FINANCIAL ECONOMICS Practice Exercises # 1

Alexandre Ribada Fraga; 2º GBD

1)​ Discuss the following elements comparing European Central Bank and the
Federal Reserve
●​ Short history of the central bank.

The FED was created in 1913, in response to the continuous banking crises suffered by
the US, but in turn its effects spread practically globally. Its fundamental objective was
to provide financial stability, in addition to acting as a lender of last resort.

The ECB was created in 1998 with the introduction of the euro, with the fundamental
objective of supervising the monetary policy of the eurozone, and as its main point
stands out the replacement of national central banks in the management of the
currency.

●​ Structure and governance.

The FED is made up of the Board of Governors, twelve regional Federal Reserve banks
and the FOMC, the main person in charge of monetary policy.

The ECB is made up of the Governing Council, the Executive Committee and the
General Council.

●​ Major functions.

The FED is in charge of controlling inflation, promoting employment, regulating the

The ECB is in charge of price stability in its area of ​action, the eurozone, of supply
control and monetary policy, of the issuance of the euro, and of general supervision of
the banking system.
 ●​ Monetary policy tools.​

The tools used by both central banks are very similar. The adjustment of interest rates
stands out, depending on the levels of inflation and economic growth forecast, the
OMAS, Open Market Operations, where bonds are traded or sold, thus manipulating the
liquidity of the financial system, credit facilities, in case a bank has liquidity problems,
and finally the reserve requirement, in the sense that it regulates the amount of money
that banks must keep in their reserve at all times.

2)​ Should central banks be independent from their corresponding governments?

On the one hand, if central banks are completely independent of governments, possible
manipulation or excessive control of monetary policy would be avoided, for example, if
politicians want to obtain immediate benefits that favor them in the face of elections.
This would help the population to trust the central banks more, feeling that their
actions are free of political interference, so that they are based on purely technical
aspects, taken by the most prestigious economic and financial minds in the world.

On the other hand, if the central banks do not depend on governments, the effects and
consequences, both economic and social, of their measures could not be stopped or
controlled by bodies democratically elected by citizens. This, ultimately, would create a
certain disconnection between what citizens ask for, formalized in government
proposals, and the measures finally executed by the central banks.

In my opinion, the most beneficial would be a central bank with sufficient autonomy to
make the economic decisions it deems appropriate at each specific moment, but at the
same time a certain supervision by governments.
 3)​ Read and critically summarize the article “IInflation Is Down to 3%. Why That
Isn’t Good Enough” by Matt Grossman​

This article explains how an inflation of 3%, apparently close to the central banks' target
of 2%, continues to be detrimental to the economic system and how it generates
discontent among the population.

First, it analyzes from a psychological perspective how, although inflation has decreased
compared to previous years, which does not mean that prices are going down,
consumers continue to perceive that these prices are still exaggeratedly high, which
translates into a general loss of purchasing power. Added to this is the FED's unachieved
2% inflation target, which tends to question whether adequate measures are being
taken to achieve it.

On the other hand, it is true that in inflationary times salaries tend to adjust, but not
automatically, but rather it takes a certain amount of time, during which the
aforementioned loss of purchasing power is confirmed. All this, added to the tariffs
imposed by President Trump, suggests a possible increase in prices in the near future.
 Answer the following questions:

1.​ The article suggests that even at 3%, inflation can still frustrate consumers. Why
do people remain dissatisfied with price levels even when inflation decreases?

Even though inflation has dropped to about 3%, consumers remain frustrated because
prices are not going down per se, but are rising more slowly, but still rising. This has
great psychological consequences, since the population keeps in mind this constant
increase in prices and observes how their purchasing power continues to decrease
compared to previous years.

Furthermore, this high inflation maintained for several years has modified their
expectations and behaviors, as they tend to advance their purchases based on a possible
increase in prices in the near future, added to the pressure they exert on entrepreneurs
to increase their salaries, which also leads to a general increase in the prices of goods
and services.

2.​ The Fed remains committed to a 2% inflation target. What are the potential
consequences of not reaching this goal, both economically and in terms of public
trust?

The fact that inflation does not reach the 2% target poses a tremendous risk that the
inflationary expectations of consumers, companies and governments will grow
uncontrollably. This would lead to an increase in the prices of goods and services,
subsequently linked to an increase in workers' salaries by companies or even state aid to
alleviate their purchasing power.

Therefore, this situation complicates economic stability in a global sense, so institutions

This would not only produce great changes in an economic sense, but also on a social
level, since citizens could probably begin to doubt the effectiveness of this type of
institutions, which, without a doubt, would create a vicious circle that is difficult to
control.
 3.​ Research shows that people resent inflation even if their wages rise to match it.
Why do workers feel that inflation erodes their living standards, and how does
this affect workplace dynamics?

Although it is true that the increase in inflation can be combated with a salary increase,
this does not happen automatically, but rather the majority of workers must negotiate
such increases with employers, a task that is often complicated to manage, which
entails a lot of stress and uncertainty and even conflicts.

In any case, assuming that such salary increases occur, they would not produce effects
immediately after the inflationary increase, it would be utopian, so there is a period of
time where inflation grows and salaries remain the same, so purchasing power is lost
there.

4.​ The article discusses how tariffs could push inflation higher. How do trade
policies like tariffs impact inflation, and what are the potential benefits and
drawbacks of using them?

Generally, tariffs tend to feed inflation, because they make products imported from a
foreign country more expensive, which translates into higher prices for domestic
consumers and also for industries that depend on mostly imported resources.

Regarding the benefits, it stands out that in theory they protect national industries,
since by increasing the prices of foreign products, they become less competitive. In
short, internal production and national employment are encouraged.

As for the disadvantages, not only does it fuel inflation, but it can also create a response
effect in those countries affected by such tariffs, thus reducing the purchasing power of
the national population.