6) What is the difference between the Federal Funds Rate and the Discount Rate?

Please give the

difference by providing an explanation of each rate and their purposes? (9 points
Technically, the federal funds rate is the interest rate that banks usually charge on other banks
while lending money to them. But federal discount rate is the interest rate which is charged by
the Federal Reserve on the commercial banks while lending money to them.
Federal fund rate
Sometimes, the financial institutions want to lend more amount of money than it has so it
borrows money from other financial institutions that has excess reserves in order to meet the
loan/withdrawal demand. When one financial institution borrows money from other bank, the
rate that is charged is said to be federal funds rate. The higher the federal funds rate, the more
expensive it is to borrow money. Since it is only applicable to very creditworthy institutions
for extremely short-term (overnight) loans, the federal funds rate can be viewed as the base
rate that determines the level of all other interest rates in the U.S. economy.
Federal discount rate
Sometimes the sudden demand for withdrawal or high demand for loans may cause to
decrease the required reserve amount. Under this situation the bank will try to borrow money
other financial institutions, finally it tries to borrow money from lender of last resort that is
central bank or Federal Reserve. This discount rate is higher than the Federal Funds Rate so
its used as a last resort for banks needing some cash to boost their reserves.
7.) Assume that the GDP deflator was 100 in 2008, 97.5 in 2009, and 96.8 in 2010. How much
would a salary offer of $80,000 in 2010 have been worth in 2008? (3 points)
2009
96.8 97.5 / 97.5 * 80,000 = 574
The worth of the salary in 2009 would be equal to $79,426 (80,000 574)
2009
97.5 100 / 100 * 76426 = 1985.65
The worth of the salary in 2008 would be equal to $77,440.35 (79,426 1985.65)

8) If the CPI value for 1960 was 0.5 and 2.5 in 2010, and a GMC four-door sedan cost $2,500
and $20,000 in 2010, what conclusions can you draw? (hint: Be careful what you say!)
Consumer price index is a measure that examines the weighted average of prices of a basket of
consumer goods and services. The value of consumer price index is calculated by taking price
changes for each item in the predetermined basket of goods and averaging them.
The numerical value of CPI indicates that a positive change in value of CPI influence to increase
the true value of money. So an increase in value of CPI from 0.5 in 1960 to 2.5 in 2010 caused to
raise the GMC four-door sedan cost from $2500 in 1960 to $20000 in 2010.
Please answer the next five questions as True, False, or Uncertain. Uncertain indicates
that the statement may or many not be true (not that the respondent is uncertain). Feel free to
provide a justification for your answer in the space provided, if you think that will be helpful.
9.) An increase in interest rates will cause a decrease in Aggregate Demand, and a slow- down in
the economy. (2 points)
True
An increase in interest rates will create adverse effect on investment because investment will be
costly. If investment fell down then other interrelated economic factors like employment
opportunities and household income will also come down. Moreover, falling employment
opportunities and income will pull down the aggregate demand through reduction in the
consumption expenditure. Overall, decreasing demand wont encourage the economic activity
instead it will slow down the economy.
10.) A decrease in interest rates will cause an increase in Aggregate Demand, and an expansion in
the economy. (2 points)
True
A decrease in interest rates will create positive effect on investment because investment will be
cheaper. If investment increases then other interrelated economic factors like employment
opportunities and household income will also increase. Thus, positive change in employment
opportunities will allow the individual to spend more and this attract the new investment and
fasten the economic activities in the country.
11.) If the economy is not expanding, and the world interest rate is exogenous, an increase in the
money supply will only cause an increase in current prices. (2 points)
Uncertain

If the economy is not expanding and the world interest rate is exogenous then an increase in
money supply may or may not cause to increase the current prices because there will be
movement of money from the domestic to international.
12.) The Consumer Price Index has difficulty accounting for changes in technology such as the
developments in computers, while the chain-weighted GDP deflator does not. (2 points)
False
Consumer price index is a measure that examines the weighted average of prices of a basket of
consumer goods and services. The value of consumer price index is calculated by taking price
changes for each item in the predetermined basket of goods and averaging them. Both CPI and
GDP deflator have difficulty in accounting for changes in technology.
13.) In the US, over the last 50 years, the Consumption component of gross domestic product has
been more volatile than the Investment component (2 points)
False
The components of GDP include consumption expenditure, investment expenditure, government
expenditure and net export. The percentage of consumption expenditure is larger than any other
components proportionate value. Last 50 years, the consumption is smoothly increasing and
there is no volatility. However, the investment is highly volatile in past 50 years.

14) All else held equal, higher budget deficits should be associated with higher trade deficits.

True
Usually economists believe that a large budget deficit will increase the value of the dollar. The
logic is that higher budget deficits are believed to cause higher interest rates, which makes
holding bonds and other dollar denominated assets more attractive. This is how a budget deficit
can cause a trade deficit.
-BONUS4.) What would a family who made $200,000 in 1995 make today? Use the 2012 index value for
today. (4 points)
When should the Fed have increased the money supply according to this table? (4 points)
Provide a detailed answer of how could they have increased the money supply. (12 points)
If gasoline had gone up at only the rate of inflation, how much would it have cost per gallon in
1994? Assume the price of gasoline today is $4.00 per gallon. (4 points)
Year

CPI

1993

144.5

1994

148.2

1995

152.4

1996

156.9

1997

160.5

1998

163

1999

166.6

2000

172.2

2001

177.1

2002

179.9

2003

184

2004

188.9

2005

195.3

2006

201.6

2007

207.342

2008

215.303

2009

214.537

2010

218.056

2011

224.939

2012`

229.594