SCENARIO #2 AN IS SHOCK!

(A new Grader)
Lets return to our original conditions: Please write down the expressions for your
ORIGINAL IS curve and LM curves in the space below (so the grader can follow your
starting points).
IS: r = ___________________________
LM: r = __________________________
Now draw four separate diagrams: (40 points total) Top left: a desired savings equals
desired investment (Sd = Id ), Top right: a FE - IS LM diagram, Bottom left: a money
market diagram, Bottom right: An AD - AS diagram, locating this initial equilibrium point as
point A. BE SURE to LABEL all diagrams completely (10 points for each correctly drawn
and labeled diagrameach diagram will have three different equilibriums points A, B, and
C)

In this scenario #2, there is a shock to the consumption function so that the new consumption
function is:
Cd = 381 + .50(Y-T) 500r (NEW)
Cd = 401 + .50(Y-T) 500r (OLD)
S2 a) (6 points) Name three reasons why the desired consumption function would change like
this.
Answer Desired consumption would change when there is decease in the autonomous
consumption may be due to decrease in the spending by the people because of decrease in
money supply, rise in the interest rate or may be due to rise in the exports.
S2 b) (4 points) Derive a new expression for the IS curve (r in terms of Y). Please show all
work
S2 c)(4 points) Now solve for the short-run equilibrium output (Keynesian) and the
corresponding real rate of interest. Please show all work. Please label this short run (fixed
price) equilibrium as point B on all four of you diagrams.

S2 d) (4 points) We now consider the long run when prices adjust. Find the new price level
associated with the long run equilibrium. Please show all work

S2 e) (4 points) Derive a new expression for the LM curve. Please show all work.
Label this long run equilibrium as point C in all four of your diagrams.
2. (40 points total) When talking about money demand, we talked of the importance in terms
of policy of identifying the shock to money demand. We characterized shocks to money
demand as either real or portfolio.
2.a) (10 points) Please explain the differences between these shocks to money demand (real
vs portfolio) using real world examples to support your answer. Please list as many portfolio
shocks as possible and make sure you sign each shock with a brief explanation as to why you
signed it (+ or - ) the way you did.
Answer The portfolio shocks include the changes in the interest rates by the monetary
authority like Fed has just decrease the interest rate by 25 basis points. Apart from that
other portfolio shocks includes increase in foreign assets due to which there will be rise in
the return received. It will be a positive portfolio shock because of rise in the assets.
We now consider a specific case, call it case #1, where the real money demand curve shifts to
the left (a decrease) due to a portfolio shock to money demand. In the space below, draw a
money market diagram complete with real money supply and real money demand with the
initial equilibrium at rawith output at Ya. Label this initial equilibrium point as point A.
10 points for correct and completely labeled diagram
2b) (5 points) We now encounter a portfolio shock that shifts the money demand curve to the
left. Please give two specific reasons as to why the money demand curve shifted the way it
did. Note, we assume that Y = Ya.
Answer The money demand curve would shift to the left because of the decline in the
money demand may be due to fall in the national income or due to rise in the interest rate.

2.c) (5 points) Now discuss the appropriate response, if any, of the Federal Reserve. That is,
write a short essay explaining the issues that the FOMC would discuss around that fancy
mahogany table in Washington DC.
Answer The issues explained in the fancy mahogany table in Washington DC are related
to the frequent changes in the interest rates and that in the GDP level that would affect the
money demand directly. Hence, it will directly affect the aggregate demand level in the
economy. Therefore, the portfolio changes occur as and when there are changes in the
interest rate.
2.d) (5 points) Suppose that the Fed decided that the response, most consistent with meeting
their dual mandate, was to keep real rates of interest the same (i.e.,, they want to perfectly
smooth the real rate of interest). What would the FOMC tell the New York Fed to do (be
specific) exactly? Be specific. Show this new equilibrium point as point B on your diagram
being sure to label your diagram completely.
Answer In order to meet the dual mandate by the Fed, the FOMC would tell the New
York Fed to reduce their interest rates so that there can be reduction in the money supply
in the economy.
2.d) (5 points) Now discuss how your answer would change (in 2.c)) if instead the source of
the shock to money demand was real, as in a change in real output. Include in your answer
how the Fed's response would likely be different given that the shock to money demand was
real rather than nominal (portfolio). You just need to discuss this and not show on your
diagram. In other words, when they called the New York Fed, how would their instructions
change? Explain.
Answer Feds response for the real money demand shock would be fall in the money
supply through its reserve requirements changes. Hence, the demand for money would fall
leading to backward shift of the demand curve.
3. (30 points total) We talked a lot about the Fed's balance sheet, quantitative easing, and the
fact that since October 2008, they (the Fed) now paid interest on reserves. The graphic below
clearly shows this development. Please answer the following questions:
3.a) (10 points) In 2008, the Fed pleaded and pleaded with Congress trying to convince them
that the economic situation was deteriorating fast and that they needed to grant the authority

to the Fed to pay interest on reserves sooner rather than later. So in October, 2008, the Fed
was officially granted the authority to pay interest on reserves. Explain exactly why the Fed
(so badly) wanted this authority and explain exactly what they did (in terms of monetary
policy) as soon as they were granted this authority. Be sure to include in your answer what
would have happened and why if the Fed behaved the exact same way without (being
granted) the authority to pay interest on excess reserves.
Answer The Fed wanted this authority so that it can affect the changes in the money
supply and hence it would have received more returns on its reserves. As soon as they got
the authority to pay interest on reserves they started granting more loans due to more
excess reserves. In case, the authority to pay interest on excess reserves would not have
granted then the money supply would be reduced automatically.
3.b) (5 points) According to graphic above, banks are currently holding almost $1.6 trillion in
excess reserves. Explain exactly why banks are (currently) holding so many excess reserves
and where did these excess reserves come from?
Answer The banks have been holding so much excess reserves because of less reserve
requirements by the Fed so that the money supply and interest rate could be affected. Such
excess reserves come from the deposits of the banks.
3.c) (10 points) Many are worried that if the banks starting lending out their excess reserves
all at once, inflationary pressures will build. Using the expression for the money multiplier
along with the quantity theory of money, show why this concern is very real. Start your essay
explaining under what conditions (i.e., why) would the banks start getting rid of their excess
reserves.
Answer The money multiplier is 1/rr and the change in the money supply would be
money multiplier times change in the high powered money. If there will be too much
lending then there would be too much money supply in the economy and hence it would
put an inflationary pressure in the economy.
3.d) (5 points) Suppose that the banks did start getting rid of their excess reserves faster than
the Fed was comfortable with. What could the Fed do exactly to slow down the amount of
excess reserve entering the system? Please be as specific as possible. I am looking for two
possible policy actions.

Answer- The two possible policy actions in such condition is that :1. Rise in the interest rate so that there will be less lending and hence less dumping of
the excess reserves.
2. Fed can follow the moral suasion so that there will be less lending by the
commercial banks.