ECO CH15
Consider the following choices and determine the correct definition for the monetary rule.
A monetary rule is a plan for increasing the money supply at a constant rate regardless of the prevailing economic condition.
What is a banking panic?
A situation in which many banks experience runs at the same time.
While serving as the president of the Federal Reserve Bank of St. Louis, William Poole stated, "Although my own preference is for zero inflation properly managed, I believe that a central bank consensus on some other numerical goal of reasonably low inflation is more important than the exact number." Source: William Poole,"Understanding the Fed," Federal Reserve Bank of St. Louis Review, Vol. 89, No. 1, January/February 2007, p. 4. Which of the following are benefits that the economy might gain from an explicit inflation target LOADING... even if the target chosen is not a zero rate of inflation?
All of the above
Which of the following is not a correct comparison between an expansionary monetary policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?
All of the above are correct statements about the two models.
Which of the following statements is correct?
All of the above are true.
Which of the following was the Fed's objective in using "quantitative easing" and "Operation Twist"?
All of the above.
Who borrows money and who lends money at this "target interest rate"?
Banks borrow and banks lend.
In the graph of the money market shown on the right, what could cause the money demand curve to shift from MD1 to MD2?
Both (a) and (c).
During 2005, the FOMC was concerned that the inflation rate would begin to accelerate due to the continued boom in the housing market, so the Fed started decreasing the target for the federal funds rate.
False
For the Fed to succeed in reducing the severity of business cycles, it must act precisely when a recession or an acceleration of inflation can be seen in the economic data
False
If the Fed decides to carry out an expansionary monetary policy because it believes aggregate demand will not increase enough to keep the economy at potential GDP, the inflation rate will most likely be lower than it would have been without the policy.
False
For more than 20 years, the Fed has used the federal funds rate as its monetary policy target. It has not targeted money supply at the same time because the
Fed cannot target both at the same time: It has to choose between targeting an interest rate and targeting the money supply.
The hypothetical information in the following table shows what the situation will be in 2021 if the Fed does not use monetary policy.
If the Fed wants to keep real GDP at its potential level in 2021, it should use an expansionary policy. The trading desk should be buying T-bills. If the Fed's policy is successful in keeping real GDP at its potential level in 2021, state whether each of the following will be higher, lower, or the same as it would have been if the Fed had taken no action: i. Real GDP will be higher than it would have been if the Fed had taken no action. ii. Full-employment real GDP will be the same as it would have been if the Fed had taken no action. iii. The inflation rate will be higher than it would have been if the Fed had taken no action. iv. The unemployment rate will be lower than it would have been if the Fed had taken no action.
According to an article in the New York Times, an official at the Bank of Japan had the following explanation of why monetary policy LOADING... was not pulling the country out of recession: "Despite recent major increases in the money supply, he said, the money stays in banks." Source: James Brooke, "Critics Say Koizumi's Economic Medicine Is a Weak Tea," New York Times, February 27, 2002.
In the quote, when the official says "the money stays in banks," he is referring to an increase in the reserves in banks. But the real problem was that banks were not lending the reserves. The reason for this may have been a lack of borrowers .
In the figure to the right, which of the following events is most likely to cause a shift in the money demand (MD) curve from MD 1 to MD 2 (Point A to Point C)?
Increase in real GDP or increase in the price level
Which of the following is a monetary policy target used by the Fed?
Interest rate.
What is the Taylor rule?
It is a rule that links the Fed's target for the federal funds rate to the current inflation rate, real equilibrium federal funds rate, inflation gap and output gap.
What do economists mean by the demand for money?
It is the amount of moneylong dashcurrency and checking account depositslong dashthat individuals hold.
What is the advantage of holding money?
Money can be used to buy goods, services, or financial assets.
Which of the following is not a correct comparison between a contractionary monetary policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?
None of the above are correct statements about the two models.
Which one of the following is not one of the monetary policy goals of the Fed?
