Economic growth over time
Mini-project 4 Macroeconomics 1. Use the accompanying data (MP4.xls), to complete the following: a. Calculate economic growth over time. Plot economic growth overtime. Was economic growth more stable before or after the year 2000?
5.00
Economic growth over time
4.00
2.00
1.00
0.00
-1.00
06 nJa 02 nJa 98 nJa 94 nJa 90 nJa 86 nJa 82 nJa 78 nJa 74 nJa 70 nJa 66 nJa 62 nJa 58 nJa 54 nJa 50 nJa 46 nJa
Economic Growth
3.00
-2.00
-3.00
-4.00
quarters
Notice that in the graph above that the variance (or standard deviation) in economic growth is diminishing over time. This suggests that the Fed is probably doing a much better job as they learn how to manage our economy because economic growth is more stable. In addition, macroeconomics did not exist before this time period. And as with everything else, it takes to learn how to do something well.
b. What is a budget deficit? What is a budget surplus? Calculate the quarterly budget surpluses (deficits) our government has run over time. Plot the budget surplus (deficit) over time. Over what periods of time did our government run budget deficits? Over what periods of time did our government run budget surpluses? A budget deficit occurs when our government spends more than it collects in taxes. A budget surplus is when our government spends less than it collects in taxes. All data points below the thick solid black line in the following diagram represent budget deficits, while all of those above it represent budget surpluses. According this diagram, the budget deficit should disappear sometime in the next year or two.
.
10/10/2006 1/14/2004 4/19/2001 7/24/1998 10/28/1995 1/31/1993 5/7/1990 8/11/1987 11/14/1984 2/18/1982 5/25/1979 8/28/1976 12/2/1973 3/8/1971 6/11/1968 9/15/1965 12/20/1962 3/25/1960 6/29/1957 10/3/1954 1/7/1952
1
0
-1
-2
-3
-4
-5
Budget surplus as a % of Real GDP
-50
-150 Budget surplus
Budget surplus over time 250
150
50
-250
-350
-450
Quarter
c. Calculate the budget surplus/deficit as a percentage of real GDP over time. Plot the budget surplus/deficit as a percentage of real GDP over time. Figure 5—Budget surplus as a % of real GDP over time 3
2
-6
-7
10/10/2006
1/14/2004
4/19/2001
7/24/1998
10/28/1995
1/31/1993
5/7/1990
8/11/1987
11/14/1984
2/18/1982
5/25/1979
8/28/1976
12/2/1973
3/8/1971
6/11/1968
9/15/1965
12/20/1962
3/25/1960
6/29/1957
10/3/1954
1/7/1952
Quarter
According the diagram above, the budget deficit will disappear sometime in the next year or two.
d. Calculate government spending (G) as a percentage of real GDP over time. Plot the government spending as a percentage of real GDP over time. Government spending as a % of real GDP 25 24
G as a % of GDP
.
23 22 21 20 19 18 17 16 15 10/10/2006
1/14/2004
4/19/2001
7/24/1998
10/28/1995
1/31/1993
5/7/1990
8/11/1987
11/14/1984
2/18/1982
5/25/1979
8/28/1976
12/2/1973
3/8/1971
6/11/1968
9/15/1965
12/20/1962
3/25/1960
6/29/1957
10/3/1954
1/7/1952
Quarter
According the diagram above, government spending has leveled off.
e. Calculate tax receipts (T) as a percentage of real GDP over time. Plot the tax receipts as a percentage of real GDP over time. Tax receipts as a % of GDP Over Time 22
21
T as a % of GDP .
20
19
18
17
16
15 10/10/2006
1/14/2004
According the diagram above, tax revenues will continue to pour into the Treasury.
