Mac Bank

Professor Hogan
ECON 310 Money and Banking
December 14, 2015
Problem Set 4
1) Risk premiums on corporate bonds are usually anti-cyclical because during business
cycle expansions, fewer corporations go bankrupt and therefore the default risk on the
bonds is lower, which means that the risk premium is lower. Furthermore, during
recessions, the risk that a corporate bond defaults is higher and, as a result, the risk
premium increases. In sum, the risk premium on corporate bonds is anti-cyclical as it
rises during recessions and falls during periods of expansion.
2) If income tax rates increase, the demand Treasury bonds would decrease as Treasury
bonds are taxable which means that people would have to pay more money for treasury
bonds, and, due to the decrease in general taxable income, they would have less money
overall to purchase Treasury bonds. As the demand for Treasury bonds decreases, the
demand for municipal bonds would rise because the tax-exempt privilege provided by a
municipal bond would become more valuable. The overall decline in demand for
Treasury bonds, and increase in demand for municipal bonds would raise the interest
rates on Treasury bonds while having the interest rates decline for municipal bonds.
3)
a. Federal Funds are the reserves that banks lend to each other overnight to help
maintain their bank reserve balances.
b. The demand for federal funds depends on the amount reserves that banks are
required to hold and the amount of the excess reserves they hold. This means that
the variation in demand is more or less dependent on the amount of excess
reserves that banks hold since all banks are required to hold a certain amount of
reserves. The federal funds rate is essentially restricted by the reserve rate, the
interest rate at which is offered by the Fed for holding reserves. This means that
the demand will be perfectly elastic at the reserve rate because no financial
institution will want to lend reserves using the federal funds rate if it below the
reserve rate because they can gain more interest by holding reserves at the Fed
and collecting the returns of the interest rate indefinitely by raising their excess
reserves indefinitely. Therefore, demand for federal funds depends on how far
above the reserve rate the federal funds rate is because the higher the federal
funds rate the more likely banks are to lend out their excess reserves because the
returns gained from the federal funds rate is greater than the returns from holding
reserves at the Fed. But, as the federal funds rate decreases they gain less from
lend and then demand more reserves to collect a larger return from holding
reserves at the Fed.

c. The supply curve for the federal funds market is perfect inelastic, until it reaches
the discount rate, the rate at which the Fed issues loans, when it turns perfectly
elastic. The supply curve is perfectly inelastic because the amount of nonborrowed reserves available to lend is fixed. Once the federal funds rate reaches
the discount rate, no financial institution will want to borrow from other banks
because they can borrow more cheaply at the Fed. Therefore, no financial
institution will be able to lend at a rate above the discount rate because it would
not be efficient, and this is why the curve becomes perfectly elastic at the discount
rate.
d. The effect of the Feds open market sale of securities to the banking sector on the
federal funds market is that the non-borrowed reserves decrease because there are
less reserves available to lend, which causes the supply curve to shift leftward.
With all things equal, the decrease in supply of reserves will cause the federal
funds rate to increase because there are less reserves to go around.
e. The Fed increasing the discount rate does effectively nothing to the federal funds
market. All that is occurs is that the ceiling of the supply curve increases, but the
equilibrium in the market remains the same.
f. The Fed increasing the required reserve ratio has effects the federal funds market
by raising the interest and the non-borrowed reserves and shifting the demand for
reserves. Currently with financial institutions holding on to large amounts of
excess reserves, this does effectively nothing.
g. The different methods available for the Fed to use to manipulate the federal funds
rate are through Open Market Operations, setting the discount rate, and setting the
required reserve ratio. But the Fed only uses the Open Market Operations. These
Open Market Operations are the most effective because the Fed has complete
control over them unlike with the discount rate, these open market operations
directly affect member bank behavior, and the open market operations are precise
and flexible so that they can be used to the extent the Fed desires. Additionally,
open market operations can be easily reserved and they can be implemented
quickly.
h. The Fed would buy bonds until the federal funds rate was .25 points lower. This
will increase the money base as the bank reserves are increasing. However, the
M1 money supply may increase depending on if these new reserves are lent out
and deposited as checkable deposits or lent out as currency in circulation. If so,
the M1 money supply will increase, and if not, the M1 money supply will not
change.
4) The two approaches are similar because they both aim to have an equilibrium that is at
the same level of non-borrowed reserves, R*. However, as the observed quantity of
reserves falls below R*, the current Feds model has will have a higher federal funds
because their discount rate is higher than the 2003 model and as the amount of reserves
demand decrease the federal funds rate increase, but the 2003 model will be restricted to
the discount rate since the discount rate is the equilibrium rate and all banks have to
option to either borrow from each other or from the Fed since no one will borrow at a rate

above the discount rate. This takes the control out of the Feds hands. When the observed
amount of reserves demanded is above R* each model will see the federal funds rate
lower until it reaches the reserve rate.
5)

