Excellent graphs and descriptions (sample problems included!)

Global Economic Environment of the Firm
Question 1

Consider the following hypothetical information about the current demand for final goods and services. All variables are in billions of dollars.

Consumption demand: C = 800 + 0.8YD
Investment demand: I = 700
Government demand: G = 2000
Taxes: Ta = 0.2Y
Transfer payments: Tr = 100
New exports demanded: NX = -300

a. Calculate the equilibrium level of national output (national income). Show your work

b. Suppose that the tax rate increases to 0.25. Calculate the change in the multiplier and explain the intuitive reason behind the results.

c. Show the effects of the tax increase on national output using a Keynesian Cross diagram.

Question 2
Suppose that Congress and the president decide to reduce transfer payments, such as welfare, but to increase government spending on final goods and services, such as education, by an equal amount. Will the equilibrium level of output rise, fall or remain unchanged by such a policy? Illustrate your result graphically.

Question 3
Describe the role of banks in the money supply process and explain conditions under which this role would break down.

Question 4
Suppose that the government gives a temporary investment subsidy to firms. With the help of a Keynesian cross diagram, consider the effects that the investment subsidy will have on consumption of households under each of the following scenarios.
a. The government does not raise taxes or cut spending to finance the subsidy. Instead it finances the subsidy by issuing new Treasury securities.

b. The government raises taxes on households to finance the subsidy to firms.

c. Under what conditions do you think that scenario a would be the preferred policy? Scenario b?

d. What would be the long-term benefit to the economy of a temporary investment subsidy?

Question 5
At the September meeting, the FOMC decided to leave its target for the federal funds rate at the current 0 - 0.25%. The minutes from this meeting were released on October 14th and an excerpt appears below:
The staff also briefed the Committee on the likely implications of very high reserve balances for bank balance sheet management and for the economy. The staff's assessment, based in part on consultations with market participants, was that many banks were currently comfortable holding high levels of reserves as a means of managing liquidity risks.... As the economy improves, however, banks could seek to lower their levels of reserve balances ...by easing their credit standards and terms in order to expand lending. Such effects, if significant, would provide further impetus to economic growth.

(http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm#2868)
a. Explain the observed behavior of banks with respect to reserves. Why are banks behaving in this way?

b. As the economy improves, the Fed staff economists expect bank behavior to change. Describe the expected change in bank behavior and with the help of an equation of the money supply, explain the effect that this change in bank behavior will have on the quantity of money.

c. Use a graph of the liquidity preference theory of interest rate determination to explain the effect of the change in part b on the interest rate and the quantity of money.

d. Explain how this change in behavior might "provide further impetus to economic growth." (Be specific.) What concern, if any, might the FOMC have with this change in behavior?

Money Supply

a) TRs = TR¬d
b) BR + NBR = RR + ER

c) TRs = Bf + (OA - OL - Cur) + DWL
Where Bf = Treasury securities held by the Fed. This is the component that the Fed affects when it buys or sells Treasury securities in an open market operation (OMO).
d) TRd = RR + ER = rr D + ER

Set TR¬d = TRs and subtract ER from both sides:
e) rr D = Bf + (OA - OL - Cur) + DWL - ER
f) D = 1/rr [Bf + (OA - OL - Cur) + DWL - ER]
Note: BR = DWL
NBR = Bf + (OA - OL - Cur)
 g) D = 1/rr [NBR + BR - ER]

The equation above allows us to identify individual components which increase or decrease Deposits and, therefore the money supply.

h) Ms = Cur + D
= Cur + 1/rr [NBR + BR - ER]
= Cur + 1/rr [Bf + (OA - OL - Cur) + BR - ER]

OMO to achieve a lower target for federal funds rate:
↑ Bf  ↑NBR  ↑Ms  ESM  ↓ i.

Dynamic Open Market Operation - OMO planned to increase (or decrease) money supply and decrease (or increase) the federal funds rate.
Defensive Open Market Operation - OMO to offset an unwanted change in i (caused by a shock to money supply and/or money demand).

Money Demand

Md = Md (Y, i, C )
+, - , +
(Money demand increases with Y, decreases with i, and increases with the Collective Factor, C )
• Other things equal, the demand for money falls when C falls. C falls if:
 Improvements in cash management technology are introduced.
 The uncertainty of future income is reduced.
 The relative risk of securities and real assets falls.
 The relative maturity of securities falls.
 The relative marketability of securities and real assets rises.
 The relative liquidity of securities and real assets rises

• In our simplified model, individuals hold their wealth in either money or bonds:
Md + Bd = Wealth.
As i increases (other things equal) individuals prefer to hold more of their wealth in bonds and less in money. Because i is the return on holding bonds, it is also the opportunity cost of holding money. Therefore, as i increases the quantity of money demanded decreases (money demand is downward sloping).

Changes in Y, Wealth, or C will shift money demand while a change in the interest rate causes a movement along the money demand curve.

Example 1: Shock = decrease in Money Supply.

Suppose the Fed is concerned about inflationary pressures in the economy and increases its target for the federal funds rate. The Fed would conduct a dynamic OMO—it would sell treasury securities to decrease NBR, decreasing deposits and the money supply:
↓ Bf  ↓NBR  ↓Ms, EDM and ↑ i

Example 2: Shock = decrease in Money Demand.

Suppose that there is a decrease in the demand for money caused by an increase in the relative liquidity of securities (meaning that the ease and speed of converting the securities to cash has increased and the public - households and firms—are willing to hold more securities and therefore less money). The Fed, however, wants to keep the interest rate at its current level. Show how the change in money demand would affect the interest rate and how the Fed would react to keep i constant.

A decrease in money demand will cause a downward shift of Md, ESM and a decrease in the interest rate and a decrease in the quantity of M demanded (measured on the x-axis) to point F on the graph below. If the Fed wants to maintain the initial (higher) level of the interest rate, it will have to decrease NBR and the money supply. To do this, the Fed will sell treasury securities, Bf and NBR will decrease, and Deposits will decrease. The money supply curve shifts to the left resulting in EDM which will cause the interest rate to increase, restoring the initial level of i (now at point G). The lefttward shift of Ms causes a further decrease in M. The final level of i is unchanged but the level of M is lower.

Example 3: Shock = Banks holding more ER (making fewer loans resulting in fewer Deposits).

Suppose that banks become more cautious. At every level of the interest rate, banks want to hold more ER, and make fewer loans.
a) Ms = Cur + D
= Cur + 1/rr (NBR + BR - ER)
All else equal, when ER increase, money supply decreases causing a shift to the left of the Ms curve. There is EDM and i increases. ↑ ER  ↓ D  ↓Ms  EDM  ↑ i