Money and Banking
FHomework #6
Spring 2015
Final Fall 2014
Janet Yellen gave testimony to the Senate Budget Committee on May 8th 2014. 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 and a clear written explanation what will happen if the Fed pulls $2.5 trillion dollars for
reserves out of the Federal Funds market.
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 and a
clear written explanation.
4. 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? You must answer using graphs and a clear written explanation.
5. What is your predication for the change in interest rates once the Fed starts to unwind its balance sheet?
Why?