%
0.7
5

i*

0.2
5
NBR*

Quantity of
Reserves

Current Interest Rate on Reserves = 0.25%

Current Primary Credit Discount Rate = 0.75%
We can expect the federal funds rate to be between 0.25% and 0.75%, potentially around
0.50%. This means that commercial banks would be trading almost all of their excess
reserves, in theory, because this estimated federal funds rate is higher than the return they
would be getting from holding their excess reserves in the Fed from the reserve rate.
The recent observations contradict my estimations and my model. Based on the
information found on bankrate.com, the federal funds rate has been trending at 0.25% for
this past week, this past month, and this past year, which is equal to the reserve rate. This
means that almost no banks will lend out their excess reserves because the returns gained
from the federal funds rate is equal to the returns gained from holding these reserves in
the Fed. I think that this can be explained because financial institutions are still a bit
hesitant to lend to other financial institutions as we are still escaping the feelings of
recession, and therefore, the Fed realizes this tendency and is trying to encourage
interbank lending and by keeping the federal funds rate equal to the reserve rate there is
no cost to lending or keeping reserves.
The Fed will most likely raise the interest rates by using the open market operation of
sale Treasury bonds. They will do this because they want to increase interbank lending to
get the country out of the recession and restore faith in the financial system by

eliminating the unnaturally low, near-zero interest rates to promote financial stability, and
increase growth.
6) The interest parity condition is a theory that describes the exchange of domestic and
foreign currency with the assumption of the free flow of currency between countries. The
interest parity condition also states the relationship between domestic interest rates,
foreign interest rates, and the expected appreciation of domestic currency. It is stated as
the foreign interest rate equals the domestic interest rate plus the expected appreciation of
domestic currency. Mathematically, the interest parity condition looks like:
e 1e 0
i =i+ 0
e
F

The interest parity condition must be satisfied if capital is perfectly mobile between
countries because the assets are assumed to be perfect substitutes, and if the expected
returns on a domestic asset is higher than those of foreign assets then no one would be
willing to hold foreign assets, and vice versa. Therefore, if existing supplies of both
domestic and foreign assets were to be held, there must be no difference that exists in
their expected returns ultimately resulting in the interest parity condition.
7)
a. The relationship that should be observed between domestic and foreign interest
rates in equilibrium is the interest parity condition, or the foreign interest rate
equals the domestic interest rate plus the expected appreciation of domestic
currency.
b. The domestic central bank would deplete some of its foreign reserves because it
would have to use its reserves of foreign currency to buy back domestic securities
from the rest of the world. Therefore, there would be a capital outflow of foreign
assets to the rest of the world from the central bank and an inflow of domestic
assets into the central bank.
c. I believe that the value of domestic currency will appreciate in the long-run
because the OMO purchase of bonds will cause the bond price to increase and the
interest rate to decrease, and the current exchange rate to depreciate. However,
this action will create an expectation for domestic currency appreciation because
the expected value of the dollar should appreciate to maintain an equilibrium
under the interest parity condition.
d. This will affect the demand for goods and services in the economy by increasing
the domestic demand (or shifting the demand curve leftward) because if the value
of domestic currency decreases in the short run, it means that people can buy
goods and services in domestic markets for less.
e. In equilibrium, the Feds purchase of bonds through open market operations will
cause the bond price to increase and the domestic interest rate to decrease.
However, one cannot be extremely certain what happens to the foreign interest

rate as it will decrease if the domestic currency has no expected appreciation or if

the domestic currency depreciates, but could remain the same or increase
depending on the extent of appreciation that occurs to the domestic currency.
f. The central bank should decrease interest rates because the purchase of bonds
through OMOs caused the interest rate to decrease and the demand for domestic
goods and services to increase as the relative price made it cheaper to buy foreign
goods and services. Therefore, the central bank must stimulate the demand for
domestic goods and services to maintain this trend by lowering the interest rate.
8) A floating exchange rate would adjust in respect to:
a. An increase in current domestic interest rates by increasing.
b. An increase in current domestic price level by increasing.
c. An expected increase in future domestic price level by decreasing.
d. Expectations of future exchange rate appreciation by decreasing
9) A fixed exchange rate regime means that the value of a currency is pegged relative to the

value of a different currency, while a floating exchange rate regime has the value of
currency fluctuating against all other currencies. The difference between these two
regime is that monetary policy is ineffective under fixed exchange rates because the
exchange rate is fixed and, as a result, in a domestic setting, inflation cannot be targeted
and the business cycle cannot be smoothed out. However, the central bank can control the
value of the domestic currency through the sale or purchase of domestic currency but that
will affect its international reserves. On the other hand, monetary policy does not affect
world aggregate demand, but it shifts causes a shift in demand for both domestic and
foreign products depending on the type of policy.