Reduce income inequality.
Which of the following best explains how the Federal Reserve acts to help prevent banking panics?
The Fed acts as a lender of last resort, making loans to banks so that they can pay off depositors.
In the graph of the money market shown on the right, what could cause the money supply curve to shift from MS1 to MS2?
The Fed decreases the money supply by deciding to sell U.S. Treasury securities.
Why would the Fed intentionally use contractionary monetary policy to reduce real GDP?
The Fed intends to reduce inflation, which occurs if real GDP is greater than potential GDP.
Which of the following statements is true about the Fed's monetary policy targets?
The Fed is forced to choose between the interest rate and the money supply as its monetary policy target.
What is the discount rate?
The discount rate is the rate at which the Fed lends to banks.
In 2015, one article in the Wall Street Journal discussed the possibility of "a September quarter-point increase in the Fed's range for overnight target rates," while another article noted, "the U.S. central bank's discount rate...has been set at 0.75% since February 2010." Sources: Justin Lahart, "Jobs Give Fed Green Light; Inflation Sets Speed Limit," Wall Street Journal, August 7, 2015; and Ben Leubsdorf, "Five Regional Fed Banks Asked to Raise Discount Rate," Wall Street Journal, July 14, 2015. What is the name of the "target interest rate" mentioned in this article?
The federal funds rate.
Suppose that the equilibrium real federal funds rate is 5 percent and the target rate of inflation LOADING... is 3 percent. Use the following information and the Taylor rule LOADING... to calculate the federal funds rate target: Current inflation rate = 1 percent Potential real GDP = $14.57 trillion Real GDP = $14.27 trillion
The federal funds target rate is 3.97%.
Consider the following statement: "The Fed has an easy job. Say it wants to increase real GDP by $200 billion. All it has to do is increase the money supply by that amount."
The statement is incorrect because an increase in the money supply does not affect real GDP directly.
Explain whether you agree with this argument: If the Fed actually ever carried out a contractionary monetary policy, the price level would fall. Because the price level has not fallen in the United States over an entire year since the 1930s, we can conclude that the Fed has not carried out a contractionary policy since the 1930s.
The statement is false. A contractionary policy could result in a lower rate of inflation rather than a fall in the price level.
In response to problems in financial markets and a slowing economy, the Federal Open Market Committee (FOMC) began lowering its target for the federal funds rate from 5.25 percent in September 2007. Over the next year, the FOMC cut its federal funds rate target in a series of steps. Writing in the New York Times, economist Steven Levitt observed, "The Fed has been pouring more money into the banking system by cutting the target federal funds rate to 0 to 0.25 percent in December 2008." Source: Steven D. Levitt, "The Financial Meltdown Now and Then," New York Times, May 12, 2009. What is the relationship between the federal funds rate falling and the money supply increasing?
To decrease the federal funds rate, the Fed must increase the money supply.
How does lowering the target for the federal funds rate "pour money" into the banking system?
To increase the money supply, the Fed buys bonds on the open market, which increases bank reserves.
An increase in the value of the currency would contribute to a slowdown in the growth of the U.S. economy because
U.S. exports will fall and imports from other countries will rise, reducing net exports and aggregate demand.
William McChesney Martin, who was Federal Reserve chairman from 1951 to 1970, was once quoted as saying, "The role of the Federal Reserve is to remove the punchbowl just as the party gets going."
When he said "to remove the punchbowl," he meant to engage in contractionary policy. In terms of the economy, "just as the party gets going" refers to a situation in which real GDP is greater than potential GDP, which will result in an increase in the inflation rate.
Which of the following is not one of the monetary policy goals of the Federal Reserve ("the Fed")?
a high foreign exchange rate of the U.S. dollar relative to other currencies
"Price stability" means
a low and stable inflation rate.
