ECO - On June 5, 2003, the European Central Bank

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On June 5, 2003, the European Central Bank acted to decrease the short-term interest rate in Europe by half a percentage point, to 2 percent.  The bank’s president at the time, Willem Duisenburg, suggested that, in the future, the bank could reduce rates further.  The rate cut was made because European countries were growing very slowly or were in recession.  What effect did the bank hope the action would have on the economy?  Be specific. 

What was the hoped-for result on C (aggregate consumption), I (planned investment), and Y (aggregate output (income))?

Besides the drop in interest rates, what other factors might have influenced the level of investment spending during those years? 

Do you think the Federal Reserve achieved its goal? Explain. 

5. For each of the following scenarios, tell a story and predict the effects on the equilibrium levels of aggregate output (Y) and the interest rate (r):

a.        During 2005, the Federal Reserve was tightening monetary policy in an attempt to slow the economy.  Congress passed a substantial cut in the individual income tax at the same time. 

b.      During the summer of 2003, Congress passed and President George W. Bush signed the third tax cut in 3 years.  Many of the tax cuts took effect in 2005.  Assume that the Fed holds Ms fixed.

c.       In 1993, the government raised taxes.  At the same time, the Fed was pursuing an expansionary monetary policy. 

d.      In 2005, conditions in Iraq led to a sharp drop in consumer confidence and a drop in consumption. Assume that the Fed holds the money supply constant.

e.      The Fed attempts to increase the money supply to stimulate the economy, but plants are operating at 65 percent of their capacities and businesses are pessimistic about the future.

6. State whether you agree or disagree with the following statements and explain why.


a.       When the real economy expands (Y rises), the demand for money expands.  As a result, households hold more cash and the supply of money expands. 

b.      Inflation, a rise in the price level, causes the demand for money to decline.  Because inflation causes money to be worth less, households want to hold less of it. 

c.       If the Fed buys bonds in the open market and at the same time we experience a recession, interest rates will no doubt rise. 

Illustrate the following situations using supply and demand curves for money:

  1. The Fed buys bonds in the open market during recession.
  2. During a period of rapid inflation, the Fed increases the reserve requirement.
  3. The Fed acts to hold interest rates constant during a period of high inflation.
  4. During a period of no growth in GDP and zero inflation, the Fed lowers the discount rate.
  5. During a period of rapid real growth of GDP, the Fed acts to increase the reserve requirement.
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    ECO - European Central Bank

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