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1. (a) Suppose the Fed has already decided that it wants to target the money stock.
(1) Will the Fed come closer to its target by setting the interest rate at a given level, or will it do better by fixing the money supply through open market operations? In your analysis, think in terms of the Fed's horizon from one Open Market Committee meeting to another -- about 4-6 weeks. This analysis involves the relative stability of money demand and the money multiplier. Consider two alternative cases: (1) a stable demand for money allows the Fed to set an interest rate that ensures it will come close to the target money supply; and (2) an unstable demand for money.
(2) In your analysis, discuss the proposition that the Fed may need to target interest rates in the short run in order to meet its target money stock while in the long run it may need to pay attention to interest rates and bank reserves and currency growth. NOTE: Shifts in money demand may reveal themselves first in movements in interest rates -- and if the Fed wants to stabilize the economy, it should respond to shifts in money demand.
(b) Within the same general context, discuss why the Fed, if it wants to stabilize and grow GDP and employment, has chosen a quantitative easing (QE) approach by growing bank reserves though purchases of Treasury securities and mortgage-backed securities and the monetary base rather than an interest rate policy (presently QE2 policy is to purchase $85 billion per month of Treasury and mortgage-backed securities? Why has the European Central Bank (EU) and Japan followed the same policy? How does this process work to stimulate economic growth? Has the QE policy since 2011 worked to increase GDP growth and employment?
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