4/19/2001
7/24/1998
10/28/1995
1/31/1993
5/7/1990
8/11/1987
11/14/1984
2/18/1982
5/25/1979
8/28/1976
12/2/1973
3/8/1971
6/11/1968
9/15/1965
12/20/1962
3/25/1960
6/29/1957
10/3/1954
1/7/1952
quarter
2. Fiscal Policy a. What happens to aggregate demand (AD) and aggregate supply (AS) when the Congress and the President cut individual and corporate income taxes? What happens to the price level and real GDP when they cut both of these taxes? PL
AS0 AS1 AD1 AD0
12
14
Y
(trillion $) Aggregate demand increases from AD0 to AD1 when the Congress and the President cut demand-side taxes. Aggregate supply increases from AS0 to AS1 when the Congress and the President cut supply-side taxes. Both of these policies increase real GDP. According to the above diagram prices are constant, but prices could rise, remain the same, or decrease. The effect of these policies on prices depends on the elasticity (slope) of AS relative to AD and how large the supply-side tax cut was relative to the demand-side tax cut.
b. What happens to AD and AS when the Congress and the President increase government spending? What happens to the price level and real GDP when they increase government spending? PL
AS0
AD1 AD0
12 13 (trillion $)
Y
Aggregate demand increases from AD0 to AD1 when the Congress and the President increase government spending, which increase real GDP and prices.
c. How does the Congress and the President finance a budget deficit? The U.S. Treasury Department auctions off US T-Bonds, US T-Bills, and US T-Notes, which are essentially like the promissory notes in the board game “Life”.
d. Which group of individuals does the Top Marginal Tax rate affect? Those making over about $300,000 a year.
e. Construct a scatterplot of Top Marginal Tax Rate versus Government Spending as a percentage of GDP. Put Top Marginal Tax Rate on the horizontal axis. Include a trendline in this diagram. Compute the slope of this trendline. Top Marginal Tax Rates vs. Government Spending (as a % of GDP) y = -0.074x + 24.148
24.00
G/GDPY
22.00
20.00
18.00
16.00
14.00
20
30
40
50
60
70
80
90
100
Top Marginal Tax Rate
f. The slope of the trendline suggests that cutting the Top Marginal Tax Rate by 1% results in a 0.07 percent decline in Government Spending as a percentage of GDP. g. Construct a scatterplot of Top Marginal Tax Rate versus Tax Receipts as a percentage of GDP. Put Top Marginal Tax Rate on the horizontal axis. Include a trendline in this diagram. Compute the slope of this trendline.
Top Marginal Tax Rates vs. Tax receipts (as a % of GDP)
y = -0.0236x + 19.686 22
21
T as a % of GDP
.
20
19
18
17
16
15 20
30
40
50
60
70
80
90
100
Top Marginal Tax Rate
h. The slope of the trendline suggests that cutting the Top Marginal Tax Rate by 1% results in a 0.0236 percent decline in Tax Receipts as a percentage of GDP. i. Comment on the effect of Tax Rate Cuts. By cutting the top marginal tax rate from 90% to 35% results in a nearly 1.3% increase in tax revenue, confirming the Laffer Curve.
2. Monetary Policy a. What is the Federal Reserve System? (The Fed is short for the Federal Reserve System.) What is the federal funds rate? What is the federal funds rate target? How does the Fed raise the federal funds rate target? What does “100 basis points” mean? What is an Open Market Operation? What is the reserve requirement ratio? What is the discount rate? The Federal Reserve System, founded by Congress in 1913, is the central bank of the United States. The Federal Reserve’s duties include: Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates; Supervising and regulating banking institutions; Maintaining the stability of the financial system; and Providing financial services to depository institutions, the U.S. government, and foreign official institutions. The federal funds rate is the interest rate at which banks lend balances (excess reserves or federal funds) at the Federal Reserve to other banks that are having difficulty meeting their reserve requirement. In 1995 the Fed began explicitly stating the federal funds rate target. The current federal funds rate target is 5.25%.
