1. Federal Funds Market Experiment.
This classroom experiment demonstrates how the Federal Open Market Committee
influences interest rates in the federal funds market by adding or subtracting
banking reserves. Most of the students in the class take the roles of
banks that borrow or lend in the federal funds market, using a double
oral auction. The rest of the students operate the Federal Reserve Open
Market Trading Desk. The instructor takes the role of the Federal Open
Market Committee (FOMC), issuing directives to the trading desk. The students
operating the trading desk must decide what quantity of open market sales
or purchases to make, based on the interest rate target in the FOMC directive.
These open market operations change the quantity of excess reserves in
the banks, thereby shifting the equilibrium interest rate in the federal
funds market. The experiment thus helps students understand why an open
market sale or purchase changes the federal funds rate. The exercise also
reinforces the idea that the Federal Reserve currently conducts monetary
policy by targeting short term interest rates rather than monetary aggregates.
Students develop a simplified Consumer Price Index (CPI) based on purchasing decisions made by the students in their class. They use their simplified CPI to practice calculating inflation rates and to draw conclusions about the strengths and weaknesses of an index like the CPI. Specifically, the exercise demonstrates the substitution and new product biases in the CPI. Moreover, it gives students a concrete example of how a price index like the CPI actually measures inflation. Finally, the experiment makes clear the distinction between the level of a variable (the CPI) and the rate of change in the variable (the inflation rate), two concepts students often confuse. The exercise can serve as an introduction to the topic of inflation and how we measure it. Or, it can provide the starting point for a more advanced discussion of the sources of bias in the CPI, and the measures the Bureau of Labor Statistics has recently taken to reduce these biases.
Students take the roles of workers and employers who use a double oral auction labor market to negotiate employment contracts. The instructor takes the role of a government that offers progressively more generous levels of unemployment compensation. The experiment produces data that students can analyze to test the general predictive power of economic theory, as well as the specific hypothesis that more generous unemployment compensation causes a higher unemployment rate and a narrower distribution of income.
Students represent firms that make investment decisions. They play a repeated game in which each firm chooses its level of investment. The one-shot game has two Pareto-ranked Nash Equilibria. In the Pareto inferior equilibrium each firm invests at a low level, generating a recession. The Pareto superior equilibrium corresponds to an expansion, as each firm invests at a high level. Participating in the experiment helps students understand theories that posit coordination failure as the cause of economic fluctuations. Students see that when firms expect a recession, their resulting low levels of investment actually cause a recession. Likewise, when firms expect an expansion, their resulting high levels of investment cause an expansion.
This experiment promotes discussion of the social origins and characteristics of money. Students take the roles of traders who face a double coincidence of wants problem. As they recognize the benefits of overcoming trading frictions, students spontaneously begin using a medium of exchange. The setting comes from Duffy and Och's (1999) experimental version of the Kiyotaki-Wright (1989) search model of money. In the Kiyotaki-Wright (KW) environment, agents specialize in production, but consume a good other than their own product. This experiment demonstrates how specialization and decentralization endogenously give rise to money. Furthermore, the experiment promotes discussion of the characteristics of an item that make it a good candidate for becoming money. Here, the commodity with the lowest storage spontaneously emerges as a generally accepted medium of exchange.
Students take the roles of borrowers and lenders in a double oral auction credit market. They negotiate loans in order to fund investment projects. Students negotiate their loans in terms of nominal interest rates. However, from the follow-up data analysis, students see that their investment decisions depended on real rather than nominal interest rates.