Question

Assume that the country of Flatland is a closed economy and it is currently in a situation of short and medium run equilibrium. 1. a. Assume that the Central Bank of Flatland wants to increase the short-term interest rate i. Identify the open market operation that the Central Bank would use. [2p] ii. Is there any alternative to an open market operation? Explain. [2p] ii Draw a correctly labeled money (financial) market graph and describe the short run effects of the open market operation in the money market. [3p] iv. Explain the effect of the open market operation on GDP and saving. [3pl b, suppose now that Flatland is an open economy with a currency called Rhombus. i. What will happen in the short run to the value of the Rhombus? [2pl ii. What will happen to the current account (net exports) of Flatland? [3p] iWill the effect on GDP of the open market operation be greater in the case of open or closed economy? Justify your answer. [2pl Assume now that you want to analyze the effect of the open market operation performed by the Central Bank in the medium run. Consider, again, a closed economy setting (as in point 1.a). c. i. Explain, using the appropriate instrument, what will happen from the short to the medium run. [3pl Describe and comment the overall effects of the open market operation on the GDP and on its components. [3p] ii.

PLEASE ANSWER ALL THE POINTS AND WRITE CLEARLY AND JUSTIFY THE ANSWERS THANKS A LOT

Answer 1

ANS 1

(a)

ANS (i) An open market operation (OMO) is an activity by a central bank to give (or take ) liquidity in its currency to (or from) a bank or a group of banks. The central bank can either buy or sell government bonds in the open market (this is where the name was historically derived from ) or, in what is now mostly the preferred solution, enter into a repo or secured lending transaction with a commercial bank. When the Fed wants the interest rate to rise, it sells securities to banks. This is known as contractionary monetary policy.

Ans (ii) An alternative to the open market operation is the expansionary monetary policy. It consists of buying U.S Treasury securities through open market operation, lowering the discount rate. and decreasing reserve requirements.

Ans (iii) The ( financial ) market graph can be drawn in the following manner:-

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When the Central bank purchases securities on the open market, the effects will be as follows:-

- To increase the reserves of commercial banks, a basis on which they can expand their loans and investments.

- To increase the price of government securities, equivalent to reducing their interest rates,

-To decrease interest rates generally, thus encouraging business investment.

ANS (iv) The monetary policy has a positive relationship with GDP although the relationship is not that significant. This positive relationship can be explained by the fact that the level of money supply in the economy influences the purchasing power of the firms, individuals and also the expenditure of the government. The rate of growth of Labour, EXPO, government expenditure, and Aggregate Investment also do not have a significant determinant on the rate of growth of GDP.

(b)

ANS (i) The balance of trade influences currency exchange rates through its effect on the supply and demand for foreign exchange. When a country's trade account does not net to zero, that is when exports are not equal to imports - there is relatively more supply or demand for a country's currency, which influences the price of that currency on the world market, thus the value of rhombus will decrease in this case.

Ans (ii) Net exports are the value of the country's total exports minus the value of its total imports. It is a measure used to calculate the aggregate country's expenditure or gross domestic product in an open economy. In other words, net exports equal the amount by which foreign spending on a home country's goods or services exceeds the home country's spending on foreign goods and services.

If a country has a weak currency, its exports are generally more competitive in international markets, which encourages positive net exports. Conversely, if a country has a strong currency, its exports are more expensive and domestic consumers can buy foreign exports at a lower price, which can lead to negative net exports.

Ans (iii) Open economies grow faster than closed economies, The world bank has reported that the per capita real income grew more than three times faster for developing countries that lowered trade barriers (5.0% per year ) than other developing countries (1.4% per year) in the 1990s. Thus, Open economy affects GDP more than the closed economy.

(c)

Ans (i) The effect of the open market operation performed by the Central Bank in the medium run, assuming that the economy is a closed economy is as follows:-

- There will be no change in the interest rate (it rises back to its initial level ).

- There is no change in the level of output (it falls back to its initial natural level).

- There will be a higher price level than at the outset.

Ans (ii) The expansionary monetary policy attempts to promote aggregate demand growth. It increases the money supply in the economy. The increase in money supply is mirrored by an equal increase in nominal output, or Gross Domestic Product (GDP). In addition, the increase in the money supply will lead to an increase in consumer spending. It also causes an increase in the prices and more potential real output.