The Federal Reserve sells U.S. T-bonds, notes, and bills that it had previously purchased from banks back to banks. Selling these securities reduces the quantity of reserves in the federal funds market, which drives up the federal funds rate. The buying and selling of these securities is called Open Market Operations. “100 basis points” is equal to 1%. The reserve requirement ratio is the ratio of reserves to deposits that banks are required to hold. Required reserves are those reserves which must be kept on hand or on deposit with the Federal Reserve in order to comply with the reserve requirements The discount rate is the rate that a bank is charged to borrow short term funds directly from the Federal Reserve. As of January 2003, the discount rate is set 100 basis points higher than the federal funds rate target.
b. What primary function does the U.S. Treasury Department perform for our government? What is a U.S. Treasury security? What is the difference between the Primary Market for U.S. Treasury securities and the Secondary Market for U.S. Treasury securities? The basic functions of the Department of the Treasury include: Managing Federal finances; Collecting taxes, duties and monies paid to and due to the U.S. and paying all bills of the U.S.; Producing postage stamps, currency and coinage; Managing Government accounts and the public debt; Supervising national banks and thrift institutions; Advising on domestic and international financial, monetary, economic, trade and tax policy; Enforcing Federal finance and tax laws; and Investigating and prosecuting tax evaders, counterfeiters, and forgers. Treasury securities are government bonds (T-bills, T-notes, T-bonds, and Savings bonds) issued by the United States Department of the Treasury. They are used to finance budget deficits. Tbills, T-notes, and T-bonds are very liquid and are heavily traded on the secondary market. The initial seller in the primary market is the Treasury. A bond that is purchased back by the Treasury is completed in the primary market as well. The secondary market is a financial market for trading of securities once they have been issued (sold by the Treasury) in an initial private or public offering (in the primary market).
c. What happens to the Supply of Federal Funds when the reserve requirement ratio is changed? What happens to the Demand for Federal Funds when the reserve requirement ratio is changed? What is the effect of changing the reserve requirement in the federal funds market? The demand for reserves increases when the required reserve ratio is changed but not the supply of reserves. The Fed might decide to increase reserve requirement ratio to encourage banks to lend less to reduce the MS and thereby slow down the economy. The effect of changing the reserve requirement depends on how large the change is. A tiny change in the reserve requirement ratio raises the federal funds rate but not the quantity of reserves:
Federal Funds Market
i ff SR
DR Q A small change did not increase reserves in the federal funds market, which leads to no change in the money supply: and no change in the real rate of interest:
Money Market MS1
r
MD Quantity of Money No change in r means there is no change in aggregate demand (AD), and so there is no change in real GDP:
AS
PL
AD1 Y
However, if the reserve requirement ratio is increased a lot, then the demand for reserves increases substantially. This increases the federal funds so much that it equals the discount rate. Demand is so high for reserves that excess reserves dry up, forcing the Federal Reserve to loan money at the discount rate:
Federal Funds Market
i ff SR
DR Q Rather than reducing the money supply, the Federal Reserve increased it because there are more reserves in the federal funds market. Higher money supply lowers the real rate of interest:
Money Market MS1
MS1
r
MD Quantity of Money Lower r raises I, and both these effects raise AD, which increases NOT decreases real GDP and the price level if aggregate supply is upward sloping:
AS
PL
AD2 AD1 Y
If the reserve requirement ratio is increased too much in an effort to cool a ‘hot” economy, it may end up increasing the federal funds rate while causing the real rate of interest to fall (contradictory results), which accelerates the economy rather than slowing it down. Thus, the Fed has not changed the reserve requirement ratio since 1992.