[Related to Solved Problem #4] Use the graph to the right to answer the following questions:
a. If the Fed does not take any policy action, in 2019 the level of real GDP will be $ 18.5 trillion (enter your response to one decimal place) and the price level will be 118 (enter your response as an integer). b. If the Fed wants to keep real GDP at its potential level in 2019, it should use a contractionary policy. This means that the trading desk should be selling Treasury bills. c. If the Fed takes no policy action, the inflation rate in 2019 will be 3.5% (enter your response as a percentage rounded to one decimal place). If the Fed uses monetary policy to keep real GDP at its full-employment level, the inflation rate in 2019 will be 1.8% (enter your response as a percentage rounded to one decimal place).
A student says the following: "I understand why the Fed uses expansionary policy but I don't understand why it would ever use contractionary policy. Why would the government ever want the economy to contract?" The government would want the economy to contract when real GDP is
above potential GDP and the price level is rising.
The following appears in a Federal Reserve publication: "In practice, monetary policymakers do not have up-to-the-minute, reliable information about the state of the economy and prices. Information is limited because of lags in the publication of data. Also, policymakers have less-than-perfect understanding of the way the economy works, including the knowledge of when and to what extent policy actions will affect aggregate demand. The operation of the economy changes over time, and with it the response of the economy to policy measures. These limitations add to uncertainties in the policy process and make determining the appropriate setting of monetary policy...more difficult." Source: Board of Governors of the Federal Reserve System, The Federal Reserve System: Purposes and Functions, Washington, DC, 1994. If the Fed itself admits that there are many obstacles in the way of effective monetary policy, why does it still engage in active monetary policy rather than use a monetary growth rule, as suggested by Milton Friedman and his followers? Policymakers at the Fed believe that
although it is not perfect, active monetary policy is still a stabilizing force in the economy.
What is the purpose of the Taylor rule? The Taylor rule is used to
analyze and predict how the Fed targets the federal funds rate.
If the Federal Open Market Committee (FOMC) decides to increase the money supply, it orders the trading desk at the Federal Reserve Bank of New York to
buy U.S. Treasury securities.
What is "quantitative easing"? Quantitative easing involved the Fed's
buying longer term Treasury securities that are not usually involved in open market operations.
The increase in interest rates
can be connected to the slowing rate of economic growth because it is a contractionary policy.
As the interest rate increases,
consumption, investment, and net exports decrease; aggregate demand decreases.
A "premature tightening" of the "pace of purchases" would slow down the economic recovery because this action would be
contractionary, reducing lending and economic activity.
Each year, the president's Council of Economic Advisers prepares and sends to Congress The Economic Report of the President. The report published in February 2008 contained the following summary of the economic situation: "Economic growth is expected to continue in 2008. Most market forecasts suggest a slower pace in the first half of 2008, followed by strengthened growth in the second half of the year." Source: Executive Office of the President, Economic Report of the President, 2008, Washington, DC: USGPO, 2008, p. 17. During 2008, real GDP
decreased.
In the summer of 2015, many economists and policymakers expected that the Federal Reserve would increase its target for the federal funds rate by the end of the year. Some economists argued, though, that it would be better for the Fed to leave its target unchanged. At the time, the unemployment rate was 5.3 percent, close to full employment, but the inflation rate was below the Fed's target of 2 percent. Source: Min Zeng,"Inflation Expectations Fall, Making Rate Hike 'More Difficult to Justify,'" Wall Street Journal, August 6, 2015. If it did not increase its target for the federal funds rate, the policy goal the Fed would be promoting is
economic growth, because maintaining lower interest rates would stimulate the economy and raise the price level.
The Fed expects that controlling that one interest rate would allow it to meet its goals for inflation and unemployment because lower short-term interest rates
encourage lending and stimulate economic activity.
The Fed's strategy of increasing the money supply and lowering interest rates in order to increase real GDP is called
expansionary monetary policy.
