Question

University of Missouri, St. Louis

Economics 1002-003: Principles of Macroeconomics.

Discussion Topic 11: Great Recession and Lost Decade

1. How has the US money supply growth since 2008 resulted in an effective ceiling on real interest

rates while allowing the US inflation rate to remain low?

2. What role might the Fed policy have had in creating an effective ceiling on real interest rates, in

terms of paying interest on excess reserves (starting in 2008 for the first time)?

3. Illustrate how an effective ceiling on real interest rates in the capital market causes less private

investment and savings in equilibrium.

4. Describe how the capital market could be “deregulated” such that the ceiling on real interest

rates is eliminated and real rates resume their unregulated equilibrium.

5. What can be the effect of a ceiling on real interest rates internationally, if other countries want

their currency to remain of the same value relative to the US (so they avoid currency

appreciation and a decrease in exports).

Answer 1

ans 1.

There is an inverse correlation between interest rates and the rate of inflation.

In the U.S, the Federal Reserve is responsible for implementing the country's monetary policy, including setting the federal funds rate which influences the interest rates banks charge borrowers.

In general, when interest rates are low, the economy grows and inflation increases.

Conversely, when interest rates are high, the economy slows and inflation decreases.

ans 2.

Excess reserves are funds that a bank keeps back beyond what is required by regulation.

As of 2008, the Federal Reserve pays bank an interest rate on these excess reserves.

The interest rate on excess reserves is now being used in coordination with the Fed funds rate to encourage bank behavior that supports the Federal Reserve's targets.

ans 3.

In the demand and supply analysis of financial markets, the “price” is the rate of return or the interest rate received. The quantity is measured by the money that flows from those who supply financial capital to those who demand it.

Two factors can shift the supply of financial capital to a certain investment: if people want to alter their existing levels of consumption, and if the riskiness or return on one investment changes relative to other investments. Factors that can shift demand for capital include business confidence and consumer confidence in the future—since financial investments received in the present are typically repaid in the future.

ans 4.

When the crisis did hit at home, Western-based economists were much less willing to accept that pain was necessary. The Fed, led by perhaps the foremost monetary economist in the world, proposed creative solutions that few in policy circles, including the usually conservative multilateral institutions, questioned. After all, they no longer had the influence of the purse or the advantage in economic training.

This is, however, not a satisfactory explanation. After all, Nobel Laureates like Joe Stiglitz, whatever one may think about his remedies, did protest very publicly about the adjustment programs the multilateral institutions were imposing on the Asian economies.

ans 5.

Currency appreciation refers to the increase in value of one currency relative to another in the forex markets.

The value of a currency is not measured in absolute terms. It is always measured relative to the currency being measured against it.

Countries use currency appreciation was a strategic tool to boost their economic prospects.