d. What happens to the Supply of Federal Funds when the discount rate is changed? What happens to the Demand for Federal Funds when the discount rate is changed? What is the effect of changing the discount rate on the federal funds rate? Since January 1st of 2003 the Fed sets the discount rate 100 basis points (1%) above its federal funds rate target. Thus, if the discount rate is increased, there is no effect on the economy because the federal funds rate and quantity of reserves do not change:
Federal Funds Market
i ff
SR
DR QR e. What happens to the Supply of Federal Funds when the Fed performs an Open Market Purchase? What happens to the Demand for Federal Funds when the Fed performs an Open Market Purchase? What is the effect of an Open Market Purchase on the federal funds rate? An Open Market Purchase (OMP) is used to accelerate the economy. If the Fed conducts an OMP, cash flows out of the Fed’s vault into the banking system while Treasury securities flow into the Fed’s vault from banks. The OMP increases the quantity of reserves, lowering the equilibrium federal funds interest rate:
Federal Funds Market
iff
SR
DR QR
Increased reserves increase the MS, lowering the real rate of interest:
Money Market MS1
MS1
r
MD Quantity of Money The OMP results in the lowering of both the federal funds rate and real rate of interest. The lower real rate of interest increases private investment and both of these effects increase aggregate demand. Increased aggregate demand increases output (real GDP) and causes some inflation if aggregate supply is upward sloping:
AS
PL
AD2 AD1 Y
f. What happens to the Supply of Federal Funds when the Fed performs an Open Market Sale? What happens to the Demand for Federal Funds when the Fed performs an Open Market Sale? What is the effect of an Open Market Sale on the federal funds rate? An OMS is the opposite of an OMP. When the Fed sells US Treasury securities to banks, securities leave the Fed’s vault while cash from member banks enters the Fed’s vault. This decreases the quantity or reserves, raising the equilibrium federal funds interest rate. Decreaing reserves reduce the money supply, raising the real rate of interest. Higher interest rates reduce private investment, which decreases aggregate demand. Hence, the OMS results in lower GDP and lower prices if aggregate supply is upward sloping.
g. What happens to AD and AS when the Fed cuts interest rates? What happens to the price level and real GDP when it cuts interest rates? See the answers in part (e) and (f).
h. Construct a scatterplot of economic growth versus the quarterly federal funds rate. Put economic growth on the vertical axis. Include a trendline in this diagram. Compute the slope of this line. Federal Funds Rate vs. Economic Growth
y = -0.0709x + 1.2312 4
3
Real GDP Growth
2
1
0
-1
-2
-3 0
2
4
6
8
10
12
14
16
18
20
Federal Funds Rate
i. The slope of this trendline suggests that cutting the federal funds rate target by 1% results in a 0.07 percent increase in economic growth. j. Comment on the effect of cutting the federal funds rate. Lowering the federal funds rate results in higher economic growth, which is important when the economy is in recession. Raising the federal funds rate results in lower economic growth, which is important when the economy is overheating.
5.00
Economic growth over time
4.00
2.00
1.00
0.00
-1.00
06 nJa 02 nJa 98 nJa 94 nJa 90 nJa 86 nJa 82 nJa 78 nJa 74 nJa 70 nJa 66 nJa 62 nJa 58 nJa 54 nJa 50 nJa 46 nJa
Economic Growth
3.00
-2.00
-3.00
-4.00
quarters
Notice that in the graph above that the variance (or standard deviation) in economic growth is diminishing over time. This suggests that the Fed is probably doing a much better job as they learn how to manage our economy because economic growth is more stable. In addition, macroeconomics did not exist before this time period. And as with everything else, it takes to learn how to do something well.
b. What is a budget deficit? What is a budget surplus? Calculate the quarterly budget surpluses (deficits) our government has run over time. Plot the budget surplus (deficit) over time. Over what periods of time did our government run budget deficits? Over what periods of time did our government run budget surpluses? A budget deficit occurs when our government spends more than it collects in taxes. A budget surplus is when our government spends less than it collects in taxes. All data points below the thick solid black line in the following diagram represent budget deficits, while all of those above it represent budget surpluses. According this diagram, the budget deficit should disappear sometime in the next year or two.
.
10/10/2006 1/14/2004 4/19/2001 7/24/1998 10/28/1995 1/31/1993 5/7/1990 8/11/1987 11/14/1984 2/18/1982 5/25/1979 8/28/1976 12/2/1973 3/8/1971 6/11/1968 9/15/1965 12/20/1962 3/25/1960 6/29/1957 10/3/1954 1/7/1952
1
0
-1
-2
-3
-4
-5
Budget surplus as a % of Real GDP
-50
-150 Budget surplus
Budget surplus over time 250
150
50
-250
-350
-450
Quarter
c. Calculate the budget surplus/deficit as a percentage of real GDP over time. Plot the budget surplus/deficit as a percentage of real GDP over time. Figure 5—Budget surplus as a % of real GDP over time 3
2
-6
-7
10/10/2006
1/14/2004
4/19/2001
7/24/1998
10/28/1995
1/31/1993
5/7/1990
8/11/1987
11/14/1984
2/18/1982
5/25/1979
8/28/1976
12/2/1973
3/8/1971
6/11/1968
9/15/1965
12/20/1962
3/25/1960
6/29/1957
10/3/1954
1/7/1952
Quarter
According the diagram above, the budget deficit will disappear sometime in the next year or two.
