how many open market operations must you conduct to satisfy Chairman Bernanke?  Show all work. 

Now Draw a Reserve market diagram depicting the initial conditions as point A and the new conditions (account for the changes from part d to part e) as point B.  A completely labeled and correct graph is worth 10 points.

3. (20 points total) We know that the Fed is heavily criticized for not reacting  aggressively enough during the Great Depression as we witnessed a fall in the money supply during the Great Depression. 

a) (10 points) It is your turn to take 'shots' at the Fed by writing an essay criticizing the Fed for not reacting appropriately during the Great Depression.  Be sure to explain exactly what shocks hit the system (and why) and how the Fed, if they acted differently, could have lessoned the devastating effects the Great Depression had on the economy and its people.

b) (10 points)  Ben Bernanke is known as a student of the Great Depression (as in expert since he has performed a significant amount of research on the topic) so if anyone knows what happened and what went wrong during the Great Depression, it would be Ben Bernanke.  In this question, we are going to see if the Fed "learned their lesson." The data you need are highlighted below (note, this is weekly data and the actual money multiplier numbers do not match those that you calculated in question 1, but don't worry about that).