I need help with completing this worksheet. Can someone please complete questions #1-4?

The notes are attached on the same worksheet, questions are at the bottom!

Q1: Given the macroeconomic situation shows in the diagram below, what would be the appropriate policy response by the central bank? Show impact of policy response on diagrams + explain how response will have this impact

Q2: In current economic situation where levels of personal + mortgage debt are at all-time highs in much o fat developed world, why might the banking industry be very much in favour of a continuation of central bank policies designed to keep interest rates very low?

Q3: What policy objective might be comprised if central banks give the banking industry what they want over a long period of time?

Q4: How might Alta-low interest rates nonetheless meet other governmental policy objectives (full employment, equity, growth)

Lesson 56 Monetary Policy (a closer look) Central banks such as the Bank of Canada, the Federal Reserve System in the United States or the Bank of England in the UK have an important role to play in the economy. They serve essentially as the regulators and lenders of last resort to the commercial banking system (ie the banks used by you and I - BMO, RBC, TD-CT etc.), and as the banks of their governments. In most countries now, their most important responsibility is the maintenance of price stability (ie to facilitate mild (2% or so) inflation). They have a number of ways of influencing the banking and finan- cial system, but their most potent tool is their ability to set the interest rate they charge banks (and which banks usu- ally charge each other). Interest rates, by influencing the borrowing and spending decisions of firms and households, have a huge impact on investment spending and on consumer spending on large items like houses and cars. Fundamentally, the central bank controls the money Interest supply, and hence interest rates, both of which have a Rate significant impact on the currency exchange rate. If the government decides to increase the money supply, they SZ can do that quite simply by changing the accounts of Supply of Savings SI the commercial banks held by the central bank. For instance, to help reduce high levels of unemployment, the Bank of Canada could simply change the mix of `Demand for Loans assets that they hold on behalf of, say, the Bank of Montreal to include more cash and fewer government Quantity of Savings/Investment bonds. Stated more simply, the Bank of Canada could LRAS buy' bonds from BMO. Now that BMO has more cash in its accounts, it can make more loans. The supply of Price Level SRAS money available to be lent in the economy has thus increased from SI to $2 below, and should result in a reduction in interest rates. This lower rate of interest should in turn result in increased borrowing by firms and consumers, who will spend their borrowed money AD 2 and thereby increase aggregate demand from ADI to AD2, as shown below. If inflation is a problem, the Bank of Canada would do the opposite (ie sell bonds), Real Output thus reducing the cash balances of the commercial banks, who would then have less money to lend, push- is rising, interest rate increases can cool things down. As ing up interest rates and thus discouraging borrowing the former Federal Reserve Chairman William and spending. Keep in mind that the result of a change McChesney Martin Jr. put it, the job of a central banker in AD in terms of output and prices will depend on the was to "to take away the punch bowl just as the party shape of the aggregate supply curve. gets going." However, as was made clear during the severe recession of the early 1980s, when interest rates Even more than fiscal policy, monetary policy is a quick higher than 20% were required to tame inflation rates fix. When unemployment is rising, interest rate cuts can that were greater than 10%, interest rate setting is a stimulate borrowing and spending, and when inflation blunt instrument. 198 Economics for CanadiansMore recently, there has been a call for central bankers maintain asset bubbles so as to avoid sharp and painful to pay more attention not just to consumer price infla- price corrections and asset price deflation has been very tion, but also to asset price (ie homes, stocks) inflation. strong. The problem from a policy standpoint, though, It is felt that artificially low (in fact, real negative) inter- is that with perpetual low rates, the room for monetary est rates since 2001 led to sharp increases in house prices policy manoeuvre is limited. If interest rates are at 1% in much of the world from 2001 until 2007, which led in or less, the scope for cutting rates in response to a crisis turn to the near collapse of the banking system and a is limited. The challenge for many central banks in serious recession when housing prices began to fall. Canada and throughout the developed world over the Asset price bubbles of this sort are increasingly seen as a next several years will be to become less reliant on mon- serious risk to economic stability and central bankers are etary policy (and in particular, ultra-low interest rates) being urged to raise interest rates when asset prices, and and to return to a more realistic interest rate regime (ie in particular home prices, begin to rise at a faster rate the rate of inflation plus 2 or 3%) which will encourage than incomes. savings and investment and discourage speculation and the formation of asset bubbles of the kind which, when In recent years, though, the pressure from the banking they pop, can destroy vast amounts of wealth. and financial services industry for low interest rates to 1. Given the macroeconomic situation shown in the diagram below, what would be the appropriate policy response by the central bank? Show the impact of the policy response on the diagram and explain how the response will have this impact. Price Level X. Real Output 2. In the current economic situation where levels of personal and mortgage debt are at all-time highs in much of the developed world, why might the banking industry be very much in favor of a continuation of central bank policies designed to keep interest rates very low? 3. What policy objective might be compromised if central banks give the banking industry what they want over a long period of time? 4. How might ultra-low interest rates nonetheless meet other governmental policy objectives (ie full employment, equity, growth)? 195