An article in the New York Times in 1993 stated the following about Fed Chairman Alan Greenspan's decision to no longer announce targets for the money: "Since the late 1970's, the Federal Reserve has made many of its most important decisions by setting a specific target for growth in the money supply ... and often adjusted interest rates to meet them." Source: Steven Greenhouse, "Fed Abandons Policy Tied to Money Supply," New York Times, July 23, 1993. If the Fed would no longer have a specific target for the money supply, it would be targeting the
federal funds rate.
An article in the Wall Street Journal notes that before the financial crisis of 2007minus2009, the Fed "managed just one short-term interest rate and expected that to be enough to meet its goals for inflation and unemployment" Source: Jon Hilsenrath, "Easy-Money Era a Long Game for Fed," March 17, 2013 The short-term interest rate the article is referring to is the
federal funds rate.
The interest rate that banks charge each other for overnight loans is called the
federal funds rate.
To affect economic variables such as real GDP or the price level, the monetary policy target the Federal Reserve has generally focused on is the
federal funds rate.
In an interview, Paul Volcker, Chairman of the Federal Reserve's Board of Governors from 1979 to 1987, was asked about the Fed's use of monetary policy to reduce the rate of inflation. Volcker replied: The Federal Reserve had been attempting to deal with ... inflation for some time. ... By the time I became chairman ... we adopted an approach of ... saying, We'll take the emphasis off of interest rates and put the emphasis on the growth in the money supply, which is at the root cause of inflation ... we will stop the money supply from increasing as rapidly as it was ... and interest rates went up a lot. ...We said ... we'll take whatever consequences that means for the interest rate because that will enable us to get inflation under control. Source: "Paul Volcker Interview," http://www.pbs.org/fmc/interviews/volcker.htm. While Paul Volcker was chairman, the Fed did not target both the rate of inflation and interest rates because
if the Fed targets interest rates, they have to accept that inflation will fluctuate significantly, and Volker's goal was to reduce inflation.
According to an article in the Wall Street Journal, "Brazil's economy grew just 2.3% in 2013, compared with 7.5% in 2010. The country also has struggled with persistently high inflation, which has forced its central bank to raise interest rates." Source: Emily Glazer and Luciana Magalhaes, "Brazil's Debt-Laden Firms Try to Stay Afloat," Wall Street Journal, March 18, 2014. The Brazilian central bank would have been "forced" to raise interest rates because of rising inflation
if this was the only policy tool that could be used to reduce aggregate demand and the inflation rate.
According to an article in the Wall Street Journal, the Reserve Bank of India lowered its key policy interest rate in 2015, "citing weakness in parts of the economy as well as favorable inflation figures." The article notes that the central bank lists constraints to further interest rate cuts, including the "risk that inflation could flare again." Source: Gabriele Parussini, "India Cuts Key Interest Rate for Second Time This Year," Wall Street Journal, March 4, 2015.
increase aggregate demand sufficiently to increase the price level.
With an expansionary monetary policy, investment, consumption, and net exports all ________, which results in the aggregate demand curve shifting to the ________, increasing real GDP and the price level.
increase; right
An article in the Wall Street Journal discussing the Federal Reserve's monetary policy included the following observation: "Fed officials have been signaling since last year that they expected to raise rates in 2015 ... pushing up the value of the currency and contributing to the economic slowdown officials now confront." Source: Jon Hilsenrath, "Fed's Rate Decisions Hang on Dollar, Growth Concerns," Wall Street Journal, April 22, 2015. "Pushing up the value of the currency" means
increasing the exchange rate between the dollar and other currencies.
If the Fed is too slow to react to a recession and applies an expansionary monetary policy only after the economy begins to recover, then
inflation will be higher than if the Fed had not acted.
By increasing U.S. interest rates, the Fed would cause the value of the currency to increase because
international investors will demand more U.S. dollars to buy U.S. financial assets that now pay higher interest rates.
