SE 19 Solutions.pdf - Department of Economics University of...

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Department of EconomicsFall 2018University of CaliforniaEconomics 1BerkeleyHead GSI: Vaishnavi SurendraSuggested Solutions: Section Exercise 19For 11/14/2018 & 11/15/20181.Answer the following questions about the Federal Reserve (The Fed) briefly, in a fewsentences.a.What is the FOMC and what does it do?
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b.What are excess reserves?
c.What is the Zero-Lower Bound?
2.Explain why changing interest rates affects unemployment. Be complete. Identify all theplaces in the process where something can "go wrong" so that the change in interest rateswinds up not affecting unemployment after all.
Department of EconomicsFall 2018University of CaliforniaEconomics 1BerkeleyHead GSI: Vaishnavi Surendra2of3A decrease in interest rates also increases net exports (NX). The decrease in US interest rates increases USdemand for foreign financial assets, increasing the demand for foreign currency. The drop in US interest ratessimultaneously decreases foreign demand for US financial assets, decreasing the supply of foreign currency. Theprice of foreign currency therefore rises (the dollar weakens against foreign currencies). Imports become moreexpensive so US residents buy fewer imports, decreasing IM. Exports from the US become less expensive inforeign currency, so the rest of the world buys more US goods and services, increasing EX. Both the decrease inIM and the increase in EX leads to an increase in NX. The initial increase in AD due to increases in I andNX 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 goodsand services, generating another round of increased output, income, and spending by the people who producedthe consumer goods and services bought by the people who produced I & NX. Round after round of themultiplier process follow. As a result of the multiplier process, the total increase in income and output in theeconomy 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 neededmore 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 unemploymentin the US.Investment: if expected rates of return also fall, or if banksaren’tlending, then lower interest rateswon’tincrease 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 processwill 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 increasingemployment.Unemployment: if discouraged workers enter the labor force as employment rises, wewon’tsee a change inunemployment.
Department of EconomicsFall 2018University of CaliforniaEconomics 1BerkeleyHead GSI: Vaishnavi Surendra3of3
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