Ch17 Answer Key, Intro to Economics

1) The Fed will sell bonds, which reduces money supply and increases interest rates. This causes investment, GDP, and the price level of the economy to fall.

2) The Fed basically believed that the US was facing a stagflation type of scenario. Rising oil prices were creating inflation pressure, but failing housing markets were hurting consumer confidence, and some people feared that the economy could be heading into a recession. What is the “right” policy? A cut in the interest rate would stimulate the economy, but exacerbate already rising price levels. An increase in the interest rate would limit inflation but also reduce output. Both options are unsavory, so the Fed chose to do nothing. They have since been cutting interest rates significantly. The “right” policy is a matter of opinion.

3A) The Fed Funds Rate.

3B) The LIBOR.

3C) Banks trust each other less. They fear that their competitors have taken too many risks (granted too many subprime loans – loans to people with bad credit history) and may go out of business. Thus, they are not willing to loan them money, even in the very short run. The Fed tried to respond to this by lowering the discount rate and encouraging banks to take loans from the Fed. This was quite a dramatic change in policy, as people usually view the Fed as a lender of last resort.

3D) By injecting cash into the system, money becomes less scarce. Hopefully, this will help banks meet their required reserves more easily. Moreover, it will allow them to lend more freely to customers and to each other. Central banks fear that without liquidity injections banks will be unwilling to extend loans even to “good” customers.