Principles of Economics (12th Edition)
12th Edition
ISBN: 9780134078779
Author: Karl E. Case, Ray C. Fair, Sharon E. Oster
Publisher: PEARSON
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Chapter 11, Problem 2.1P
To determine
Fed, investment spending, and the federal funds rate.
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The Federal Reserve Board of Governors has the power to raise or lower short-term interest rates. Between 2005 and 2006, the Fed aggressively increased the benchmark federal funds interest rate from 2.5 percent in February 2005 to 5.25 percent in June 2006, where it remained until July 2007. From July 2007 to December 2008, the Fed rapidly decreased the federal funds rate, where it dropped to 0.16 percent and remained between 0.07 percent and 0.20 percent through November 2015, after which it again began to rise. Assuming that other interest rates also increased and then decreased along with the federal funds rate, what effects do you think those moves had on investment spending in the economy? Explain your answer. What do you think the Fed’s objective was in increasing and then decreasing the federal funds rate? When and why might the Fed decide to start raising the federal funds rate?
In 2003, as the U.S. economy finally seemed poised to exit its ongoing recession, the Fed began to worry about a “soft patch” in the economy, in particular the possibility of a deflation. As a result, the Fed proactively lowered the federal funds rate from 1.75% in late 2002 to 1% by mid-2003, the lowest federal funds rate on record up to that point in time. In addition, the Fed committed to keeping the federal funds rate at this level for a considerable period of time. This policy was considered highly expansionary and was seen by some as potentially inflationary and unnecessary.
a. How might fears of a zero lower bound justify such a policy, even if the economy was not actually in a recession?
b. Show the impact of these policies on the MP curve and the AD/AS graph. Be sure to show the initial conditions in 2003 and the impact of the policy on the deflation threat.
The following graph shows a hypothetical demand function for federal funds. Currently, the total
amount of reserves in the banking system is $50 billion, the discount rate is 3.5 percent, and
interest on reserves equals IOR = 1 percent. If demand for federal funds increases by $40 billion,
the equilibrium fed funds rate will equal:
Federal Funds Rate (FFR)
5.50%
5.00%
4.50%
4.00%
3.50%
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
SO $10
O a. FFR = 3.00%
Ob. FFR = 3.50%
O c. FFR = 4.00%
d. FFR = 4.50%
Oe. None of the above.
$20
$30
$40
$50 $60 570 580 $90 $100 $110 $120 $130 $140
Bank Excess Reserves (SBillion)
Chapter 11 Solutions
Principles of Economics (12th Edition)
Ch. 11.A - Prob. 1PCh. 11.A - Prob. 2PCh. 11.A - Prob. 3PCh. 11.A - Prob. 4PCh. 11.A - Prob. 5PCh. 11.A - Prob. 6PCh. 11.A - Prob. 7PCh. 11.A - Prob. 8PCh. 11.A - Prob. 9PCh. 11.A - Prob. 10P
Ch. 11.A - Prob. 11PCh. 11.A - Prob. 12PCh. 11 - Prob. 1.1PCh. 11 - Prob. 1.2PCh. 11 - Prob. 1.3PCh. 11 - Prob. 2.1PCh. 11 - Prob. 2.2PCh. 11 - Prob. 2.3PCh. 11 - Prob. 2.4PCh. 11 - Prob. 2.5PCh. 11 - Prob. 2.7PCh. 11 - Prob. 2.8PCh. 11 - Prob. 2.9PCh. 11 - Prob. 3.1PCh. 11 - Prob. 3.2PCh. 11 - Prob. 3.3PCh. 11 - Prob. 3.4PCh. 11 - Prob. 3.5PCh. 11 - Prob. 3.6P
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