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a description of the state of the economy provided below and to explain how their policy recommendation will affect the economy.
Your deliverable may include graphs and figures from credible news or research articles as long as the source is clearly stated. Please note that the number of points per question is shown in square brackets (i.e., [x]).
Question 1 [10 points]
Suppose the Federal Open Market committee releases the following statement about the state of the economy:
“Information received by the FOMC indicates that inflation increased much faster than anticipated, while the unemployment rate remains somewhat below its estimated natural rate. Consumer demand remains strong, and job openings exceed the number of unemployed. Price increases in goods and services are primarily driven by higher wages. Commodity prices and transportation costs remain near their average over the last 20 years.”
Provide a brief comparison of this assessment of the economy with the dual mandate of Federal Reserve and describe whether the Federal Reserve is currently achieving the goals of the dual mandate.
Question 2 [10 points]
Provide a monetary policy recommendation based on this assessment of the economy.
Question 3 [25 points]
Provide a comprehensive reasoning explaining why the recommendation you gave in response to Question 2 is the appropriate action, and how you expect the relevant macroeconomic variables (industrial production and gross domestic product, inflation, and unemployment) to respond to your recommendation.
In Questions 4 through 7, you will consider the channels through which your monetary policy recommendation is expected to affect the economy.
Question 4 [20 points]
Describe how your monetary policy action is expected to affect the Treasury yield curve, assuming that the market participants expect that the Fed will be able to correct the inflationary behavior fairly quickly and that the inflation will come back to its historical levels within one to two years. In your response to this question, please:
- Explain whether and why you expect to see the bond yields to rise or fall;
- Explain whether and why this effect will be more pronounced for short-term or long-term bonds; and
- Characterize the behavior of the yield curve as bullish flattening, bullish steepening, bearish flattening, or bearish steepening, and explain your judgment.
Question 5 [15 points]
Describe why and how your recommendation will affect banks and banks’ lending policies. Please identify and explain in your own words the three channels through which the supply of credit will be affected; and note how the supply of credit will be affected.
Question 6 [15 points]
Identify and explain, in your own words, at least two ways through which firms’ investment decisions will be affected by your recommendation.
Question 7 [15 points]
Consider two households that bought their houses and obtained their mortgages 7 years ago:
- Household A purchased their house with a 30-year, 5/6 hybrid adjustable-rate mortgage (ARM) (that is, the mortgage rate resets every 6 months based on a benchmark rate after the initial 5-year fixed period), and
- Household B financed their home purchase with a 30-year fixed rate mortgage.
(Recall that we’ve discussed fixed- and adjustable-rate mortgages in the first half of the course. You may want to review the content of Module 1 live lecture and case study to refresh your memory of how they work.)
Discuss how your monetary policy recommendation affects each household in terms of its consumption patterns, and which household is more likely to immediately respond to your recommendation.
Question 8 [15 points]
Imagine that you are the Fed chair giving the post-FOMC press conference announcing your interest rate policy you recommended in response to Question 2. A reporter asks you:
“Chair, the banks currently have over $3.5 trillion in reserves that they can lend out in other overnight funding markets. This is a lot of cash floating around! How will the Fed implement the policy you announced? And how will you make sure that as of next week, what you’ve announced is what we see happening in the markets in terms of interest rate changes?” What is the reporter concerned about and how would you, as the Fed chair, respond to this question? Please name and explain (in your words) the tools the Fed would use to implement the policy to within the announced parameters. Keep in mind that the setting of this scenario is in the post-2008 policy world.
Question 9 [10 points]
Now suppose the FOMC statement were to differ slightly and now reads as follows:
“Information received by the FOMC indicates that inflation increased much faster than anticipated, while the unemployment rate remains somewhat below its estimated natural rate. Price increases in goods appear to be primarily driven by supply shortages in chip factories due to extreme weather events and are expected to ease within the next 6 months. So far, wage increases have been moderate.”
Discuss in detail how the differences in the statements in Question 1 and Question 9 would affect your assessment of the economy and compare the state of the economy in this statement with the Fed’s dual mandate.
Question 10 [15 points] In light of this new statement, would you give a different monetary policy recommendation compared to your original recommendation in Question 2? Why or why not? Please explain.
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