Reference no: EM1373121

1. This question is about the theory of money demand.

(a) Consider two financial assets A and B, which could be quite dissimilar in terms of risk, liquidity, etc. If something happens that increases the supply of asset A (i.e. it shifts its supply curve to the right), what will happen to the price of asset A? What about the nominal interest rate on asset A?

(b) How might this affect the price of asset B? What about the interest rate on asset B?

(c) Liquidity preference theory (LPT) is generally represented as the graph of money demand and money supply curves. LPT is the basis of much of Keynesian thought and, at its core, is the notion that the demand for money is negatively related to interest rates. Explain in some detail why Monetarists do not think that this is a useful way of thinking about the demand for money. [HINT: Monetarists criticize Keynesians for many reasons. For this question, just focus on interest rates.]

2. This question is about the structure of the money supply. For simplicity, assume there is no cash.

(a) Describe how an open market purchase leads to an increase in the money supply when the central bank pays for it with reserves - even though reserves themselves are not part of the money supply.

(b) Continue your argument in (a) to explain why ultimately the change in the money supply is generally greater than the change in the monetary base (i.e. why there is a multiplier).

(c) Explain briefly why a similar process is set in motion when the Fed makes discount loans instead of performing an open market purchase.

3. This question is about central banks. Assume that central banks use primarily open market operations as a tool to fulfill their goals.

(a) Suppose that the central bank neutralizes a shock that would otherwise have increased the value of its currency above some target level. Does this involve buying or selling foreign currency or assets?

(b) Does this increase or decrease the monetary base? Does it increase or decrease domestic interest rates?

(c) Among the goals that various central banks pursue are exchange rate stability, interest rate targeting and stability of the money supply. Suppose the central bank is attempting to neutralize shocks to the exchange rate. Explain why this is incompatible with either of the other two goals.

(d) Recall that unexpected inflation is good for borrowers. Explain how this implies that there may be a moral hazard problem if both fiscal and monetary policy are determined by the same agency. How might fixing the exchange rate solve that problem?