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21 Sep 2018

Macroeconomics (7th edition) by Olivier Blanchard

10. Monetary policy in a liquidity trap
Suppose that money demand is given by Md = $Y(0.25 - i) as long as interest rates are positive. The questions below then refer to situations where the interest rate is zero.

a. What is the demand for money when interest rates are zero and $Y = 80?

b. If $Y = 80, what is the smallest value of the money supply at which the interest rate is zero?

c. Once the interest rate is zero, can the central bank continue to increase the money supply?

d. The United States experienced a long period of zero interest rates afer 2009. Can you find evidence in the text that the money supply continued to increase over this period?

e. Go to the database at the Federal Reserve Bank of St. Louis known as FRED. Find the series BOGMBASE (the monetary base) and look at its behavior from 2010 to 2015. What happened to the monetary base? What happened to the federal funds rate in the same period?

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Related questions

Under the liquidity trap, money demand becomes very flat at low-interest rates. For this problem, consider the money demand function to be horizontal at a zero nominal interest rate.

A. Draw the LM curve. How does the slope of the curve change when the interest rate rises above zero?

B.Draw the IS curve. Does the shape of the curve change (necessarily) when the interest rate falls below zero?

C.Draw the AD curve? (Hint: From the IS-LM diagram, think about the price level at which the interest rate is zero. How does the AD curve look above this price level? How does the AD curve look below this price level?)

D.Draw the AD and AS curves and assume that equilibrium is at a point where output is below the natural level of output and where the interest rate is zero. Suppose the central bank increases the money supply. What will be the effects on output in the short run and the medium run? Explain in words.

  1. If the Fed lowers the federal funds rate using an open market sale, what will be the effect on other interest rates? The exchange rate? Money and bank loans? Long-term real interest rate? Expenditure plans? Aggregate demand?

  1. What limits the Fed's ability to steer the economy to avoid both recession and inflation?

  1. Why is there a difference between the short-run and long-run effects from an increase in the quantity of money?

  1. Why must the Fed decide to target either the interest rate or the monetary base? Why can't the Fed determine acceptable values for both and then use open market operations to hit both targets?

  1. What are the benefits of using rules to conduct monetary policy?

Which answer from the highlighted is correct?

1. According to Positive Money, in the traditional money multiplier model, 

A. If the reserve ratio is 10%, the money supply will be about 100 times the economy's base money.

B. If the reserve ratio is 10%, the money supply will be about 10% of the output in the economy.

C. If the money multiplier is 10, a £100 increase in the money supply will increase output by £1000.

D. If the reserve ratio is 10%, the money supply will be about 10 times the base money in the economy.

E. If the money multiplier is 10, a £100 increase in government spending will increase output by £1000.

 

2. According to Positive Money, in 2006, for the British pound, bank-created money was

A. zero, and it was 14 times base money after the latest global financial crisis and the Bank of England's quantitative easing.

B. 14 times base money, and it was 14 times base money after the latest global financial crisis and the Bank of England's quantitative easing.

C. 80 times base money, and it was 14 times base money after the latest global financial crisis and the Bank of England's quantitative easing.

D. negative, and it was 80 times base money after the latest global financial crisis and the Bank of England's quantitative easing.

E. 14 times base money, and it was 80 times base money after the latest global financial crisis and the Bank of England's quantitative easing.

 

3. Consider the risk premium, as defined in the lecture and in the textbook. If the domestic central bank has a fixed exchange rate policy that the markets find credible, then

A. Nominal interest rates should be the same in the domestic country and the foreign one only if that risk premium is zero.

B. Nominal interest rates should be the same in the domestic country and the foreign one only if that risk premium is nonzero.

C. Nominal interest rates should be the same in the domestic country and the foreign one only if that risk premium is negative.

D. Nominal interest rates should be the same in the domestic country and the foreign one only if that risk premium is positive.

E. Nominal interest rates in the domestic country and the foreign one cannot be the same, even if that risk premium is zero since there is another term in the uncovered interest parity formula.

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