1. Which components of aggregate demand respond to interest rates? Which interest rates?
The Investment function within AD responds to REAL interest rates.
2. Does growth in aggregate demand in excess of growth in potential output always cause inflation to increase? Explain why or why not? Is it possible for inflation to be rising and the rate of growth of aggregate demand to be slower than the rate of growth of potential output?
Yes because of the AD curve, an increase in potential output (Ybar) will cause inflation (π) to increase in order to reach equilibrium. Yes because when potential output peaks, the rate of growth slows.
3. What is meant by a negative output gap? In such a situation, what can you say about the unemployment rate? What is happening to inflation?
An output gap is when potential output is greater than actual output.
The unemployment rate will be high in this case.
Inflation (π) in this scenario is low.
4. If real GDP grows at a 2.5 percent annual rate over the next two years, what will the unemployment rate be at the end of this period (it currently is 4.1 percent)? Alternatively, what would the unemployment rate be is there is no growth in real GDP over the next two years?
The UR will be 2.85% if RGDP increases by 2.5%. If there is no growth in RGDP, then there will be no change in the UR.
5. If there is no output gap and expected inflation is 2 percent, what will be the actual rate of inflation? What will happen to actual inflation if expected inflation increases to 4 percent? What options does the Fed have for lowering the inflation rate back to 2 percent? Which is least disruptive?
2%. Actual inflation will increase along with expected inflation. The Fed can use contractionary monetary policy to lower the interest rates to lower inflation. This would be the least disruptive way.
6. If inflation was 4 percent and there was a positive output gap of 2 percent, what would the Taylor Rule prescribe for the setting of the federal funds rate? Show your calculation.
2+4+0.5(4-2)+0.5(-2) A) I=6
7. In banking panics, why is maturity transformation (maturity mismatches) key? What role does leverage play in causing a credit crunch?
Maturity mismatches are key during banking panics because they can use long-term assets to offset short-term debt, and then profit over the excess cash flows. Leverage will cause a credit crunch if it is easier to obtain debt with the uncertainty of repaying the debt.
8. How did the most recent financial crisis differ from standard banking panics? What was the role of shadow banks?
The most recent financial crisis differed from standard banking panics because of the amount of leverage increased by shadow banks not following standard banking procedures, and lending out money to those who could not repay the principle.
9. How are the goals of monetary policy and financial stability interrelated?
The goals of monetary policy are to decrease the unemployment rate, hold prices stable, and hold long-term interest rates constant. Financial stability occurs when prices are stable, unemployment is controlled, and interest rates are not volatile. Therefore, financial stability and the goals of monetary policy go hand-in-hand.
10. How will the Law of One Price be achieved under the following circumstances and a fixed exchange rate: The price of a particular Nikon camera is 500 British pounds in London and 650 dollars in New York and the exchange rate is $1.50 per pound? How will it be achieved if the dollar-pound exchange rate floats? Describe the process. You are not required to come up with numerical answers.
Fixed Exchange Rate: Arbitrage will cause the rates to equalize over time. Floating Exchange Rate: According to the Law of One Price, the price of two items will cost the same regardless of exchange rates.
11. How would an increase in interest rates in the United States affect the dollar-pound exchange rate? A reduction in interest rates in the United Kingdom?
An increase in interest rates within the U.S. would cause the exchange rate to also increase. Alternatively, a decrease in the interest rates in the U.K. would cause the exchange rate to decrease from their side.
12. What will happen to the price level of a country with a fixed exchange rate and an undervalued currency? What will happen to its holdings of foreign currency reserves?
The price level of a country will decrease due to undervalued currency, this creates an excess of currency reserves.
13. Why have major industrial countries abandoned fixed exchange rate regimes in favor of floating exchange rates? What have been the implications for monetary policy? Price stability?
Because the floating rate is determined throught private market’s supply and demand, making it “self-correcting”. Central Banks have to interferre less when handling a floating rate as opposed to a fixed rate, this increases price stability within a county.
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