### Problem Session-2

```ISL244E Macroeconomics
Problem Session-4
by
Research Assistant
Serkan Değirmenci
(Ph.D. Candidate)
D202/05-07.03.2012
Today
• GNH (2009), Macroeconomics in Context
- Chapter 11: Money and Monetary Policy
Review Questions (RQ):
5-6-7-8-9-10-11 (Page: 284-285)
 Exercises (E):
9 (Page: 286-287)
Chapter 11: RQ-5 (Page: 284)
• Draw up and explain the components of a
balance sheet for a private bank.
See Table 11.1.
Chapter 11: RQ-6 (Page: 284)
• Draw up and explain the components of the
balance sheet of the Federal Reserve.
See Table 11.2.
Chapter 11: RQ-7 (Page: 284)
• Show what happens to the Fed's balance
sheet and the balance sheet of a bank, when
the bank sells bonds to the Fed.
See Table 11.3.
Chapter 11: RQ-8 (Page: 284)
• Describe how a Fed open market purchase
leads to a sequence of loans and deposits, and
thus a multiplier effect.
See Table 11.4 and related discussion.
Chapter 11: RQ-9 (Page: 284)
• Describe two tools the Fed can use to affect
the money supply, other than open market
operations.
Changes in required reserves and
changes in the discount rate.
Chapter 11: RQ-10 (Page: 284)
• Describe how a Fed open market purchase changes
the federal funds rate.
Increases reserves, which shifts out the supply of
federal funds, lowering the equilibrium rate.
Chapter 11: RQ-11 (Page: 285)
• What are two important factors affecting investment?
Show how they work using graphs.
Confidence and interest rates.
See Figures 11.4 and 11.5.
Chapter 11: E-9 (Page: 286)
•
Suppose the nominal prime interest rate for a one-year loan in an economy is
currently 6 percent.
a. If inflation is running at 1 percent per year, what is the current real interest
rate?
b. Suppose many people believe that the inflation rate is going to rise in the
future-probably up to 2 percent to 3 percent or more within a few years. You
want to borrow a sum of money for ten years, and are faced with deciding
between
1. a series of short-term, one-year loans. The interest rate on this year’s loan
would be 6 percent, while future nominal interest rates are unknown. Or
2. a ten-year fixed-rate loan on which you would pay a constant 6.25 percent per
year.
If you agree with most people and expect inflation to rise, which borrowing
strategy do you expect might give you the better deal? Why? Explain your
reasoning.
c. Could your reasoning in part (b) help explain the pattern of interest rates
shown in Figure 11.12? Explain.
a. r = i − π so r = 6% − 1% = 5%
b. The question here is which choice is likely to give you a lower real interest rate,
overall.
- If you borrow for one year now at a 6% rate, you will be slightly better off over the
next year with the short-term loan instead of the long term loan (since you pay 6%
- But if inflation rises in the future, when you go to find your next one-year loan you
will probably find that lenders will have raised their nominal rates as well. If, instead,
you choose the fixed-rate ten-year loan, then, by the equation re = i − πe your
expected real interest rate over most of the ten years will be something below 5%-and perhaps substantially below:
re = 6.25% − (expected inflation of 2-3% for most of the loan duration)
= 4.25% or less, for most of the loan duration
Since you believe inflation will rise substantially, you should probably "lock in" to a
low nominal rate—and thus a low expected future real rate--by choosing the long
term loan.