econ 102 final exam
what really happened during the great depression (explain with terms from new chapter)
1) once people realized what was going on they started to withdraw their money from banks which led 3,000 banks to fail 2) if everyone is withdrawing money the money supply is obviously going to decrease because of a decrease in the money multiplier- not because of the fed (which was claimed by milton friedman and anna schwartz) 3) a decrease in the money multiplier leads to an increase in the currency drain ratio and the required reserve ratio which makes it harder for banks to make loans etc. 4) there was also a decrease in monetary base (which is made up of currency and the banks reserves) because people were withdrawing their money because of the financial crisis (causing many banks to fail)
Reserves consist of the currency in the _____ plus the balance on its _____ account at _____.
banks vaults; reserve; a federal reserve bank
the supply-side effect of an increase in taxes ______ employment and ______ real GDP
decreases; decreases
when the fed sells securities in the open market the monetary base _____ and the interest rate _____
decreases; rises
an increase in public investment
increases aggregate demand because investment is a component of aggregate demand, and in the long run increases capital, which increases potential GDP and aggregate supply
by lowering the interest rate the Fed makes it ______ costly for banks to borrow monetary base and the interest rate ______
less; falls
what are the objectives of monetary policy?
maximum employment, stable prices, and moderate long-term interest rates
what is the money multiplier
(1+ (C/D))/(R/D)+(C/D))
what is the second way to lower the federal funds rate (show all steps)
1) other short term and long term interest rates 2) real long term and short term interest rates decrease 3) this increases borrowing by HH and firms 4) this increases consumption and investment 5) this increases real GDP and inflation
monetary policy transmission mechanism (expansionary monetary policy example)
1) target federal funds rate 2) fed buys bonds (government securities) 3) this increases the excess reserves of banks 4) this now increases the amount of lending that banks can do 5) then borrowing increases by households and firms 6) consumption expenditure increases, investment increases, AD increases 7) this then increases real GDP and inflation
what are the goals of interest rates on reserves?
1) to reduce fluctuations in excess reserves (most important) 2) to improve implementations of MP (monetary policy) 3)encourage banks to hold excess reserves so that depositors view their deposits as safe
automatic fiscal policy
Changes in government expenditures and/or taxes that occur automatically without (additional) congressional action.
discretionary fiscal policy
Changes in taxes or spending that are the result of deliberate changes in government policy.
when a bank makes a loan, _____. The amount of loans and new deposits that a bank can create is limited by _____.
It creates a new deposit for the person who receives the loan; the banks excess reserves, the desired reserve ratio; and the currency drain ratio
what is the quantity of money or M, made up of?
M= D+C (deposits and currency)
what is the monetary base or MB made up of?
MB= R+C (desired reserves and currency)
what would be the overall impact on the money multiplier and the money supply if the banks decided to hold more excess reserves than before?
R/D increases, money multiplier goes down and m1 decreases (increase in excess reserves means a decrease in loans that are lent out)
can the fed change the discount rate?
The Fed would most likely not change the discount rate because it doesn't directly affect the money multiplier.
What is the Fed and what is the FOMC?
The fed regulates financial institutions and the FOMC meets every 6 weeks to discuss the review the state of the economy
limiting the Feds independence could result in
a congressional bias toward persistently increasing money growth to increase real GDP growth, resulting in higher inflation and higher interest rates in the long run
quantitative easing or large scale asset purchases (LSAP)
a large scale open market purchase at a low or possibly zero federal funds rate -this lowers long term interest + mortgage rates (doesn't mean people are going to go out and buy houses but they will be more active in the market) -also eases credit condition
The shoe leather costs of inflation include all of the following EXCEPT: A. the lost purchasing power of cash. B. the extra costs incurred to avoid holding cash. C. the cost of more frequent trips to the bank. D. the installation of a new cash management system
a. the lost purchasing power of cash
what happens if there is a low interest rate to increase interbank loans?
aggregate demand is affected which then creates an overheating of the economy since there is too much credit in the economy
the shoe leather costs of inflation are costs that arise from
an increase in the velocity of circulation of money
a decrease in tax revenues in a recession is _______ fiscal policy additional government expenditure to upgrade highways is ______
automatic; discretionary
forward guidance
communication by the central bank about future policy prospects (likely future course of monetary policy)
when the Fed raises the federal funds rate,
consumption expenditure, investment, and net exports decrease up to a year later
what is monetary base made up of?
currency in circulation and bank reserves
what is money supply made up of?
currency in circulation and checkable deposits
when the economy is at full employment what is there none of?
cyclical unemployment but there can be structural, seasonal, and frictional unemployment
increase in excess reserves due to an increase in the required reserve ratio...
decrease in loans lent out call back loans decrease in money supply
when reserves in the banking system ____. Banks _____loans.
decrease; call in
if the government cuts its outlays but tax revenue is unchanged, explain the effects on saving, investment, the real interest rate, and growth of real GDP the real interest rate ____ Private saving ____, and total saving ____ Investment ____ and the growth rate of real GDP ______.
falls decreases; increases decreases; decreases increases; increases
the government cuts the income rax rate. The real wage rate paid by employers ____, and the real wage rate received by employees ____
falls; rises
the government cuts the income tax rate. As a result, the supply of labor _____ and the demand for labor ____.
increases; does not change
the government cuts the income tax rate. The equilibrium level of employment ____ potential GDP _____.