d. Calculate government spending (G) as a percentage of real GDP over time. Plot the government spending as a percentage of real GDP over time. Government spending as a % of real GDP 25 24
G as a % of GDP
.
23 22 21 20 19 18 17 16 15 10/10/2006
1/14/2004
4/19/2001
7/24/1998
10/28/1995
1/31/1993
5/7/1990
8/11/1987
11/14/1984
2/18/1982
5/25/1979
8/28/1976
12/2/1973
3/8/1971
6/11/1968
9/15/1965
12/20/1962
3/25/1960
6/29/1957
10/3/1954
1/7/1952
Quarter
According the diagram above, government spending has leveled off.
e. Calculate tax receipts (T) as a percentage of real GDP over time. Plot the tax receipts as a percentage of real GDP over time. Tax receipts as a % of GDP Over Time 22
21
T as a % of GDP .
20
19
18
17
16
15 10/10/2006
1/14/2004
According the diagram above, tax revenues will continue to pour into the Treasury.
4/19/2001
7/24/1998
10/28/1995
1/31/1993
5/7/1990
8/11/1987
11/14/1984
2/18/1982
5/25/1979
8/28/1976
12/2/1973
3/8/1971
6/11/1968
9/15/1965
12/20/1962
3/25/1960
6/29/1957
10/3/1954
1/7/1952
quarter
2. Fiscal Policy a. What happens to aggregate demand (AD) and aggregate supply (AS) when the Congress and the President cut individual and corporate income taxes? What happens to the price level and real GDP when they cut both of these taxes? PL
AS0 AS1 AD1 AD0
12
14
Y
(trillion $) Aggregate demand increases from AD0 to AD1 when the Congress and the President cut demand-side taxes. Aggregate supply increases from AS0 to AS1 when the Congress and the President cut supply-side taxes. Both of these policies increase real GDP. According to the above diagram prices are constant, but prices could rise, remain the same, or decrease. The effect of these policies on prices depends on the elasticity (slope) of AS relative to AD and how large the supply-side tax cut was relative to the demand-side tax cut.
b. What happens to AD and AS when the Congress and the President increase government spending? What happens to the price level and real GDP when they increase government spending? PL
AS0
AD1 AD0
12 13 (trillion $)
Y
Aggregate demand increases from AD0 to AD1 when the Congress and the President increase government spending, which increase real GDP and prices.
c. How does the Congress and the President finance a budget deficit? The U.S. Treasury Department auctions off US T-Bonds, US T-Bills, and US T-Notes, which are essentially like the promissory notes in the board game “Life”.
d. Which group of individuals does the Top Marginal Tax rate affect? Those making over about $300,000 a year.
e. Construct a scatterplot of Top Marginal Tax Rate versus Government Spending as a percentage of GDP. Put Top Marginal Tax Rate on the horizontal axis. Include a trendline in this diagram. Compute the slope of this trendline. Top Marginal Tax Rates vs. Government Spending (as a % of GDP) y = -0.074x + 24.148
24.00
G/GDPY
22.00
20.00
18.00
16.00
14.00
20
30
40
50
60
70
80
90
100
Top Marginal Tax Rate
f. The slope of the trendline suggests that cutting the Top Marginal Tax Rate by 1% results in a 0.07 percent decline in Government Spending as a percentage of GDP. g. Construct a scatterplot of Top Marginal Tax Rate versus Tax Receipts as a percentage of GDP. Put Top Marginal Tax Rate on the horizontal axis. Include a trendline in this diagram. Compute the slope of this trendline.
