1. The headline of an article published in the Wall Street Journal...

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1. The headline of an article published in the Wall Street Journal: Analysis: Fed May Lift Rates with Confidence as Inflation Shows Signs of Life.

a. Let’s start with the basics. When the Fed raises the nominal interest rate, the price of money (the U.S. dollar) in different markets is expected to be affected. Think about the following three markets: the bond market (or the market for money), the goods and services market, and the foreign exchange market. Which of these is the main market Fed officials look at when deciding whether or not to raise the rate? What is the expected effect of a rate rise on the price of money in this market? Would the effect be typically seen immediately or only after a while?

b. Now let’s talk about all three markets. Assume a flexible exchange-rate regime. Of the four components of GDP (C, I, G, and NX), which are expected to be affected most directly, and in which direction(s), when the Fed raises the rate? What is expected to happen to the price of bonds? What is expected to happen to the price of the U.S. dollar in the foreign exchange market?

c. When the Fed raises the interest rate, it is the nominal interest rate (i) that it raises directly. But savers, borrowers, investors, and other players in the economy care about the real interest rate because they care about the real value of saving, the real cost of borrowing, the real rate of return on investment, etc. Does the Fed affect the short-run real interest rate in the economy (r)? If yes: how? If no: why not? Does it affect the long-run real interest rate (r*)? If yes: how? If no: why not?

d. Imagine that the Fed wants to support a faltering economy, but can no longer reduce the short-run nominal interest rate because it has hit the zero lower bound (ZLB). What can it do to try to reduce the real interest rate (short or long run)? Give at least one example. Your example may include unconventional monetary policy actions that have been taken by central banks over the past decade, and/or unorthodox ideas that have been discussed by central bankers in the past few years but have not been tried recently.

e. Now let’s consider the WSJ article above. What could be the costs of waiting too long before increasing the interest rate, if in the meantime the economy is opening an expansionary gap?

f. What could be the costs of increasing the rate if the economy hasn’t yet closed its recessionary gap?

g. What is the expected effect on the dollar in foreign exchange markets if the news about higher inflation hits markets by surprise? Explain.

2. An article in the Economist from almost six quarters ago (“American business investment: Econondrum,” August 27, 2016) attempts to explain why investment spending in the U.S. has been disappointing, in spite of strong consumer spending and strong hiring. The article states:
“There are three potential explanations for this widespread reluctance to invest. … That leaves the third explanation: that in spite of strong spending, slow trend growth is reducing opportunities for profitable long -term investments. On this view, the recent downturn in business investment was less of a cyclical blip than a sign of things to come.”

a. On this view, does the downturn in investment referred to in the article reflect a slowdown in potential output, a slowdown in actual output, or both? Explain.

b. On this view, would it make sense for policymakers who attempt to do something about the slowdown to engage in long-term growth-promoting policies, short-term stabilization policies (such as monetary easing), or both? Give two examples of sensible policies.

c. An article in the Financial Times a year later (“US economy has strongest quarter since 2015,” August 30, 2017) updates:
“The US economic expansion gathered pace in the second quarter, driven by household spending and firmer investment, in a sign that the recovery is maintaining its momentum despite a lack of policy progress in Washington.”
Indeed, as we have seen in class, business investment has recovered since the Economist article was published, and has now been growing for several quarters. What has changed? First, let’s consider your answer in (b) above. Have any of the sensible policies you listed (or other such policies that you didn’t list) materialize, or have investors started expecting them to materialize?

d. Finally, let’s consider another option: could it be that the view expressed in the Economist article looks now—6 quarters later—less plausible? Explain.

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Question 1)
a) The Main market Fed officials look when deciding whether or not to raise the rate is the money market or the bond market which would affect the price of money in this market. When the Fed increases the nominal interest rate, the price of money would increase in this market and hence the demand for money (for investments) would reduce . The effect of the higher interest rates on increasing the price of money would be immediate.
b) An raise in the interest rate would...

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