Reference no: EM13900712

A new Federal Reserve chairman

Suppose, in a hypothetical economy, that the chairman of the Fed unexpectedly announces that he will retire in one year. At the same time, the president announces her nominee to replace the retiring Fed chair. Financial market participants ex- pect the nominee to be confirmed by Congress. They also believe that the nominee will conduct a more contractionary monetary policy in the future. In other words, market participants expect the money supply to decline in the future.

a. Consider the present to be the last year of the current Fed chair's term and the future to be the time after that. Given that monetary policy will be more contractionary in the future, what will happen to future interest rates and future output (at least for a while, before output returns to its natural level)? Given that these changes in future output and future interest rates are predicted, what will happen to output and the interest rate in the present? What will happen to the yield curve on the day of the announcement that the current Fed chair will retire in one year?

Now suppose that instead of making an unexpected an- nouncement, the Fed chair is required by law to retire in one year (there are limits on the term of the Fed chair), and finan- cial market participants have been aware of this for some time. Suppose, as in part (a), that the President nominates a replacement who is expected to conduct a more contractionary mon- etary policy than the current Fed chair.

b. Suppose financial market participants are not surprised by the President's choice. In other words, market participants had correctly predicted who the President would choose as nominee. Under these circumstances, is the announcement of the nominee likely to have any effect on the yield curve?

c. Suppose instead that the identity of the nominee is a sur- prise and that financial market participants had expected the nominee to be someone who favored an even more contractionary policy than the actual nominee. Under these circumstances, what is likely to happen to the yield curve on the day of the announcement? (Hint: Be careful. Compared to what was expected, is the actual nominee expected to follow a more contractionary or more expansionary policy?)

d. On October 24, 2005, Ben Bernanke was nominated to succeed Alan Greenspan as chairman of the Federal Re- serve. Do an internet search and try to learn what hap- pened in financial markets on the day the nomination was announced. Were financial market participants surprised by the choice? If so, was Bernanke believed to favor poli- cies that would lead to higher or lower interest rates (as compared to the expected nominee) over the next three to five years? (You may also do a yield curve analysis of the kind described in Problem 8 for the period around Bernanke's nomination. If you do this, use one-year and five-year interest rates.)