Top Marginal Tax Rates vs. Tax receipts (as a % of GDP)
y = -0.0236x + 19.686 22
21
T as a % of GDP
.
20
19
18
17
16
15 20
30
40
50
60
70
80
90
100
Top Marginal Tax Rate
h. The slope of the trendline suggests that cutting the Top Marginal Tax Rate by 1% results in a 0.0236 percent decline in Tax Receipts as a percentage of GDP. i. Comment on the effect of Tax Rate Cuts. By cutting the top marginal tax rate from 90% to 35% results in a nearly 1.3% increase in tax revenue, confirming the Laffer Curve.
2. Monetary Policy a. What is the Federal Reserve System? (The Fed is short for the Federal Reserve System.) What is the federal funds rate? What is the federal funds rate target? How does the Fed raise the federal funds rate target? What does “100 basis points” mean? What is an Open Market Operation? What is the reserve requirement ratio? What is the discount rate? The Federal Reserve System, founded by Congress in 1913, is the central bank of the United States. The Federal Reserve’s duties include: Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates; Supervising and regulating banking institutions; Maintaining the stability of the financial system; and Providing financial services to depository institutions, the U.S. government, and foreign official institutions. The federal funds rate is the interest rate at which banks lend balances (excess reserves or federal funds) at the Federal Reserve to other banks that are having difficulty meeting their reserve requirement. In 1995 the Fed began explicitly stating the federal funds rate target. The current federal funds rate target is 5.25%.
The Federal Reserve sells U.S. T-bonds, notes, and bills that it had previously purchased from banks back to banks. Selling these securities reduces the quantity of reserves in the federal funds market, which drives up the federal funds rate. The buying and selling of these securities is called Open Market Operations. “100 basis points” is equal to 1%. The reserve requirement ratio is the ratio of reserves to deposits that banks are required to hold. Required reserves are those reserves which must be kept on hand or on deposit with the Federal Reserve in order to comply with the reserve requirements The discount rate is the rate that a bank is charged to borrow short term funds directly from the Federal Reserve. As of January 2003, the discount rate is set 100 basis points higher than the federal funds rate target.
b. What primary function does the U.S. Treasury Department perform for our government? What is a U.S. Treasury security? What is the difference between the Primary Market for U.S. Treasury securities and the Secondary Market for U.S. Treasury securities? The basic functions of the Department of the Treasury include: Managing Federal finances; Collecting taxes, duties and monies paid to and due to the U.S. and paying all bills of the U.S.; Producing postage stamps, currency and coinage; Managing Government accounts and the public debt; Supervising national banks and thrift institutions; Advising on domestic and international financial, monetary, economic, trade and tax policy; Enforcing Federal finance and tax laws; and Investigating and prosecuting tax evaders, counterfeiters, and forgers. Treasury securities are government bonds (T-bills, T-notes, T-bonds, and Savings bonds) issued by the United States Department of the Treasury. They are used to finance budget deficits. Tbills, T-notes, and T-bonds are very liquid and are heavily traded on the secondary market. The initial seller in the primary market is the Treasury. A bond that is purchased back by the Treasury is completed in the primary market as well. The secondary market is a financial market for trading of securities once they have been issued (sold by the Treasury) in an initial private or public offering (in the primary market).
