Skip to main content

Exercise: federal funds market

 

Assume that you have the following information about the federal funds market:

  • Note that the discount rate must be above the federal funds rate in order for the latter to be effective. In other words, the supply curve becomes perfectly elastic at the DR. 
  • Another important point is that the demand for federal funds also becomes perfectly elastic when the interest rate is at or below zero percent. At this rate, commercial banks demand federal funds as much as they can.
You are tasked with conducting the optimal open market operation given that the economy just started to experience a downturn. Given available data you conclude that the optimal rate must be at 0.5%. 
  • Solve for the new supply curve, find how many government bonds (in terms of dollars) should the Fed buy or sell. Then, explain what will happen to the aggregate demand on the AD/AS model.
    • solve for the original rho (FFR):
    • Set the FFR equal to 0.5%, and solve for the dollar amount:
    • Assuming that in our case $=1 is worth one million dollars, the Fed must increase the amount of liquidity by one million dollars in the banking system for excess reserves. Thus, they central bank must buy one million dollars worth of bonds from commercial banks.
    • Buying bonds from commercial banks shifts the money supply curve to the right, lowering the nominal interest rate, which will ultimately shift the aggregate demand to the right. This is an expansionary policy.
Let's graph that:













Labels:
Location: Boston, MA, USA

Comments

Post a Comment

Popular posts from this blog

Macroeconomics: real vs nominal gross domestic product

Nominal GDP:   A nominal GDP measures the value of a nation's output produced in a year, given the prices charged for that year. However, if prices increase while the output level stays constant in a given year, the nominal GDP will drastically increase, even though the level of production is equal to that of the previous year. Estimating real GDP: To determine the actual change in output from one year to the next, we must adjust the nominal value of a country's output in a year based on changes in the average price level during that year.  Inflation is when the price level increases, whereas deflation is when the price level is decreasing. To determine whether the nominal GDP overestimates or underestimates the output of a country, one must know whether the average price level has increased or decreased. In order to achieve this task can use a price index known as the GDP deflator. The GDP deflator: Real GDP is calculated by replacing the prices for that current year with tho...
Post a Comment
Read more

Microeconomics: Firms and cost in the short run

In Economics, the term short run refers to a time period where at least one variable of interest does not change . In our case, the short run for a firm is when at least one input  (labor, land, capital) stays fixed. Usually land and capital are considered fixed in the short run.  If an input is fixed during a period time, no matter how much the total product a firm produces, its cost stays the same. This cost is commonly known as fixed cost (FC). Examples of fixed costs: rent, property taxes, loan payments. Labor is often considered to be a part of the  variable cost (VC) . Variable cost can be defined as the cost a firm has control over during the short run. Unlike fixed cost, variable cost increases (decreases) as a firm's total product increases (decreases). Examples of variable costs include: utility bills, wages, raw materials A firm's total cost (TC) is the sum of its variable and fixed costs. As you can see, the fixed cost...
Post a Comment
Read more

Macroeconomics: the money market and loanable funds market

  The money market: The money market combines the supply of money and the demand for money for a country. The supply curve (Sm) is inelastic and is determined by the central bank. The demand curve (Dm) is the horizontal summation of the asset and transaction demand curves and is sloping downward. The intersection between the Sm and Dm is the equilibrium interest rate for a country. A change in the nominal interest rate implies that either or both curves (i.e Sm and Dm) have shifted to the right or left. An increase in nominal GDP (P*Y) will lead to an increase in the transaction demand for money which will shift the total demand (Dm) to the right. The nominal interest rate goes up. A decrease in the level of output (Y) will shift the Dm curve to the left. The Sm curve will shift whenever the central bank decides to change the money supply due to a monetary policy decision. The Fed expands the supply of excess reserves in commercial banks, by purchasing bonds from banks, Sm shi...
Post a Comment
Read more