economic

Economics 100B Professor K. Kletzer UCSC Spring 2020

Problem Set 5 Due: Wednesday, June 3, 2020 at 11:59 pm

1. Corporate bond interest rates are a good measure of the interest rate facing firms planning investments. Before the financial crisis, this rate was about 2% higher than the fed funds rate. At the peak of the crisis in October 2008, the Baa rated bond rate was almost 9 percent higher than the fed funds rate. a) Go to the FRED database and look up the series BAA10Y and extend the data range to “max”. Compare what you see to the TED spread TEDRATE for the same range. Find the definitions for each of these interest rate spreads. Why do you think these two measures are often used to discuss financial conditions in the macroeconomy? b) Suppose the economy begins in steady state, and there is a shock to the interest spread 𝑓.̅ Use the IS- MP and AD/AS diagrams to show and explain how the economy reacts if the Fed follows the simple monetary rule and does not change its inflation target. c) Continuing from part b), use the AD/AS graph to explain how the economy adjusts back towards the steady state when the shock to 𝑓 ̅lasts for one quarter. How long does the recession last? d) Does your answer to part c) suggest that financial crises should cause sharp but short recessions followed by rapid recoveries? Compare the graphs of the interest rate spreads in part a) to the graph of short-run output from 2008 to 2012 (you can use https://fred.stlouisfed.org/graph/?g=f1cZ). Do you think this is a very complete model for the great recession, yet? 2. In the financial crisis of question 1, we now let the Fed change its policy. a) Using the simple monetary rule, show how the Fed can mitigate the impact of the financial shock on output by changing its inflation target away from 𝜋$ = 2%. Use both the IS-MP and AS/AD diagrams and explain. Should the Fed raise or lower 𝜋$? b) Use numbers to compute the change in inflation and output. Assume the shock to 𝑓 ̅equals 4% and lasts one period. Let 𝑏$ = 1/2, 𝑚- = 1/2, �̅� = 1/2, and �̅� = 2%. Initial inflation equals 2% and 𝑎$ = 0. Determine the fed funds rate the Fed needs to set to keep short-run output equal to zero. Give both the real and nominal fed funds rates. c) Suppose the shock 𝑓 ̅is larger and equals 6%. What is the nominal fed funds rate that will keep short- run output equal to zero, now? Can the Fed do this? Explain what happens if the Fed cannot set a nominal interest rate less than zero. d) Briefly, describe one policy the Fed might take in circumstances such as you found for part c) when 𝑓̅ = 6%.

3.The financial crisis coincided with a collapse in house prices. Many households owned houses that were no longer worth as much as the mortgages they owed. a) How should a large decrease in household financial wealth affect aggregate demand? Could it help explain the depth of the recession and why the recovery was slow? Briefly explain. b) Suppose a homeowner chose not to sell it. Should the fall in the value of their house affect their consumption? (Treat this as a puzzle and think it through.) How do you think this is relevant to the role of housing wealth on aggregate demand? c) The fall in housing prices could also affect investment. Employment in construction is quite sensitive to the business cycle. Explain how a halt in construction may be a strong explanation of why the collapse of the housing bubble led to a deep recession. You can use graphs to illustrate.