Question;Part 1: 70 points total1) (25 points total) We are going back to the fall of 1998, back in the 'midst' of the new economy.The Us economy weathered the E. Asian quite well and the US economy, by almost all accounts,was performing brilliantly. In August of 1998, Russian defaulted on all the debt held by foreigninvestors. This "shock" rattled financial markets so much that the Fed went into action andlowered short term interest rates 3 times in a seven week period. In what follows, we are going tomodel this 7 weeks period using our new acquired reserve demand / reserve supply diagram.In order to do this problem correctly, we need to go back to 1998 and 'fetch' the three relevantFOMC statements. To help you along, I provide the links for you below.Statements (1998) September 29 October 15 November 17Note importantly, we are modeling the behavior of the federal funds rate during this period. Theforecasted reserve demand at this time is given below. For simplicity, this reserve demandfunction is stable (constant) throughout this exercise.Rd = 900 - 100 iffa) (10 points for correct and completely labeled diagram) In the space below, draw areserve demand / reserve supply diagram depicting as point A, the conditions before theFOMC meeting in September, 1998. Note, you need to use the prevailing federal fundstarget and solve for the appropriate reserve supply. You will be adding points B, C, and Dto this diagram.b) (5 points) Now show as point B, the conditions shortly after the FOMC meeting onSeptember 29, 1998. Please show work.c) (5 points) Explain exactly how the Fed (the FOMC in Washington DC) changesconditions in the federal funds market. Be sure to refer this particular case, the movementfrom point A to point B.Now add to your diagram as point C, the conditions in the federal funds market shortlyafter the statement in October and point D, the conditions in the federal funds marketfollowing the FOMC meeting in November (the points for this part are included in thepoints for the complete and correctly labeled diagram.d) (5 points) Now label points B, C, and on the diagram below.2) (45 points total) In this problem, we are going to use the money market to model two real worldevents:i) a portfolio shock to money demand and ii) a shock to the money multiplier.Suppose you have the following information:Original money demand function:Md = P X [ 200 +.5 Y - 200 i]where P = 1 (P remains constant in this problem), Y = 1600, M s = 600, MB = 400 MM=1.5a) (5 points) Solve for the nominal interest rate (i) that clears the money market.b) (10 points for correct and completely labeled diagram) In the space below, draw a moneydemand / money supply diagram depicting these initial conditions.c) (5 points) We now experience a portfolio shock to money demand so that the new moneydemand function is:Md = P X [ 400 +.5 Y - 200 i]Solve for the new market clearing interest rate, assuming there is no change in themoney supply and label as point B on your diagram.d) (5 points) Assuming the Fed wanted to keep interest rates constant, what would theyneed to do exactly? Please explain and show as point C, the conditions after the Fed didwhat they need to do to keep interest rates steady and their initial level as in part a).(10 points for a correct and completely labeled diagram) Re-draw a money demand andmoney supply diagram showing the initial conditions and label as point A.e) (5 points) Instead of a portfolio shock to money demand, we now experience a shock tothe money multiplier. In particular, the money multiplier (MM) falls and is now =.8 (it was1.5 before the shock). Assuming the Fed does nothing, what is the new money marketclearing interest rate? Label this as point B on your diagram.f) (5 points) Now we assume that the Fed is pro-active and responds to the moneymultiplier shock immediately to keep interest rates at their initial level. What would theFed have to do exactly in terms of open market operations (show work) and label this aspoint C on your diagram.
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