Intermi Macroeconomics~~Several Question.

1. Read the following article by Bloomberg columnist Frank Aquila titled “What
Chairman Bernanke Could Learn From Professor Bernanke.”
http://www.businessweek.com/investor/content/sep2010/pi20100922_108414.h
tm?campaign_id=rss_topStories
Now, the Fed has done its best to keep interest rates low over the past couple of
years to try to stimulate the economy. Consider some of the effects of this policy.
Do so by using a graph similar to Figure 3‐12 in the Mankiw book (that is, an
Investment‐Savings graph where savings is upward sloping and therefore varies
positively with the interest rate).
a. Label the equilibrium interest rate r* on the graph as well as the equilibrium
levels of savings and investment, S* and I*.
b. Suppose the Fed induces a below‐equilibrium interest rate rlow,. Which is larger at
that below‐equilibrium interest rate, the quantity of investment Ilow or the quantity
of savings Slow?
c. The aggregate demand for goods and services in a closed economy can be written
out as AD = C + I + G. Explain how the lower interest rate caused by the Fed will
increase C and I and might also facilitate an increase in G. Will the Fed’s lowinterest‐
rate policy stimulate AD in the short run?
d. Where do the dollars come from to fund the amount of investment Slow ‐ Ilow?
e. Which is bigger, S* or Slow? If saving money today increases possible future
consumption spending, will future possible consumption spending be larger or
smaller than it would otherwise have been if the Fed had done nothing to lower the
interest rate?
f. Which is bigger, I* or Ilow? If investment today increases the economy’s future
production capacity, will the economy’s future production capacity be larger or
smaller than it would otherwise have been if the Fed had done nothing to lower the
interest rate?
g. Compare your answers to parts d and e. How might these two effects relate to
Japan’s stagnation over the past 20 years during which the Bank of Japan has kept
interest rates near zero?
h. Could there be a trade‐off between stimulating current demand and getting out of
a current recession on the one hand and on the other hand creating over‐capacity
that will lead to a greater likelihood of recessions in the future? Read the Wikipedia
entry on Austrian Business Cycle Theory before giving your answer and feel free to
incorporate some of the ideas there into you answer if you feel that doing so would
be useful. http://en.wikipedia.org/wiki/Austrian_Business_Cycle_Theory

2. I want you to learn a little bit about the Yield Curve, which is the graph you get
when you plot the interest rates of bonds of different maturities (1‐year bonds, 5‐
year bonds, 20‐year bonds, etc) on the same chart. The yield curve is normally
upward sloping but often inverts right before a recession. So a lot of people watch it
very carefully as a possible predictor of where the economy is heading.
As background reading, start with this short entry at Investopedia:
http://www.investopedia.com/terms/y/yieldcurve.asp
Then read the Wikipedia entry: http://en.wikipedia.org/wiki/Yield_curve
Now go play with the Living Yield Curve page at SmartMoney.com:
http://www.smartmoney.com/investing/bonds/the‐living‐yield‐curve‐7923/
Next, answer the following questions.
a. If the Fed buys up a lot of a certain type of bond, what happens to the demand for
that bond? What happens to its price? And therefore what happens to its yield?
b. Normally the Fed only buys up short‐term government debt when it uses openmarket
operations. Thus, which end of the yield curve does the Fed normally affect?
c. During the financial crisis, the Fed purchased large amounts of mortgage‐backed
securities. In doing so, which end of the yield curve did the Fed affect?
d. Since the Fed has driven short‐term interest rates extremely low, the left end of
the yield curve is near zero. Thus, would it be possible for the yield curve to invert if
we were about to enter another downturn? Given the position of the left end of the
yield curve, what sort of recessionary signal might you look for instead?

