Take-home Midterm #3 for Economics 102 Cold-Test Answers

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Winter 2008 Mr. Smitka Take-home Midterm #3 for Economics 102

Cold-Test Answers
1. Identify "money" in the US context. What is it? where does it come from? and so on…
Money consists only in part of "cash" – and of the $700-odd billion that the the Treasury Department (or more precisely, the Comptroller of the Currency) has printed, perhaps half is held outside the US and so is not available to our economy. Most money instead consists of checking accounts and other liquid bank deposits.

This money is created by banks; they "print" it, not the US government. This is done through the lending process: when a bank makes a new loan [an asset], it is paid to the borrower as a check, which is new money [a liability].

This process is finite in scope because prudential management of a financial institution means banks keep a certain percentage of deposits on hand to cover withdrawals. Historically not all banks were prudent, so the Federal Reserve Act of 1913 (and similar legislation in other countries) mandated that banks maintain a specified level of "required reserves." The interest rate that banks need to pay to acquire extra reserves -- or that they get from lending out excess reserves -- places a natural limit on this credit creation process.
Notes: 1. Nothing but trust backs modern money; gold, silver and other commodities have had no particular role since the 1930s, though gold remained in use among central banks in very specific circumstances until 1971. 2. Reading your quizzes, the "money multiplier" as expounded by the B&B text is more confusing than helpful. Furthermore, among OECD members, no one pays attention to the "money supply" any more. Central banks focus exclusively on interest rates.
2. What interest rates can the Fed drive down, and how would it do so?
The Fed directly affects only the overnight interest rate on "Federal Funds" (which banks can count as reserves). Other short-term interest rates, however, tend to trace the Fed Funds rate very closely. It has less and less of an impact as maturities become longer; mortgage interest rates can move in the opposite direction...

To drive down interest rates, the Fed needs to make more Fed Funds available. It normally does so through Open Market operations (though it can lend reserves directly through the Discount Window, something that until a few weeks ago had not been used for that purpose). To return to the normal practice: to drive down rates, the Federal Reserve Open Market Committee instructs the Open Market Trading Desk in the New York Federal Reserve Bank of New York to buy bonds. It then pays for these bonds by crediting the account at the Fed of the bank that handles the transaction. That gives that bank extra reserves, which it can "sell" (lend) to other banks or itself use. To help "anchor" the interest rate, the Fed also announces its target rate – it is very hard to judge supply and demand for Fed Funds so as to hit that target exactly, but in general interest rates deviate very little from it.

3. What is the impact of τ ↓ ? Use an arrow chart to trace this step-by-step, to make sure you have a good grasp of the chain of transmission. Explain how assumptions might affect the answer, such as whether the tax cut is permanent and whether the economy is growing normally.
τ ↓ ⇒ disposable income ↑ ⇒ (∆S↑ if temporary) ⇒ C ↑ ⇒ (the multiplier) ⇒ Y ↑.

if π ↑ then the Fed ⇒ i ↑ ⇒ crowing out, partially but not wholly offsetting Y↑ .
Qualifications in prose:

If the tax cut is temporary, then (as per the lifecycle savings model) we would expect much of it to be saved, so C would change only a little (though the rest of the process would remain the same).

If the economy is growing normally, then ceteris paribus this would shift AD right and up the AS curve, so that only a portion would be seen as higher real Y, and the remainder would show up as higher π. The Fed is (highly!) likely to respond to such an inflationary threat with i↑ so that we would see some combination of I↓ and (through an appreciation of the US$ forex rate) a change in net exports (X-M)↓. After the multiplier etc this would mute (but not fully offset) the original increase. This is our "crowding out" story.

4. In the US, what are the (i) strengths and (ii) weaknesses of using (a) FP and (b) MP?

Both FP & MP suffer from the lack of real-time data: we can suspect that the US economy is slowing, but we can't be sure until GDP data come out months later. Similarly, inflation and unemployment data are a month behind and are volatile, so identifying a trend requires several months' data.

In terms of side effects, FP is better for addressing an inflation because it does not lead to an increase in real i and a consequent crowding out of investment and/or trade, while using FP to stimulate the economy can lead to crowding out and so is undesirable. Conversely, MP would be better for addressing a slow economy and/or deflation because it boosts I and thus g, while it ought not be used to slow the economy, as it lowers I and g.

