Department of Economics Fall 2018 University of California Economics 1 Berkeley Head GSI: Vaishnavi Surendra1of 3 Suggested Solutions: Section Exercise 19For 11/14/2018 & 11/15/2018 1.Answer the following questions about the Federal Reserve (The Fed) briefly, in a few sentences. a.What is the FOMC and what does it do? The FOMC is the Federal Open Market Committee, a committee of the Federal Reserve that determines monetary policy. b.What are excess reserves? Reserves are balances held by banks within the Federal Reserve, and banks use them to clear checks between banks. Banks are required by the Fed to hold a minimum of 10% of checking deposits at the bank as reserves. Excess reserves are reserves held by the banks at the Fed in excess of the required ratio of 10% of deposits. c.What is the Zero-Lower Bound? The Zero-Lower Bound is when the effective Federal Funds Rate is at or is nearly zero, generally thought to preclude the Fed from lowering interest rates any further in an attempt to stimulate the macroeconomy. The ZLB is seen as a floor (or boundary) that limits the actions of the Fed, particularly when we are experiencing a lengthy stretch of at-or-near zero interest rates. However, there have been experiences in Denmark, Japan and Sweden where the central banks have offered negative interest rates, though research continues in this area.2.Explain why changing interest rates affects unemployment. Be complete. Identify all the places in the process where something can "go wrong" so that the change in interest rates winds up not affecting unemployment after all.
A decrease in interest rates also increases net exports (NX). The decrease in US interest rates increases US demand for foreign financial assets, increasing the demand for foreign currency. The drop in US interest rates simultaneously decreases foreign demand for US financial assets, decreasing the supply of foreign currency. The price of foreign currency therefore rises (the dollar weakens against foreign currencies). Imports become more expensive so US residents buy fewer imports, decreasing IM. Exports from the US become less expensive in foreign currency, so the rest of the world buys more US goods and services, increasing EX. Both the decrease in IM and the increase in EX leads to an increase in NX. The initial increase in AD due to increases in I and NX kick start the multiplier process: workers and business-owners whose companies produce the additional I & NX receive additional income. They spend part of this additional income on domestically-produced goods and services, generating another round of increased output, income, and spending by the people who produced the consumer goods and services bought by the people who produced I & NX. Round after round of the multiplier process follow. As a result of the multiplier process, the total increase in income and output in the economy will be larger than the initial increase in I & NX. In order to produce more output (which happened in each round of the multiplier process), businesses needed more workers. There will be an increase in employment, and therefore a decrease in unemployment. Things can at every single step in the process through which a change in interest rates could affect unemployment, and therefore there is no guarantee that expansionary monetary policy will in fact result in reduced unemployment in the US. Investment: if expected rates of return also fall, or if banks aren’tlending, then lower interest rates won’t increase I. NX: if exchange rates are controlled, nothing will happen in NX as a result of a change in interest rates. Multiplier: if MPM is large relative to the MPC, additional spending created during the multiplier process will be going to foreign countries and thus increasing output and income in those countries and not in the US. Employment: if productivity and AD rise at the same time, we can increase output without increasing employment. Unemployment: if discouraged workers enter the labor force as employment rises, we won’tsee a change in unemployment.