Question

During the 1990s, American depositors dramatically increased the share of their funds in money market mutual fund accounts. Although these accounts have restrictions (such as limited access to funds and minimum deposit requirements), they offer depositors higher interest rates versus standard checking. The widespread use of financial instruments during the 1990s led to a decrease in money demand because people held a smaller share of their deposits in checkable accounts (demand deposits).

a. How would this shock affect the U. S. output, interest rate, exchange rate, consumption, investment, and trade balance?

b. How would your answer to (a) change if the Fed used monetary policy to stabilize output?

c. How would your answer to (a) change if the Fed used monetary policy to maintain a fixed exchange rate?

Answer 1

for clear understanding i am typing the answer.

Answer:

During the 1990s,

Across economies, savings is a critical part of investments and capital generation which ultimately affects the growth rates in an economy as a whole.

The household save money in various forms these can be deposited directly in bank accounts or can be invested in various means such as through mutual funds, gold bonds etc.

Banks directly are able to give away loans from the savings which they collect.

This happens because they only need to maintain a part of the money while the remaining can be given out to institutions and companies which utilize them for buying machinery, and helping them in the production process respectively.

specifications:

In a situation in which consumers deposit lesser amounts of money into checking accounts, banks would have significantly lesser capabilities of giving out loans to institutions.

As a result the overall market demand and supply would take a big shock.

The government in this case, generally uses the monetary or the fiscal policy to control the supply of money in the economy directly or indirectly respectively.

(a) shock affect on the US Output, Interest Rate, Exchange Rate, Consumption, Investment and Trade Balance:

The shock to the economy which arises because of reduced savings has a great impact on all the listed factors directly.

The savings are used by banks to give out loans to companies which contribute towards national output. As a result of reduced capital availability, the overall output decreases.

Banks on their parts are forced to increase interest rates on loans in the short run and also may change the rates on deposits to allow the situation to ease down a bit.

Further, the currency sees lesser demand in the national and international market, and it value goes down.

On part of the consumption, since output gets reduced, people begin losing jobs and their availability of capital gets effected and the overall consumption declines.

As explained, when corporations tend to have lesser availability of funds, since banks cannot give away loans and the overall demand for products and services is lower, investment is significantly lower in the economy. Further as a result the trade balance becomes negative.

(b) if the Fed used monetary policy to stabilize output then:

The monetary policy is the policy which is implemented by the Federal Bank in the United States.

In a situation wherein the overall demand is sluggish and output gets reduced due to decreased savings.

To stabilize output in the economy, the amount of capital available to companies needs to be stabilized.

This is done by decreasing the cash reserve requirements in the economy.

The cash reserve requirements are that portion of the savings, which commercial banks must necessarily hold on to once the requirements are reduced, the banks can easily give out more loans which results in a significant increase in overall output respectively.

(c) if the fed used monetary policy to maintain a fixed exchange rate then:

If the fed used interest rate as a policy and maintained the exchange rates, in the short run the supply of money in the economy would largely stabilize.

The end result of such stabilization would be that the economy would come back to its normal levels once the production and overall demand matches each other respectively.