econ final review 14
What are the three ingredients of a financial and banking crisis?
A financial and banking crisis occurs when there is a widespread fall in assets prices, high levels of defaults, an increase in bankruptcies, and a run on banks. When these events occur, banks and other financial institutions face incipient failure and so they drastically decrease their lending activities. This can cause an economic depression.
What are the objectives of monetary policy?
As set out in the Federal Reserve act, as amended in 2000, the objectives of monetary policy are to achieve "maximum employment, stable prices, and moderate long-term interest rates."
What are the policy actions taken by the Fed and the U.S. Treasury in response to the financial crisis of 2007-2008?
The Fed and the U.S. Treasury have undertaken eight policies designed to combat the financial crisis. The Fed conducted massive open market operations to provide liquidity to banks. To provide liquidity to money market funds, the Fed also created an asset-backed commercial paper money market mutual fund liquidity facility. To provide liquidity to other financial institutions, the Fed created programs that allowed term auction credit and also primary dealer and other broker credit. The U.S. Treasury engaged in two Troubled Asset relief Programs. TARP was designed to give banks more liquidity. Finally, accounting rules were changed to allow financial institutions to use fair value accounting rather than mark-to-market accounting to value assets. This change also increased their solvency and made failure less likely.
What is the Fed's monetary policy instrument?
The Fed chooses to use a short-term interest rate, in particular, the federal funds rate. The federal funds rate is the interest rate on overnight loans of reserves (which are part of the monetary base) that commercial banks make to each other
What are some of the key indicators the Fed uses to monitor the economy
The Fed monitors a number of indicators to help gauge core inflation and the output gap.These include the core PCE deflator, CPI, interest rates, capacity utilization, unemployment insurance claims, etc.
Who is responsible for U.S. monetary policy and what are the roles of the Fed, Congress, and the President?
The Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) are responsible for the conduct of U.S. monetary policy. The President's formal role is to appoint the members and the chair of the Board of Governors. Some Presidents, however, have also tried to influence Fed decisions. The Congress plays no direct role but the Fed must make two reports about its monetary policy to Congress each year.
Are the goals of monetary policy in harmony or in conflict (a) in the long run and (b) in the short run?
The monetary policy goals are essentially in harmony for the long run. In the long run, stable prices will bring about maximum employment because firms and households can make the best possible decisions against a backdrop of stable prices. With stable prices, the inflation rate is low—perhaps even zero if prices are precisely stable. The nominal interest rate equals the real interest rate plus the (expected) inflation rate. If the inflation rate is low, then the nominal interest rate will be as low as possible. In the short run, however, the monetary policy goals might conflict with each other. In the short run, in a recession the Federal Reserve might lower the federal funds rate and increase the growth rate of the quantity of money to combat the recession. The Fed's policy will increase employment and real GDP but also increase the price level and eventually the nominal interest rate.
What are the main influences on the FOMC federal funds rate decision?
Though the Federal Reserve does not use an explicit formula to determine changes in its targeted federal funds rate, the Fed responds to the inflation rate, the unemployment rate, and the output gap when determining its federal funds target rate.
Describe the channels by which monetary policy ripples through the economy and explain how each channel operates
When the Federal Reserve lowers the federal funds rate, other short-term interest rates also fall. As a result, the exchange rate falls because investors decrease their demand for U.S. dollars since the interest yield on dollars is lower. When the Federal Reserve lowers the federal funds rate it does so by buying securities in the open market. Bank reserves increase so that banks have excess reserves. Because banks have excess reserves, they loan the excess. Loans increase and a multiple expansion of the quantity of money results. The supply of loanable funds increases so that the long-term real interest rate falls and consumption and investment increase. Net exports increase because of the lower exchange rate. All three of these changes increase aggregate demand, so that real GDP growth and the inflation rate both increase.
