Reference no: EM131237839

Q1. In the wake of the Great Recession, the U.S. Federal Government ran large budget deficits, primarily because federal income tax revenues fell as GDP declined.  In addition, the Federal Reserve engaged in several emergency lending programs that, as was well documented in class, caused reserves held in the banking system to grow from $40B to $2.5T in six years.   Many observers predicted at the time that large budget deficits and the "huge" increase in bank reserves would cause runaway inflation.  Yet no inflation materialized.  

Using your knowledge of (a) the process of creating money (M1), (b) the relationship between money growth and inflation, and (c) the conditions that are required to create a hyperinflation, explain why these predictions of high inflation did not pan out.  

In developing your answer, draw on the central bank balance sheet, the quantity theory, the money multiplier and other macro relationships as needed.  You may also refer to relevant case studies and data from class notes. Use complete, carefully worded sentences that focus on providing a cogent, tightly focused and sophisticated analysis.

Q2. You are the head of the central bank of Country Q.   Your country has experienced a severe draught that has increased the natural or "full-employment" rate of unemployment, denoted as Un, from 5 percent to 8 percent.  The higher natural rate is expected to last from 2016 through 2021.   In response to the rise in unemployment, many in Q's Parliament are demanding the central bank act to lower unemployment.   You, of course, are well aware that the central bank of Q must operate under the so-called "dual mandate" (which, in fact, was copied from the Federal Reserve Act) in which the central bank's goals must be to (a) promote "full employment" and (b) maintain "price stability". 

Assume that you can set inflation in any year to exactly what you want. Also assume that the economy of country Q has the Phillips Curve , U = Un - .5(π - π(e)), where U is the unemployment rate, π is inflation, π(e ) is expected inflation which is equal to last year's actual inflation ( i.e. π(e )  = π(-1)).  

Choose a set of annual inflation targets for years 2016 thru 2021 that you think will satisfy the dual mandate. Assume everyone knows that Un has gone from 5 percent to 8 percent. Explain how your policy satisfies the dual mandate. Use complete sentences to defend your policy choice in a way that will be convincing to skeptical parliamentarians.

Q3. Two policymakers, A and B, are on Sunday morning talk show debating the impact of government budget deficits on the economy.  Policymaker A says that budget deficits are bad because they lower national savings that would otherwise be available for investment.  Policymaker B says, no, the way that government spending is financed (either by taxes or deficits) is not the relevant issue.  Instead he says that it's really the level of government consumption itself that is the critical variable in reducing savings and investment.  Which of these policymakers, A or B, is correct?  Use equations and explain them. 

4. You work for a commercial real estate firm.  Your boss is buying a commercial property using a 10-year mortgage. The bank has offered the following terms:  An initial 3-year "teaser" rate set using the currently low 3-year U.S. treasury rate of 2% (annualized) as the base rate plus a 3% markup for a total of 5%.  At the end of year 3, the annual interest rate for the remaining seven years of the mortgage will be then be set at whatever the 7-year U.S. treasury interest rate is at that time (plus the 3% markup).

Your boss is concerned because she does not know what the 7-year treasury rate that will prevail three years from now will be. "A much higher rate could blow us outta the water!" she says.

You have a brainstorm.  "Let's ask the bank to lock in the three-year-ahead interest rate for the 7-year treasury base rate now", you say.  "Great idea" says your boss, "but what rate makes sense for us to ask for - that the bank might accept?"

Running out to your car, you get your old Global Economics Notes out of the trunk where you have wisely kept them for just this kind of emergency.  "We can calculate what the 7-year treasury rate three years from now is expected to be very easily", you remark, "That's the 7-year rate we will propose to the bank. To do that, let's go online and look up what the current 10-year treasury interest rate is".  Going online and finding the U.S. treasury yield curve at Treasury Direct, you see that the 10-year treasury rate is currently 4.5% (annualized rate). 

Based on this, what can you expect the interest rate on the mortgage to be reset to in three years that is fair to both you and the bank?  Show the basic calculation. Then explain it.

Do only Question 1 and 2 only.

Attachment:- Assignment.rar