Assignment

1. 1) On October 29, 2014, the members of the Federal Open Market Committee (FOMC) of the Federal Reserve Board voted to maintain its federal fund target within the same range of between 0.25% basis points to 0% percent, as it was set by the FOMC in August 2011. But in 2011, the economy was in severe recession and the purpose was to boost the economy by increasing liquidity in the banking system at this low rate when the inflation was also very low. The specific action of the Fed trade was to purchase treasury securities every day to increase the money supply and thus keep the interest rate (the federal fund rate) low to stimulate the economy.

But in October 2014, the economy has showed its near full recovery and stock market and financial institutions are performing very well since 2011. On October 29, 2014, the FOMC also decided to end the asset purchase plans under Quantitative Easing (QE III) under which the Fed had been buying mortgage backed securities and LT Treasury Bonds since the recovery started in 2011. Upon this decision to end the QE III of asset purchase and keeping the same federal fund rate target, the Dow Jones Industrial Average Price gone down significantly and did not fully recover by the end of the trading day.

Question: What are the macroeconomic trends that did prompt the FOMC to end the QE III but to keep the federal fund rate still at its historic low? You need to give reasons for both of these policy measures.

For more information, please visit the press release of FRB in the url link here.

Also, read some newswire analysis here on cnn portal on the same day.

2) Draw a supply-demand diagram of the Federal funds market which illustrates the effects of a massive treasury bill sale by the Fed in the open market.

3) If banks desire to increase their lending, but the Federal Reserve is not adding reserves to the banking system, what will happen to the level of short term interest rates? Explain your answer carefully.

4) "Sweep" accounts are combination checking/money market accounts which large banks currently offer to their corporate customers. These accounts sweep just enough funds out of the money market portion of the account to prevent checks written on the checking part of the account from bouncing. Suppose that banks suddenly made these accounts available to households. Draw a supply/demand diagram of the federal funds market to show the effect on the federal funds rate if the Fed did nothing. What action in the open market would the Fed have to take to maintain its existing interest rate target under these circumstances?

5a) Explain carefully why interest rates on each of the following short-term financial instruments will be closely tied to the level federal funds rate: short-term bank CDs, short-term Treasury bills, short-term commercial paper.

5b) Why is the yield on short-term Treasury bills usually less than the federal funds rate?

6) Suppose households and small firms withdrew funds from banks in response to rumors circulating that a computer virus would destroy banks customer account databases. What action would the Fed have to take in the open-market to maintain its existing fed funds target rate?

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