Question

Ch 14 1. List and define the 5 transmission and amplifications mechanisms that cause shocks to have a greater effect 2. Describe the effect of each of the following three shocks, as well as what transmission/amplification mechanisms drive the a. Bad rainfall that dries out crop country b Surprise collapse of a large company that employed many people o. Christmas season Ch 15 1. Define Monetary Base", "M1" and M2 and describe what each includes. 2. What is the Reserve Ratio? What is the Money Multiplier? (See the book for the definition) 3. If the Reserve Ratio is 1/5, how much might an increase of bank reserves of 10,0005 increase M12 4. When the Fed buys bonds, what happens to the price of bonds? What happens to the interest rate? 5. What four issues must the Fed monitor to control money? o. Who appoints the Fed Chair and Board of Govemors? Ch 16 Monetary Policy 1. What is the Rules vs Discretion question? 2. What problems can arise if the Fed over stimulates and has to tower inflation?

Answer 1

14(1): Five transmission and amplification mechanisms are-

1. Intertemporal substitution
2. Uncertainty and irreversible investments
3. Labor adjustment cost
4. Time bunching
5. Collateral Damage

Intertemporal substitution: People tends to work hard when working hard offers that attractive returns. Similarly when a economy realizes boom people are less likely to retire. They magnify economic shocks

Uncertainty and irreversible investments: With negative shocks uncertainty increase and investor tends to wait for a prolong time to gather more information as investments are irreversible.

Example negative impact after 9/11 in US.

Time Bunching: Economic activities that coincides in cluster of time with others as such coordination pays off. It makes buying and selling more efficient.

Labor adjustment cost: Cost involved in shifting of labor from sick sectors to booming sectors of an economy is the labor adjustment costs. This shocks are difficult and costly.

Collateral Damage: The guarantee that even the product fails the firm will pay back the loan.

2. (a)Bad rainfall that dries out crop country:

Rainfall shocks have a negative impact on agricultural productivity. It has a greater impact on household consumption. Demands of agriculture products will surpass supply resulting in inflation.

One of the transmission and amplification mechanism related to it is

Uncertainty and irreversible investments: As investors are in this segment are unaware of this shock and investments are irreversible.

(b) Surprise collapse of a large company that employed many people:

Such collapse results in negative impact in the unemployment rate. At the same time all the stake holders are affected too.

One of the transmission and amplification mechanism related to it is

Labor adjustment cost: Adjustment of employees from this company to others will cost to economy

(c) Christmas season: Consumption increase giving a positive shock to economy. Demand of common household increases.

Time Bunching: Buying and selling rises that coincides with the economy.

3. Irreversible in reference to investment signifies sunk cost that a company loses out of bad investment decision or a negative shock of the economy. This is an issue for because such cost cannot be recovered and results in a negative sentiment for the market.

15.

1. Monetary Base: The total amount of currency that are in actual circulation in the economy with general public or with the commercial banks

M1 : It is a money supply reference which represent the most liquid form of money that can be convertible into cash.

M2: Calculation of money that includes both M1 and all other saving deposits, money market securities, mutual funds. It is less liquid than M1 and not suitable for exchange.

2. Reserve ratio: The commercial banks are guided to hold a certain amount of liabilities as against lending out or invest.

Money Multiplier: It is the ratio of deposits to reserves in the banking system that a bank generates with each dollar in reserve.

3. Reserve ratio=1/5

i.e For every $1 increase in the bank reserve it can lend $0.80 in the market (M1)

Therefore $10,000 increase in bank reserve will increase $8000(0.80*10000) in the market M1.

4. When fed buys bond to inject money into the banking system, it increases the price of bonds and interest rates of banks are lower.

5. Four issues that Fed monitors

• Manages Inflation
• Supervises the banking system
• Supervise the stability of financial system
• Speculating banking sevices

6. Fed Chairman and board of governor is appointed by President of United States.

16 (1): The “Rules versus discretionary” is questioned because though a discretionary central bank vouch for low inflation rate but with low inflation rate economy slows down and on the contrary surprise inflation boost employment. In the end the long it will result in higher inflation rate with no improvement in either employment or output.

(2) With low inflation growth is sluggish and economy slows down. The aggregate demand of the economy slopes downward and unemployment will tend to rise.