An investment blog said about Fed Chair Janet Yellen, "She is arguably the world's most powerful woman, and perhaps the most powerful person in the world. Can you name anybody with more might"? Source: Barbara Friedberg, "Fed Chief Janet Yellen: The Most Powerful Woman in the World," log.personalcapital.com, September 17, 2014. This assessment
is generally accepted by economists because of the influence the Fed chair has on monetary policy and the effect monetary policy has on inflation, employment, and financial stability.
A countercyclical policy is one that
is used to attempt to stabilize the economy.
The Fed uses policy targets of interest rate and/or money supply because
it can affect the interest rate and the money supply directly and these in turn can affect unemployment, GDP growth, and the price level.
If the economy moves into recession, monetarists argue that the Fed should
keep the money supply growing at a constant rate.
The article also notes that after the financial crisis, "the Fed is working through a broader spectrum of interest rates." The reference to "a broader spectrum of interest rates" means that the Fed began to focus on
longer term Treasury rates and mortgage rates.
Why is the Fed sometimes said to have a "dual mandate"? The Fed is said to have a" dual mandate" because
maintaining price stability and high employment are the two most important goals of the Fed that are explicitly mentioned in the Employment Act of 1946.
Milton Friedman would have liked the Fed to follow a monetary rule where the
money supply is increased every year by a percentage rate equal to the long-run growth rate of real GDP.
As interest rates decline, stocks become a __________ attractive investment relative to bonds, which causes the demand for stocks and their prices to __________.
more; rise
Economists and policymakers might disagree over the best rule to guide monetary policy because
of differing views about the significance of inflation and unemployment.
The choice of the price index the Federal Reserve uses to measure inflation can affect monetary policy because
one goal of monetary policy is price stability and, if the price index used to measure inflation is consistently wrong, monetary policies based on that information will be wrong.
An article in BusinessWeek in 2013 reported that Fed Chairman Ben Bernanke testified to Congress that: "If we see continued improvement and we have confidence that that is going to be sustained, then we couldlong dashin the next few meetingslong dashwe could take a step down in our pace of purchases." According to the article, Bernanke also told Congress that "'premature tightening' could 'carry a substantial risk of slowing or ending the economic recovery.'" Source: Nick Summers, "Confusion about the Fed Slowing Its $85 Billion in Monthly Bond Buying Is Roiling the Markets," Bloomberg BusinessWeek, June 10-16, 2013. The purchases Fed Chairman Bernanke is referring to are
open market purchases of government securities.
The difference between what was expected and what actually occurred illustrates that the formulation of economic policy
relies on economic forecasting that is subject to frequent revisions and errors.
An increase in interest rates affects aggregate demand by
shifting the aggregate demand curve to the left, reducing real GDP and lowering the price level
A former Federal Reserve official argued that at the Fed, "the objectives of price stability and low long-term interest rates are essentially the same objective." Source:William Poole, "Understanding the Fed," Federal Reserve Bank of St. Louis Review, Vol. 89,No. 1, January/February 2007, p. 4. This is true because
stable prices make it easier to plan for the future, so expectations can be stable, which makes it less costly to make loans.
Congress broadened the Fed's responsibility since
the 1930s as a result of the Great Depression.
August 2017 was the sixty-fourth consecutive month that the rate of inflation as measured by the core personal consumption expenditures (PCE) price index was below the Federal Reserve's target of 2 percent. The consumer price index (CPI) might yield a rate of inflation different from that found using the core PCE price index because
the core PCE does not measure food and energy prices, which are measured by the CPI.
An article in the Wall Street Journal in 2015 reported that the interest rate on five-year German government bonds had become negative: "The negative yield means investors are effectively paying the German state for holding its debt." The article quoted an investment analyst as saying: "The negative yield is not scaring investors away." Source: Emese Bartha and Ben Edwards, "Germany Sells Five-Year Debt at Negative Yield for First Time on Record," Wall Street Journal, February 25, 2015. The interest rate on German government bonds became negative when
the inflation rate exceeded the nominal interest rate.
The federal funds rate is
the interest rate that banks charge each other for overnight loans.