c. What happens to the Supply of Federal Funds when the reserve requirement ratio is changed? What happens to the Demand for Federal Funds when the reserve requirement ratio is changed? What is the effect of changing the reserve requirement in the federal funds market? The demand for reserves increases when the required reserve ratio is changed but not the supply of reserves. The Fed might decide to increase reserve requirement ratio to encourage banks to lend less to reduce the MS and thereby slow down the economy. The effect of changing the reserve requirement depends on how large the change is. A tiny change in the reserve requirement ratio raises the federal funds rate but not the quantity of reserves:
Federal Funds Market
i ff SR
DR Q A small change did not increase reserves in the federal funds market, which leads to no change in the money supply: and no change in the real rate of interest:
Money Market MS1
r
MD Quantity of Money No change in r means there is no change in aggregate demand (AD), and so there is no change in real GDP:
AS
PL
AD1 Y
However, if the reserve requirement ratio is increased a lot, then the demand for reserves increases substantially. This increases the federal funds so much that it equals the discount rate. Demand is so high for reserves that excess reserves dry up, forcing the Federal Reserve to loan money at the discount rate:
Federal Funds Market
i ff SR
DR Q Rather than reducing the money supply, the Federal Reserve increased it because there are more reserves in the federal funds market. Higher money supply lowers the real rate of interest:
Money Market MS1
MS1
r
MD Quantity of Money Lower r raises I, and both these effects raise AD, which increases NOT decreases real GDP and the price level if aggregate supply is upward sloping:
AS
PL
AD2 AD1 Y
If the reserve requirement ratio is increased too much in an effort to cool a ‘hot” economy, it may end up increasing the federal funds rate while causing the real rate of interest to fall (contradictory results), which accelerates the economy rather than slowing it down. Thus, the Fed has not changed the reserve requirement ratio since 1992.
d. What happens to the Supply of Federal Funds when the discount rate is changed? What happens to the Demand for Federal Funds when the discount rate is changed? What is the effect of changing the discount rate on the federal funds rate? Since January 1st of 2003 the Fed sets the discount rate 100 basis points (1%) above its federal funds rate target. Thus, if the discount rate is increased, there is no effect on the economy because the federal funds rate and quantity of reserves do not change:
Federal Funds Market
i ff
SR
DR QR e. What happens to the Supply of Federal Funds when the Fed performs an Open Market Purchase? What happens to the Demand for Federal Funds when the Fed performs an Open Market Purchase? What is the effect of an Open Market Purchase on the federal funds rate? An Open Market Purchase (OMP) is used to accelerate the economy. If the Fed conducts an OMP, cash flows out of the Fed’s vault into the banking system while Treasury securities flow into the Fed’s vault from banks. The OMP increases the quantity of reserves, lowering the equilibrium federal funds interest rate:
Federal Funds Market
iff
SR
DR QR
Increased reserves increase the MS, lowering the real rate of interest:
Money Market MS1
MS1
r
MD Quantity of Money The OMP results in the lowering of both the federal funds rate and real rate of interest. The lower real rate of interest increases private investment and both of these effects increase aggregate demand. Increased aggregate demand increases output (real GDP) and causes some inflation if aggregate supply is upward sloping:
AS
PL
AD2 AD1 Y
f. What happens to the Supply of Federal Funds when the Fed performs an Open Market Sale? What happens to the Demand for Federal Funds when the Fed performs an Open Market Sale? What is the effect of an Open Market Sale on the federal funds rate? An OMS is the opposite of an OMP. When the Fed sells US Treasury securities to banks, securities leave the Fed’s vault while cash from member banks enters the Fed’s vault. This decreases the quantity or reserves, raising the equilibrium federal funds interest rate. Decreaing reserves reduce the money supply, raising the real rate of interest. Higher interest rates reduce private investment, which decreases aggregate demand. Hence, the OMS results in lower GDP and lower prices if aggregate supply is upward sloping.
g. What happens to AD and AS when the Fed cuts interest rates? What happens to the price level and real GDP when it cuts interest rates? See the answers in part (e) and (f).
h. Construct a scatterplot of economic growth versus the quarterly federal funds rate. Put economic growth on the vertical axis. Include a trendline in this diagram. Compute the slope of this line. Federal Funds Rate vs. Economic Growth
y = -0.0709x + 1.2312 4
3
Real GDP Growth
2
1
0
-1
-2
-3 0
2
4
6
8
10
12
14
16
18
20
Federal Funds Rate
i. The slope of this trendline suggests that cutting the federal funds rate target by 1% results in a 0.07 percent increase in economic growth. j. Comment on the effect of cutting the federal funds rate. Lowering the federal funds rate results in higher economic growth, which is important when the economy is in recession. Raising the federal funds rate results in lower economic growth, which is important when the economy is overheating.