increases; increases
in the long run what is money growth equal to
inflation rate + real GDP growth rate
the fed uses it's policy tools to...
influence the interest rate and regulate the amount of money circulating the United States by adjusting the reserves in the banking system
interest rate on reserves
interest paid on required reserve balances and on excess reserve balances (when lend it out, earn interest, vs, if don't
discount rate
interest rate on loans from the central bank to commercial banks
besides the fed, who else can borrow money in the LF market>
investment banks (they can also do this in the private sector and other financial institutions)
what happens when the required reserve ratio increases?
it decreases the money multiplier
what happens to the discount rate when there is an increase in M1
it decreases therefore there can be an increase in 1) loans to commercial banks 2) reserves 3) lending from excess reserves
what happens to the discount rate when there is a decrease in M1
it increases
when the fed raises the federal funds rate,
it takes a few weeks to a few months for the quantity of money and supply of loanable funds to decrease
by increasing the required reserve ratio, the fed forces banks to hold a _____ quantity of monetary base and the interest rate _____
larger; rises
Lender of Last resort (liquidity provision)
lending to financial institutions purposes: enhance the stability of the financial system -promote credit availability
what happens when there is an increase in the currency drain ratio
money multiplier decreases and m1 decreases HH decrease deposits into banks HH withdraw money from banks reduce the amount of reserves in banks decrease loans lent out
can the fed change the currency drain?
no, that is determined by households and firms
real interest rate=
nominal interest rate - inflation rate
what are the shoe leather costs of inflation?
refers to the cost of time and effort that people spend trying to counter-act the effects of inflation, such as holding less cash and having to make additional trips to the bank.
What are the Fed's main policy tools?
required reserve ratios, discount rate, and open market operations
bank reserves
required reserves + excess reserves
the federal funds rate is the interest rate at which banks can borrow and lend _____ in the _____ market
reserves; federal funds
if the fed wants to decrease the quantity of money. It makes an open market _____.
sale
how can the fed indirectly control M1
since M1= m * MB they can "control" M1 by changing MB (they do this by purchasing bonds in the open mkt)
the rise in the U.S. interest rate and expectations that the European central bank will lower interest rates, _______
the demand for U.S. dollar increases and the supply of U.S. dollar decreases (think of it in terms of the fed decreasing the supply of money when they sell securities)
in an economy with hyperinflation vs. an economy with stable prices, which has a higher money growth rate and why?
the economy with hyperinflation has a higher growth rate because in the long run, money growth= inflation rate + real GDP growth rate
which economy has a higher velocity of circulation, one with hyperinflation or one with stable prices? how about more frequent wage payments?
the economy with hyperinflation would have a higher velocity of circulation and more frequent wage payments because the opportunity cost of money increases under hyperinflation
what is the fed's monetary policy instrument? a monetary policy instrument is...
the federal funds rate a variable that the fed can directly or closely target
required reserve ratio
the minimum percentage of checkable deposits a bank must hold as reserves
what happens to reserves when the fed buys government securities?
the money is transferred from securities to reserves and lowers the securities to increase the reserves
desired reserve ratio
the percentages of checkable deposits a bank holds as reserves
what is a required reserve ratio?
the portion of a deposit that a bank must keep on hand
what is an open market operation>
the purchase of gov. securities by the federal reserve system in the open market
if the fed raises the interest rates too late...
the recovery will be too strong and the inflation rate will be too high
if the fed raises the interest rate too soon...
the recovery will be too weak and the unemployment rate will be too high for too long
a deficit reduction plan that includes an increase in taxes on the wealthy might have serious supply-side consequences because _____
the wealthy will decrease their supply of labor and decrease their saving, which will decrease potential GDP
how does the fed lower long term interest rates
they buy LT bonds - this increases price of LT bonds and decreases LT interest rates
what happens when the Fed decreases the required reserve ratio?
they decrease the amount that banks need to hold in excess reserves which allows them to lend out more money
the higher the required reserve ratio means that banks will have to cut the amount of loans they can make because:
they have fewer excess reserves with which to make loans
what did the fed do during the great recession that they did not do during the great depression?
they increased the monetary supply by buying bonds in the open market M1= m(MB) (if money multiplier is decreasing during a time of economic turmoil then an increase in monetary base is needed to curb the effects)
what does it mean when there is a higher opportunity cost when there is higher inflation in the economy?
this means that you are loosing or gaining more depending on what you decide to do with your money- when there is high inflation people don't want to hold onto their money so they deposit it as soon as possible or try to invest it in order to not loose as much money as they would holding onto it
what is the purpose of forward guidance
to increase inflation expectations real int rate= nominal int rate- inflation (if inflation rate rises then real interest rate decreases) (if nom int rate=0- cannot go below this but they can jack up expectations of inflation rate if they are lowering real interest rate)
when the fed raises the federal funds rate, the inflation rate responds about
two years later
structural unemployment
unemployment resulting from industrial reorganization, typically due to technological change, rather than fluctuations in supply or demand.
explain what happens when the required reserve ratio increases and decreases.
when required reserve ratio increases: banks have to keep a larger portion of each deposit on hand therefore can make fewer loans (contractionary policy) when the required reserve ratio decreases: banks can keep a smaller portion of each deposit made and therefore can make more loans (expansionary policy)
credit easing
when the central bank buys private securities or make loans to financial institutions to stimulate their lending
