Week 5: The Federal Reserve and Monetary Policy

Suppose the interest rate is 8% and you deposit $5000 in the bank. What will your deposit be worth in a year? $5400 $5200 $5600 $5800

$5400

3 Fed instruments of monetary Policy

- Setting the Discount Rate -Adjusting RR and M -Open Market Operations

Three major reasons why interest rates differ

- The term or maturity of the loan. This refers to the length of time until it must be paid off. In general, longer term loans command a higher interest rate. - Degree of risks (chance of default/non-payment) - Liquidity: illiquid assets, or loans usually command higher interest rates

Three functions of money

-Medium of Exchange -Unit of account or standard of value -Store of value (people can hold onto money this year and then spend it next year).

Keynesians' view on approaches to recessionary and depressionary ranges

that expansionary fiscal policy is much more appropriate

According to the Monetarists: 1. Inflation happens when the government prints too much money. 2. Recession happens when the government prints too little money. 3. Stagflation happens when the government refuses to print additional money All of the above 1 & 2 only

1 & 2 only

Interest is: 1. The payment made for the use of money 2. The "price of money" 3. The rate of return from commodity money All of the above 1 & 2 only

1 & 2 only

Monetary Policy involves changes in the money supply to: 1. Contract the economy 2. Expand the economy 3. Diversify the economy 1 & 2 only 2 & 3 only

1 & 2 only

To fight the stagflation of the late 1970s, Federal Reserve Chairman Paul Volcker: 1. Dramatically raised interest rates 2. Induced a recession 3. Cut taxes All of the above 1 & 2 only

1 & 2 only

When you hold cash rather than invest it in stocks or bonds and wait for a better price, such speculation is an example of what kind of demand for money? 1. Asset demand 2. Transactions demand 3. Withdrawal demand All of the above 1 & 2 only

1. Asset demand

The money multiplier equals: 1/RR 1/MPS 1/RR - MPC

1/RR

Milton Friedman believed that the Great Depression was caused by: 1. A dramatic cutback in government expenditures 2. A dramatic cutback in the money supply 3. A dramatic rise in the tax rate 4. All of the above 5. 1 & 2 only

2. A dramatic cutback in the money supply

If the money multiplier is 5, what must be the reserve requirement? 20% 10% 30% 40% 50%

20%

Runs on the banks

A bank run occurs when a large number of customers of a bank or other financial institution withdraw their deposits simultaneously over concerns of the bank's solvency. As more people withdraw their funds, the probability of default increases, prompting more people to withdraw their deposits. In extreme cases, the bank's reserves may not be sufficient to cover the withdrawals A marker of the Great Depression.

Money Supply Multiplier / monetary multiplier

Describes how an initial deposit leads to a greater final increase in the total money supply. It represents the largest degree to which the money supply is influenced by changes in the quantity of deposits.

Fractional Reserves

Is a banking system that allows commercial banks to profit by loaning part of their customers' deposits, while just a small fraction of these deposits are stored as real cash and available for withdrawal. (Homo sapiens)

Monetarist cure

A solution would be to set monetary targets and stick with them. For example, if we want economic growth to proceed at an annual rate of 3%, then we should simply increase the money supply by 3%.

The goldsmiths of several hundred years ago accounted for the first: 1. Bank interest 2. Paper money 3. Fractional reserve banking All of the above 1 & 2 only

All of the above

Which of these are objectives of monetary policy? 1. Provide a high level of employment 2. Insure stable prices 3. Provide moderate long-term interest rates All of the above 1 & 2 only

All of the above

Which of these statements are true about bank runs? 1. Bank runs usually happen when people suddenly believe they may not be able to get their money out of their bank. 2. When everybody tries to get their money at once during a bank run, the bank fails 3. The fear that a bank may fail sets in motion a chain of events that can lead to the actual failure of a perfectly healthy bank All of the above 1 & 2 only

All of the above

Asset Demand

Also called the speculative motive

Liquid asset

An asset that can quickly be converted into cash with little risk of loss

Transactions Demand

Arises because people and firm use it as a medium of exchange. For example, households need money to buy groceries and firms need money to pay for materials and labor.

Checkbooks represent a form of: Bank Money Commodity money Fiat or paper money

Bank Money

What determines transactions demand?

Basic determinant of the amount of money demanded for transactions, is the level of nominal GDP. The larger the total money value of all goods and services that are exchanged in the economy, the larger amount of money need, to negotiate these transactions.

When and why did Monetarism start challenging Keynesianism?

By 1969, inflation had crept over 5%, high for those good old days. And by the early 1970s it had jumped to almost double digits. And it was at this point as a new phenomenon known as stagflation began to emerge that monetarism began to challenge the Keynesian orthodoxy.

2 major determinants of money demand

the Transactions Demand the Asset Demand

3 kinds of money

Commodity money, like gold nuggets, represents the preferred money of centuries past. Today, however, in virtually all countries, commodity money has been replaced by the two other kinds of money, bank money (e.g. checkbook) and paper (or fiat) money-bills.