3. Most business investments cost a lot up front and then produce a stream of
revenues for a long time in the future. Entrepreneurs only take on projects where
they think profits can be made. So in terms of borrowing money to fund projects,
they would only borrow money when they anticipate that the revenues that will be
thrown off by an investment will be sufficient to pay off the debt that had to be
incurred to fund it.
However, entrepreneurs can then choose between two debt strategies. (A) Take on
a single long‐term loan at the beginning. (B) Use short‐term debt that must be
rolled over multiple times as it is being paid off.
a. Given that yield curves are normally upward sloping, would it be more profitable
to use strategy A or strategy B?
b. Which strategy is less risky? Explain.
c. If the Fed sees a recession coming and only does its normal open‐market
operations (purchasing or selling short‐term U.S. government debt), what will
happen to the yield curve all other things equal? As a result, will firms be more
tempted to use strategy A or B? Will the composition of debt held by firms (the
percent of all debt that is long‐term vs. the percent of all debt that is short‐term)
become more or less risky?

4. Read the opinion piece by Princeton economist Alan Blinder in the Wall Street
Journal titled “The Fed is Running Low on Ammo.” That article is normally behind a
“pay wall”, but you can get to it for free if you click through from a Google search
results page. So, type the title into Google, hit return, and then click through to get
to the full article for free. (You should also look up a Blinder’s bio on say Wikipedia
to understand why his opinion counts.)
a. What do banks have to do with the Fed’s problems stimulating the economy?
b. According to Blinder, what might the Fed do to motivate banks to lend more?
c. Thinking things through on your own, if banks do lend more, what will happen to
the level of risk in the financial system? Who or what would be on the hook for that
risk if things go wrong?

5. Answer the following questions about money and debt.
a. From what I talked about in lecture, does the Fed purchasing government bonds
in the secondary market (that is, NOT directly from the Federal government)
increase, decrease, or leave unaffected the total quantity of government debt held by
the public? (Hint: Are Federal Reserve Notes a government liability?)
b. From what I talked about in lecture, does the Fed purchasing private‐sector bonds
increase, decrease, or leave unaffected the total quantity of government debt held by
the public?
c. When the U.S. Treasury issues new debt and sells it to the public, is there any
change in the total amount of money in circulation outside of the Fed?
d. What if the U.S. Treasury issues new debt and sells it to the Fed? Does the amount
of money in circulation outside the Fed increase, decrease, or stay the same? Use
your answer to explain why the Fed is said to be “monetizing the debt” any time it
purchases Treasury bonds directly from the U.S. government.
e. Why are Fed purchases of government debt directly from the Treasury likely to be
more inflationary than Fed purchases of government debt made on the secondary
markets, from private citizens?
6. As I explained in class, during a financial crisis the asset demand for money (as
opposed to the liquidity demand for money) goes way up. If the Fed is allowed to
utilize open market operations, it can accommodate changes in the asset demand for
money during times of crisis.
Read this blog entry by C.J. Maloney that was posted to the Mises Daily blog run by
the Austrian‐school advocates at the Mises Institute: http://mises.org/daily/4651
a. After reading Maloney’s criticisms of allowing the Fed discretion over monetary
policy both during times of crisis and during ordinary times, what is your reaction to
his arguments? Do you like the current system that gives the Fed tremendous
discretion over monetary policy? Would you like a Fed that has little or no
discretion? Argue for whatever you think would be best (including any system of
your own devising).
b. If Maloney had his way and the Fed could not expand the money supply during
times of crisis in response to sharp increases in the asset demand for money, what
would happen to interest rates, all other things being equal? Would the quantity of
investment rise or fall? What about the quantity of savings?
c. Think about the Austrian perspective that during bubbles there is a lot of
“malinvestment” in the economy. Now look at your answers to part b. To an
Austrian economist, after a debt‐fueled bubble ends with a financial crisis, is there
much need for a lot of new investment? Would it be good to save a lot and pay off
old debts? Is it OK for interest rates to go really high? Would high interest rates
help encourage people to pay off old debts more quickly?