Problem 1 (30p): This question is about the recent sharp decline in oil prices. Imagine you are working for consulting firm that provides economic analysis. Assume the U.S. economy has sticky prices and starts with output equal to potential output. [Note: "Recent" refers to Fall 2014] a. (9p) Client A notes that lower oil prices reduce the cost of production. Explain the likely impact on U.S. real output, on inflation, and on the real interest rate. Assume no policy response; for now, disregard lower bounds on interest rates. Mark the boxes, use the output-inflation diagram below to support your answer, and explain your reasoning. In the diagram, mark initial values with "0" and the economy's new position with "A". Impact on: Inflation rate Real Interest rate Real Output (up/down/constant/uncertain) Output - Inflation Diagram Explain: (Use for parts a and b) b. (9p) Client B notes that lower oil prices may reduce the demand by oil-producing countries for U.S. exports. Assume this demand-reduction is in addition to the change examined in (a). Explain the overall impact of these changes on U.S. real output, on inflation, and on the real interest rate. Again, assume no policy response and disregard bounds on interest rates. Mark the boxes below, use the output-inflation diagram above to support your answer, and explain your reasoning. In the diagram, mark the economy's new position with "B". Overall impact on: Inflation rate Real Interest rate Real Output (up/down/constant/uncertain) Explain: B-2Problem 1 continued: c. (6p) Client C wonders if the U.S. economy's response may be different than under normal condition because nominal interest rates are near zero. If you take account of the zero lower bound (ZLB) on interest, how would this change your answers in (b)? Explain. Focus on how the answers about output, inflation, and interest rates differ from the answers in (b). [No need to comment on overall effects (a-c combined), though you may describe the overall effects if this helps you to explain the differential effect of the ZLB.] Modified impact Inflation rate Real Interest rate Real Output as compared to (b): up/down/constant/uncertain) d. (6p) Client D is concerned that the sharp drop in oil prices may have reduced expected inflation. How would your answers in (c) change if expected inflation has declined? Explain. Focus on how the answers about output, inflation, and interest rates differ from the answers in (c). [No need to comment on overall effects (a-d combined), though you may describe overall effects if this helps you to explain the differential effect of reduced expected inflation.] Modified impact Inflation rate Real Interest rate Real Output as compared to (c): up/down/constant/uncertain) B-3Problem 2 (501)): Consider an economy with sticky prices in the short run. Prices adjust in the longer run. Initially, money growth is 3%; the real interest rate is 1%; output equals potential output. Assume potential output is constant and velocity is constant in the long run. Consider the following p_olicy change: The central bank announces that it is shifting the MP curve up by one percent. (That is, F in the equation r = F + it 11: increases by 0.01.) Assume that the policy change is unexpected and permanent. a. (15p) Determine the short-run effects of this policy change on real output, the real interest rate, and the ination rate. Mark the boxes below, illustrate your answer in an output-ination diagram, and explain your reasoning. In the diagram, mark initial values with \"0" and mark the economy's position after the policy change with \"SR". Output Ination Diagram Explain: (Use for parts a and f) b. (5p) Determine the likely impact on stock prices. Mark the box below and explain briey. m Real Output Real Interest Rate Ination rate Stock Prices '\"'\"'\"\"\"'"_ B4 Problem 2 continued: c (8p) Assume the central bank uses purchases or sales of Treasury bills to implement the announced policy change. Determine the short run impact on the equilibrium quantity of money and on the nominal interest rate. Illustrate your answer in a money-interest rate diagram. Money - Interest Rate Diagram Explain: Impact on: Money Stock Nominal rate i [up/down/constant/uncertain) d. (8p) Explain how the open market operations in (c) affect the Fed funds market. Assume the Fed funds rate is initially between ior and ia. Illustrate your answer in a Fed funds diagram. Fed Funds Diagram Explain: Impact on: Fed Funds Rate Bank Reserves (up/down/constant/uncertain) B-5Problem 2 continued: e. (9p) Determine the 19mm effects of the policy change on real output, the ination rate, nominal interest rates, and real interest rates. i. For each variable, determine the directional impact (up, down, unchanged, or uncertain) relative to the value without the policy change. ii. If the MP function has slope A. - 1f 3, can you give quantitative answers? Explain briey and mark the boxes below. Interest rate Interest rate WWW mummiulvllucsl Explain: f. (5p) Turn back to the output-inflation diagram in (a). Identify the economy's long-run position and mark it with the label \"LR\". Explain how, according to the New-Keynesian model, the economy transitions from the SR to the LR position. Be clear about the assumptions. B-6 Problem 3 (20p): Suppose the interest rate on Fed Funds is 0.1%. Yields on Treasury bonds with 1, 2, and 3 years to maturity are bonds are 0.2%, 0.6%, and 1.1%, respectively. Assume bond investors demand a liquidity premium of 0.1% to hold l-year Treasuries rather than Fed Funds, they demand a liquidity premium of 0.2% to hold 2-year Treasuries rather than l-year Treasuries, they demand a liquidity premium of 0.3% to hold 3-year Treasuries rather than l-year Treasuries. [Notefhint Part (c) can be answered without doing (a) or (b).] a. (8p) Use the above information to compute expected yields on l-year Treasury bonds looking 1 and 2 years ahead. Enter the expected yields below. l-year Treasury yield: 1 year ahead 2 years ahead b. (3p) Can you use information above to compute the average Fed funds rate expected over the coming year and the each of the following two years? Explain briey. Enter your estimates below. Mund- Tum-r c. (9p) Suppose the FOMC announces the following: Six months from now, the FOMC will increase the Fed funds rate to 0.5% and keep the rate constant for one year. Thereafter (i.e., 18 months ahead), the Fed funds rate will be increased to 1.5% and then stay constant. Assume the announcement is credible. What is the likely impact on the yields of Treasury bonds with l, 2, and 3 years to maturity? Enter the predicted values below. M