Fiscal policy faces substantial implementation delays, because in normal cases it depends on the budget cycle, and takes months if not a full year. (The budget is normally drafted in late fall, submitted to Congress in February, and in principle passed before summer recess so that departments can put plans in place before the start of the US fiscal year on October 1st.) For the most part, fiscal policy is merely a side effect of choices made over taxing and spending for other reasons, rather than a direct focus of Congressional policy. It is very hard to adjust along the way if conditions change.

In contrast monetary policy can be changed on a few hours' notice, and MP is a primary task of the Fed. The FOMC meets 8 times a year to set interest rates, and so it is natural to make incremental changes. In that sense MP is vastly superior.

Both take time to "bite." When a budget is passed, new expenditures typically don't start immediately, while the multiplier process is not instantaneous. Likewise, monetary policy works only as businesses adjust their investment plans – and those plans are dominated by expectations, not modest changes in interest rates. Similarly, households take time to adjust their plans for building new houses. Hence it takes at least 6 months, and often 9 months, from changes in the implementation of either FP or MP for them to start making a measurable difference, and 18 months for the full impact to be felt.

The net of all this is that in the normal course of events MP is the only active tool of macroeconomic policy. But it is asymmetric (see more below): the Fed is far less effective at preventing recessions than inflation. In recognition, many governments make "price stability" the (legal) primary goal of their central bank. The US does not. And so far 2008 is not proving a normal year...FP is actually being used as an explicit macro policy tool, outside the normal budget cycle. Let's hope it works...

5. "The Emperor, Ben Bernanke, has no clothes." Explain in terms of the current US macroeconomic environment. Hint: among other topics, you might want to refer to "illiquidity" and "insolvency" in your response.
You can lead a horse to water, but you can't make it drink; you can slow an economy by pulling on a rope, but you can't push it to go faster. Investment is driven primarily by expectations and not interest rates, and in addition short term interest rates are less relevant than mortgage rates. The Fed cannot directly affect either long rates or expectations. In the current context of falling house prices, even very cheap mortgage interest rates are not going to encourage people to borrow to buy a house.

Second, illiquidity is an issue the Fed can address through emergency lending, asset purchases and "talking" to the markets to try to calm expectations. Hence it has considerable ability to quell a panic that may shut out a set of financial institutions from the ability to borrow (for a "traditional" bank, attract deposits). The Bear Stearns case is an example – while rumors had it as "belly up" it was due to liquidity problems - a short-term inability to borrow enough from banks to cover its asset positions - and not because it had run through all its capital and was insolvent. Indeed, the initial purchase price of $2 per share has now been boosted to $10 per share.

Third, a central bank cannot address issues of solvency; emergency loans are not a good way to handle banks that have loan losses exceeding their capital. Some institutions are deemed "too big to fail," and a central bank will under duress arrange a bailout. But the Fed is simply not in a position to bail out the multiple mortgage companies that have failed, much less the host of homeowners who are defaulting on their mortgages.

A milder version of that is a "credit crunch" in which banks have lost a lot of money and so cut back on their lending to improve the ratio of capital to assets. In such cases even otherwise creditworthy borrowers with deserving projects can't get loans. But empirically the main issue in a recession is that businesses and people don't want to borrow, rather than that banks don't want to lend; credit crunches are unusual.

Fourth and finally, the proximate cause of the problems in the US economy is a downturn in housing prices. That again is an issue that a central bank cannot address. The Fed has no means to start buying massive amounts of real estate in the affected areas to try to stem the decline. Most economists believe that is just as well, since prices seem to have been a product of the "irrational exuberance" of a "bubble" and not the opportunity cost of renting. Propping up an unsustainable level of prices is hard. (Of course, judging what is "unsustainable" is difficult.) Relative prices have to change, and while inflation could raise other prices until California housing prices seem relatively sensible, central banks view that suggestion as heresy and furthermore have a hard time creating high inflation quickly in an economy in recession. The Fed cannot make "real" problems disappear by waving a monetary wand.
Addendum: In the current context, house prices are in all too many cases below the value of the mortgage. Borrowers quite sensibly contemplate handing those houses back to the bank (and when they are subprime borrowers, they may in any case be unable to meet monthly payments). In those cases banks suffer losses, and must "write down" the value of the loans. (It is not unusual that they can recover only 50¢ on the dollar.) This erodes their capital, and once it falls below a certain level (4% in the US), they can be (and typically are) shut down and the FDIC takes over to pay off depositors and wind down operations. As banks approach that point, they become reluctant to make new loans -- the "capital crunch" story -- but that is irrelevant as with housing prices falling, who wants to borrow?

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