Homework 2 Econ 301 A Summer 2020 Due Sunday 7/19/2020 9:00

homework 2 Econ 301 A Summer 2020due Sunday 7192020 900pm Pst

Analyze two recent policies or mechanisms adopted by the Federal Reserve to combat the recession caused by the coronavirus pandemic, describing their functions and comparing them with the Fed’s traditional approaches to meet its dual mandate.

Explain the main insight from the quantity equation for money assuming constant velocity, and prove it mathematically. Discuss whether an increase in the money supply can raise real GDP under different assumptions about velocity and output. Clarify the validity of the statement regarding the Fisher Effect and real interest rates. Examine whether certain policies involve a tax, particularly those related to the Federal Reserve’s open market operations, government debt issuance, and monetary policy actions affecting interest rates and inflation.

Using the provided exchange rate data, assess whether your reasoning about exchange rates and visiting Applevokia is correct, and explain the logic behind it. Describe how war impacts the trade balance for small countries, especially during civil wars versus world wars involving major nations. Discuss whether nominal exchange rates provide information about real goods and services or if they are purely nominal variables.

Paper For Above instruction

The recent policies adopted by the Federal Reserve reflect an evolving toolkit aimed at stabilizing and supporting the economy during unprecedented times caused by the COVID-19 pandemic. Two pivotal mechanisms are the introduction of large-scale asset purchases (LSAPs), often termed quantitative easing, and the establishment of emergency lending facilities. LSAPs involve the Fed purchasing longer-term securities from the financial markets to inject liquidity directly into the economy, thereby lowering long-term interest rates and promoting borrowing and investment. These policies extend the traditional role of the Fed by significantly increasing its balance sheet, compared to earlier measures primarily focused on short-term interest rate adjustments.

The emergency facilities, such as the Primary Dealer Credit Facility (PDCF) and the Main Street Lending Program, are designed to provide direct support to businesses, banks, and financial institutions facing liquidity shortages. These mechanisms differ from the traditional dual mandate strategies centered on adjusting interest rates to control inflation and promote maximum employment, since they focus more on crisis-specific support rather than standard monetary policy tools. While traditional policies influence the economy gradually through interest rate adjustments, these new facilities enable more targeted, immediate interventions to prevent credit crunches and financial system collapses.

Turning to the quantity equation, it summarizes the relationship among money supply (M), velocity (V), price level (P), and real output (Y): M × V = P × Y. When velocity (V) is constant, the main takeaway is that changes in the money supply directly influence the nominal value of output (nominal GDP), with proportional effects on the observed price level if real output is fixed. Mathematically, if V remains unchanged, then manipulating M alters P × Y directly; thus, increasing M under constant V results in proportionate inflation if Y is stable, or inflation accompanied by increased nominal GDP if the economy can respond to the increased monetary base.

If velocity is no longer assumed to be constant, but output (Y) remains fixed in the short run, the central bank can influence the real economy by increasing the money supply, primarily through lowering interest rates and expanding liquidity. In such a scenario, an increase in M can stimulate aggregate demand and lead to higher real GDP, assuming prices are sticky and the economy is below potential. However, if output is not fixed and velocity fluctuates, the relationship complicates; changes in M might not translate into changes in real GDP, as shifts in V could offset or amplify the effects, making the impact less predictable and potentially leading to inflation or deflation, depending on the direction of velocity changes.

The statement about the Fisher Effect—that real interest rates will never change because nominal rates adjust—does not hold entirely true. The Fisher Effect asserts that nominal interest rates do adjust over time with inflation expectations to leave real interest rates relatively stable in the long run. However, in the short run, real interest rates can vary due to monetary policy, shocks, or changes in inflation expectations, making the statement overly simplistic and generally incorrect in a short-term context.

Regarding seigniorage, which is the revenue the government gains from printing money, certain policies have different implications. When the Federal Reserve buys Treasury Bills from banks through open market operations, it is effectively increasing the monetary base without necessarily causing a tax—a process that injects liquidity directly into the banking system. This is generally not considered a tax but can lead to inflation, which acts as a hidden tax on holders of cash or fixed-income assets. Conversely, when Congress issues debt to fund expenditure, it is creating a future liability; this isn't a tax but a financial obligation that can influence fiscal stability. If the Federal Reserve raises interest rates sharply, leading to deflation, the policy can diminish the monetary base's value, effectively creating a contractionary environment which, although not a tax, can have redistributive effects on wealth and income.

Examining exchange rates, the data on inflation and nominal exchange rate movements provide insights into currency valuation relative to purchasing power. If the Applevokia inflation rate is significantly higher than the US inflation rate, the real exchange rate depreciates, making Applevokia's goods less competitive internationally, unless nominal exchange rate adjustments offset this inflation differential. Your friend’s logic that a lower nominal rate now indicates a better deal is incomplete without considering relative price changes and inflation rate differences. Real exchange rates, which account for price level differences, are more informative about the actual purchasing power and competitiveness than nominal rates alone.

In times of war, the effect on the trade balance varies with the scale of conflict. During civil wars, the destruction of infrastructure and productivity tends to reduce exports and imports, impacting trade balances unpredictably. In contrast, during major world wars, especially involving multiple allied nations, increased government spending and resource reallocations generally lead to larger trade deficits for small countries, due to increased demand for imports for military purposes and disruptions in global supply chains. These wars can distort normal trade patterns, emphasizing the importance of government expenditure and resource allocation in determining trade balances during conflicts.

Finally, nominal exchange rates are nominal variables reflecting the relative price of currencies, but they do not directly inform us about the real value of goods and services exchanged. Real exchange rates integrate price level differences and provide a more accurate measure of competitiveness and purchasing power. A nominal rate might suggest favorable currency valuation, but if domestic inflation is high, the real rate could be unfavorable, reducing international competitiveness. Hence, nominal exchange rates alone do not tell the full story of real economic conditions; they must be analyzed alongside price levels to understand transferability and real goods and services exchange rates effectively.

References

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