Money and Banking
Final: Spring 2014.
Janet Yellen gave testimony to the Senate Budget Committee on May 8th. What is relevant for this test
is that in the course of her testimony she said that she thought it would take between 5 and 8 years to
unwind the feds balance sheet from $4.3 trillion to something more sustainable in the long term.
1. Assume that initially the Fed’s Balance sheet is $4.3 trillion and that the Fed Funds rate is at .25%
which is the interest rate the Fed pays on reserves held at the fed. Also assume that the Discount rate is
set at .75%. Also assume that the Federal Funds rate starts to rise once the quantity of reserves falls
below $2 trillion
a. Show with a graph what will happen if the Fed pulls $2.5 trillion dollars for reserves out of the Federal
Funds market.
b. What is the highest the Federal Funds rate can rise? Show with a graph what the Fed has to do to
increase the Federal Funds rate above this level.
2. Continuing to discuss the shrinking of the Fed Balance sheet…
a. Show the decline in $2.5 trillion in reserves on the balance sheet of the Federal Reserve.
b. Show the decline on the balance sheet of the banking system if there is a 5% reserve requirement,
assuming banks hold no excess reserves.
c. Is the actual real world impact of the Fed shrinking its balance sheet likely to be as large as it is 2b?
Why?
3. Switch to the simple—liquidity preference framework—model of interest rates where all bonds are
the same. What effect will the decrease in the money supply from 2b do to the interest rate? Is it
obvious that there will be a short run effect? Will the interest rate change in the long run? Why? You
need multiple graphs here.
4. The Fed will only start shrinking its balance sheet once the economy starts to improve. If the
economy is improving can we say what will happen to the interest rate on bonds? Show why we can or
cannot say what will happen to interest rates.
5. Also, if the economy is improving this should reverse the “flight to quality” caused by the recession.
What should this do to interest rates on risky bonds (say, BBB bonds). What will this do to Treasury
bond rates? What will this do to the risk premium on risky bonds?
6. What is your predication for the change in interest rates once the Fed starts to unwind its balance
sheet? Why?
7. Suppose interest rates in Europe increase suddenly.
a. What will this do to the exchange rate in the US is the US allows its currency to float? What will this
do to the US economy in general? Why?
b. Now suppose the US wants to keep it’s exchange rate with Europe at a fixed rate. Show what needs
to happen for the US to maintain its exchange rate with Europe, what are the effects of maintaining this
fixed rate on the US economy?