Two economists at the Federal Reserve Bank of Cleveland note that "estimates of potential GDP are very fluid, [which] suggests there is considerable error in our current measure." They conclude that "this lack of precision should be recognized when policy recommendations are made using a Taylor-type rule." Source: Charles Carlstrom and Timothy Stehulak, "Mutable Economic Laws and Calculating Unemployment and Output Gaps-An Application to Taylor Rules," Federal Reserve Bank of Cleveland, June 5, 2015. The Federal Reserve Bank of Cleveland economists made this argument based on
the likelihood that potential output or the natural rate of unemployment cannot be accurately measured.
If the price level decreases,
the money demand curve shifts to the left.
If real GDP increases,
the money demand curve shifts to the right.
Which of these variables are the main monetary policy targets of the Fed?
the money supply and the interest rate
If the FOMC orders the trading desk to sell Treasury securities,
the money supply curve will shift to the left, and the equilibrium interest rate will rise.
One of the goals of the Federal Reserve is price stability. For the Fed to achieve this goal,
the rate of inflation should be low, such as 1% to 3%, and should be fairly consistent.
The Fed gave up targeting the money supply because
the relationship between monetary aggregates and other economic variables was becoming unreliable.
Investors were willing to buy bonds with a negative interest rate because
they believed there was no chance that the government would default.
How can investment banks be subject to liquidity problems? Investment banks can be subject to liquidity problems because
they often borrow short term, sometimes as short as overnight, and invest the funds in longer-term investments.
Support for a monetary rule of the kind advocated by Friedman declined since 1980 because
the Fed's performance since 1980 has been excellent even without a formal inflation target.
What is "Operation Twist"? "Operation Twist" refers to
the Fed's program to purchase $400 billion in long-term Treasury securities while selling an equal amount of shorter-term Treasury securities.
When Congress established the Federal Reserve in 1913, its main responsibility was
to make discount loans to banks suffering from large withdrawals by depositors.
An article in the Wall Street Journal quoted a Federal Reserve economist as referring to "the Fed's existing dual mandate to achieve maximum sustainable employment in the context of price stability." Source: Pedro Nicolaci Da Costa, "Fed Should Make Bond Buys a Regular Policy Tool, A Boston Fed Paper Finds," Wall Street Journal, April 23, 2015. "Maximum sustainable employment" means the economy is producing at its potential where
unemployment includes frictional and structural unemployment.
If the Fed believes the inflation rate is about to increase, it should
use a contractionary monetary policy to increase the interest rate and shift AD to the left.
If the Fed believes the economy is about to fall into recession, it should
use an expansionary monetary policy to lower the interest rate and shift AD to the right.
Additionally, the federal funds rate is
very important for the Fed's monetary policy because the Fed uses the federal funds rate as a monetary policy target since it can control the rate through open market operations.
What is the disadvantage of holding money?
Money, in the form of currency or checking account deposits, earns either no interest or a very low rate of interest.
When interest rates on Treasury bills and other financial assets are low, the opportunity cost of holding money is _________, so the quantity of money demanded will be _________.
low; high
In discussing the Taylor rule, John Taylor wrote: "I realize that there are differences of opinion about what is the best rule to guide policy and that some at the Fed (including Janet Yellen) now prefer a rule with a higher coefficient [on the output gap]." Source: John Taylor, "Cross Checking 'Checking in on the Taylor Rule'," www.economicsone.com, July 16, 2013. If the Taylor rule was changed to have a higher coefficient on the output gap, then during a recession the federal funds rate would be
lower, because more weight would be given to the output gap.
Suppose that when the Fed decreases the money supply, households and firms initially hold less money than they want to, relative to other financial assets. As a result, households and firms will _________ Treasury bills and other financial assets, thereby _________ their prices, and _________ their interest rates.
sell; decreasing; increasing
When the Fed conducts monetary policy, the most relevant interest rate is the
short-term nominal interest rate.
