Question 1.

Interest rates have been at record low levels since 2008. The most recent normal year in the US economy was 2007, the eve of the onset of the global financial crisis. In 2007, the total amount borrowed in the US loanable funds market was $51 trillion, and the real interest rate was 2 percent a year. Both the demand and the supply of loanable funds include borrowing and lending decisions by households, firms, governments, financial institution) (including private institutions and the Fed), and the rest of the world. By mid-2009, due to the economic recession, expected business profit had fallen which decreased investment from $2.2 trillion in 2007 to $1.5 trillion and the demand for loanable funds by households and u businesses had decreased sharply. The federal government had launched a massive rescue plan that increased its outlays and demand for loanable funds. Despite the large increase in government demand, the overall demand for loanable funds decreased. The demand by households, businesses, and financial institutions decreased by more than the demand by the federal government increased. By 2013, the demand for loanable funds had overall decreased. On the supply side of the market, the Fed continued to supply large quantities of funds. The Fed's goal was to lower the interest rate and stimulate investment. By 2013, the supply of loanable funds had overall increased. The real interest rate was as percent per year and the quantity of loanable funds was $55 trillion.

(a) Use a diagram of the loanable funds market to show the developments between 2007 and 2013. Use the names SLF07,SLF13, DLF07, and DLF13 to denote the Supply-of-Loanable-Funds and Demand-for¬Loanable-Funds curves in the years 2007 and 2013. Explain how the curves move and why.

(b) What was the effect of the increase of the supply of loanable funds by the federal government? How would the real interest rate and quantity of loanable funds be in 2013, compared to their values in 2007, without the government intervention?

Question 2.

At the peak of the economy in 2008, real GDP was $15 trillion and the price level was 99. In the second quarter of 2009, real GDP had fallen to $14.3 trillion and the price level had risen to 100. The financial crisis that began in 2007 and intensified in 2008 decreased the supply of loanable funds and investment fell. In particular, construction investment collapsed. Recession in the world economy decreased the demand for US exports. In 2007, there was a rise in oil prices and a rise in the money wage, whose full impact might have been shown in 2009.

Use an aggregate-supply and aggregate-demand diagram to account for the developments in real GDP and price level between 2008 and 2009. Use the names AD08, AD09, AS08, and AS09, for the aggregate demand and aggregate supply curves in years 2008 and 2009.

Question 3.

Critically evaluate the video in the link below (from the European Central Bank) about the welfare cost of inflation (the "inflation monster").

https://www.youtube.com/watch?v=pbgYOdYoBvA

Question 4.

In the long past it was observed that economic fluctuations were often coincidental with the appearance of large dark spots on the sun. (Astronomers - or should we say astrologers - were the chief economic advisers in those times, as it may be happening sometimes even today). It might have been believed that the spots were the cause of the economic contractions or they were the omen of the vengeful wrath of ancient spirits or perhaps both. Today, economic theories in which fluctuations in economic activities, or financial crises, are caused by seemingly unrelated events are called sunspot theories. Carefully show how some theories of financial crises and business cycles that we have studied in class may be regarded as sunspot theories of economic fluctuations.

Question 5.

During the 1960s, 1970s, and 1980s, the velocity of money circulation (of M2) was constant. The growth rate of real GDP slowed from .5 percent annual growth rate in the fast-expanding 1960s to a more moderate pace of 3 percent annually during the 1970s and 1980s. The growth rate of the quantity of M2 increased from around 7 percent in the 1960s to around 9.5 percent in the 1970s and slowed to around 8 percent in the mid-1980s, and the inflation rate moved in line with the changed money growth rate. During the 1990s, the M2 growth rate slowed again to less than 6 percent but the velocity of circulation increased to 1.5 percent. With the real GDP growth rate unchanged, the inflation rate fell. The 2000s saw the M2 growth rate increase but the velocity of circulation shrank at a similar rate to that at which it had grown during the 1990s. Inflation remained close to its level in the previous decade, but real GDP growth slowed. Aside from the small increases in velocity growth during the 1990s and 2000s, which cancelled each other out, all the decade-by-decade variation in the inflation rate has resulted from changes in the growth rate of the quantity of money.

(a) What can you say about the rate of growth of the nominal GDP in the 2000s? Carefully explain how you obtained your answer from the information given.

(b) Has the Quantity Theory of Money been successful at predicting the year-to-year changes in the inflation rate? Why or why not?
Question 6. (Optional. 2 bonus points in the final test)

Consider the non-arbitrage stock pricing formula we have seen in class:
qt+1 dt+1
qt = (1)
1 + R

Assume the future dividend is zero, so that the above formula can be written as:

qt+1 = (1 + R) x qt (2)

Taking logarithms of both sides we obtain:

ln(qt+i) = In(qt) + + R) (3)

(a) Go to the Federal Reserve Bank of St. Louis and find daily data on the S&P-500 stock price index (https://fred.stlouisfed.orgiseries/SP500). Calculate the (natural) logarithm of S&P-500 from 2011 to 2016. (Use the built-in In() function in Excel, e.g. " =In(10)" gives the natural logarithm of 10). Plot the values of the logarithm of the index (on the vertical axis) against its value in the previous period (on the horizontal axis). What do you observe?

(b) Obtain the line of best fit (regression line) in the data set. (Depending on your version of Excel in the "Chart Elements" pop-up menu, choose "Trend Line", then "Linear"). What is the average required rate of return for holding a portfolio similar to S&P-500 index?