You Have Estimated a Government Reaction Function, I

question 25

Essay

You have estimated a government reaction function, i.e., a multiple regression equation, where a government instrument, say the federal funds rate, depends on past government target variables, such as inflation and unemployment rates. In addition, you added the previous period's popularity deficit of the government, e.g. the (approval rating of the president - 50%), as one of the regressors. Your idea is that the Federal Reserve, although formally independent, will try to expand the economy if the president is unpopular. One of your peers, a political science student, points out that approval ratings depend on the state of the economy and thereby indirectly on government instruments. It is therefore endogenous and should be estimated along with the reaction function. Initially you want to reply by using a phrase that includes the words "money neutrality" but are worried about a lengthy debate. Instead you state that as an economist, you are not concerned about government approval ratings, and that government approval ratings are determined outside your (the economic)model. Does your whim make the regressor exogenous? Why or why not?

Understand the concept of beta and its role in measuring market risk.

Grasp the relationship between risk and return as depicted by the Security Market Line (SML).

Understand the implications of changes in market conditions (e.g., risk-free rate, market risk premium) on the SML.

Recognize the difference between systematic (market) risk and unsystematic (business-specific) risk.

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Definitions:

Transaction

An exchange or transfer of goods, services, or funds between two or more parties.

Gain

An increase in wealth, resources, or advantage, often observed in financial contexts such as investment returns.

Comparative Advantage

The ability of a country, individual, company, or region to produce a good or service at a lower opportunity cost than a competitor, leading to more efficient international trade and allocation of resources.

Production Possibilities Line

A graphical representation that shows the maximum possible output combinations of two products or services an economy can achieve when all resources are fully and efficiently utilized.