Econ 202: Intermediate Macroeconomics

Problem Set 4: The money market model and non-traditional monetary policy

Spring 2023

Due date: This assignment is due via Blackboard by 12:30 pm on Thursday February 23.

Instructions: For full credit, you need to show all steps and work, clearly label all graphs, and

fully explain any answers that ask for an explanation. You can either type your answers (but be

sure to still show all steps and work) or write them by hand and scan them using the camera on

your phone/tablet (this is what I would do).

Question 1: Bond prices and interest rates (10 points)

Consider a bond that promises to pay $100 in one year.

a. What is the equilibrium interest rate on the bond if its price today is $85? $95?

b. Explain why there is an inverse relationship between bond prices and interest rates.

(Explain the economic logic, not only the mechanics of the formula).

c. If the interest rate is 4%, what is the price of the bond today?

Question 2: Monetary policy in a liquidity trap (10 points)

Consider the following graph of a money market and answer the following questions:

𝑖 𝑀!

” 𝑀#

” 𝑀$

”

𝑀%

𝑀

a. What intervention does the central bank make in bond markets to move from 𝑀!

” to 𝑀#

“?

b. Why does this bond market intervention reduce the interest rate?

c. When the central bank increases the money supply from 𝑀!

” to 𝑀#

“, does it stimulate

economic activity? Why or why not?

d. When the central bank increases the money supply from 𝑀#

” to 𝑀$

“, does it stimulate

economic activity? Why or why not?

e. After the Great Recession, the Federal Reserve lowered all the interest rates all the way to

zero, and the U.S. economy fell into a liquidity trap. What was the Federal Reserve’s

policy response to the liquidity trap? Describe the policy in 1-2 sentences.

Question 3: Monetary policy when the economy is in a liquidity trap (10 points)

Suppose that money demand is given by:

M& = $Y(0.25 − i)

if interest rates are positive. This question refers to the situation where the interest rate is zero.

a. What is the demand for money when interest rates are zero and $Y=80?

b. If $Y=80, what is the smallest value of the money supply at which the interest rate is

zero?

c. Once the interest rate is zero, can the central bank continue to increase the money supply?

Why or why not?

d. Graphically show the effect of monetary policy on money markets when interest rates are

zero (at the zero lower bound). Explain your answer (the shape of the money demand

curve, and the effect of monetary policy).

Question 4: Current monetary policy (5 points)

a. Go to FRED database and download monthly data from 1980 to the present for the

effective federal funds rate. Download your graph and submit it with your assignment.

b. In late 2008, the Federal Reserve lowered the federal funds rate to zero. How does the

timing of this change in the federal funds rate overlap with the 2008 financial crisis (note

that the recession is shaded on your FRED graph)? What does this imply about the

efficacy of standard monetary policy (open market operations) as a policy tool with

which to combat the 2008 crisis?

c. Current monetary policy: Go to the website for the Federal Reserve Board of Governors

and download the most recent monetary policy press release of the Federal Open Market

Committee (FOMC). Based on this report, briefly summarize the current stance of

monetary policy.