Money and Banking

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2a) An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply and demand analysis for bonds, show what effect this action has on interest rates. Answer: When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supply curve BS to the right. The result is that the intersection of the supply and demand curves BS and Bd occurs at a lower equilibrium bond price and thus a higher equilibrium interest rate, and the interest rate rises.

2b) Calculate the duration of a 1,000, 6% coupon bond with three years to maturity. Assume that all market interest rates are 7% Answer: Year 1 2 3 Sum
Payments 60.00 60.00 1060.00
PV of Payments 56.07 52.41 865.28 973.76 Time Weighted PV of Payments 56.07 104.81 2595.83
Time Weighted PV of Payments 0.06 0.11 2.67 2.83 of divided by price
This bond has a duration of 2.83years. Note that the current price of the bond is $973.76, which is the sum of the individual “PV of payments”.

3a) What incentives arise for a central bank to fall into the time-inconsistency trap of pursuing overly expansionary monetary policy? Answer: Central bankers might think they can boost output or lower unemployment by pursuing overly expansionary monetary policy even though in the long run this just leads to higher inflation and no gains on the output or unemployment front. Alternatively, politicians may pressure the central bank to pursue overly expansionary policies.

3b) Which goals of the Fed frequently conflict?
Answer: The goal of price stability often conflicts with the goals of high economic growth and employment and interest rate stability. When the economy is expanding along with employment, inflation may rise. In order to pursue the goal of price stability the Fed may have to pursue contractionary anti-inflationary policy that...
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