Which is the most important function of the U.S. Federal Reserve, America's central bank? Conduct monetary policy Issue currency Regulate financial institutions

Conduct monetary policy

Examples of the "opportunity cost" of holding money include: 1. The interest that could have been earned by lending the money. 2. The rate of return that could have been earned by investing the money in stocks. 3. The increase in value from holding money during inflation. All of the above 1 & 2 only

Correct 1 & 2 only

The major determinants of money demand are: 1. Asset demand 2. Transactions demand 3. Withdrawal demand All of the above

Correct 1 & 2 only

Suppose the nominal interest rate is 12% and the real interest rate is 6%. What must be the rate of inflation? 6% 3% 18% 24%

Correct 6%

If interest rates rise, what happens to the asset demand for money? Decreases Increases Stays the same

Correct Decreases

The more liquid the loan: The lower the interest rate The higher the interest rate There is no difference in the interest rate

Correct The lower the interest rate

If the Federal Reserve wants to increase the money supply, it can: Decrease the reserve requirement Increase the reserve requirement Decrease the money multiplier

Decrease the reserve requirement

In the presence of inflation, the value of money: Decreases Increases Is unaffected

Decreases

Inflation: Decreases the value of money Increases the value of money Has no effect on the value of money

Decreases the value of money

In theory, which can be used with more precision to close a recessionary gap? Fiscal policy Monetary policy Exchange rate policy

Fiscal policy

Precision in monetary policy vs fiscal policy

From a mechanistic keynesian point of view, monetary policy is conducted with less precision than fiscal policy.

Friedman's view on the origin of the economic collapse in 1929

He attributes it to bad monetary policy by the Federal Reserve rather than any inherent Keynesian instability with the system. He argued the Federal Reserve contracted the money supply, plunging a private economy that would otherwise have been pretty stable into a depression.

If the Federal Reserve wants to decrease the money supply, it can: Increase the discount rate Decrease the discount rate Increase the money multiplier

Increase the discount rate

If we want economic growth to proceed at a rate of 5%, the Monetarists would recommend: Increasing the money supply by 5% less the rate of inflation Increasing the money supply by 5% plus the rate of inflation Not sure Increasing the money supply by 5%

Increasing the money supply by 5%

The money multiplier and reserve requirement are: Inversely related Directly related Equal to one another

Inversely related

The Federal Reserve Chairman

Is the public face of the Federal Reserve Bank. The main responsibility of the chairman is to carry out the mandate of the Fed, which is to promote the goals of maximum employment, stable prices, and moderate long-term interest rates.

The Fed composition and ownership

It consists of 12 regional banks spread throughout the country, and they are owned by the commercial banks. While legally these 12 regional banks are private, in reality, the Fed as a whole behaves as an independent government agency.

Which school of macroeconomics supports an activist role for monetary policy? Keynesians Classical economists Monetarists

Keynesians

Why is monetary policy on the imprecise side

Link between the money supplu and shifts in the AE curve is complex. While the Fed can raise or lower interest rates, it can't know with precision how investment consumption, and net exports will respond.

Central Bank's role in runs on the banks

Loan money to banks who are unable to pay their depositors.

Which is NOT a function of money? Medium of barter Medium of exchange Standard of value Store of value

Medium of barter

Monetarism's leading exponent

Milton Friedman

Richard Nixon may have lost the 1960 presidential election to John F. Kennedy because of: Monetary policy Fiscal policy Exchange rate policy

Monetary policy

A system of fractional reserve banking works because: No more than a small amount of consumers are likely to come in for their cash Banks can close temporarily if they run of cash Banks can loan to one another if one gets into trouble

No more than a small amount of consumers are likely to come in for their cash

The basic determinant of transactions demand is: Nominal GDP Normalized GDP Real GDP

Nominal GDP

Lender of last resort

One of the functions of the Fed.

If you want to adjust for inflation when evaluating an investment, you would rely on the: Real interest rate Nominal interest rate Normalized interest rate

Real interest rate

M1 money supply

Transactions money. includes, most imporantly, paper currency and coins. Plus, checking account demand deposits.

If prices and (real GDP plus inflation) triple, what happens to the transactions demand for money? Triples Stays the same Doubles

Triples

The Fed

The Federal Reserve, created in 1913 following the financial crisis of 1907.

Asset Demand

The amount of assets that are held as cash, which will be low when interest rates are high and will be high when interest rates are low.

Which of these investments would have the lowest interest paid out? The bonds of the U.S. government The bonds of countries with large overseas debt and unstable political systems. The "junk bonds" of businesses close to bankruptcy, The municipal bonds of cities with shrinking tax bases,

The bonds of the U.S. government

Liquidity

The ease with which an asset can be converted into the economy's medium of exchange

The longer the term of a loan: The higher the interest rate The lower the interest rate There is no difference in the interest rate

The higher the interest rate

Nominal Interest Rate

The interest rate as usually reported without a correction for the effects of inflation

Real Interest Rate

The interest rate corrected for the effects of inflation

A major purpose of a nation's central bank is to be: The lender of last resort The lender of first resort The primary lender in the banking system

The lender of last resort

Tight money policy

Used for contraction, to fight inflation

Keynesian Stagflation Dilemma

Using expansionary policies to reduce unemployment, simply created more inflation. While using contractionary policies to curb inflation only deepened the recession.

Multiple expansion of the money supply

When the seller deposits it in his or her bank, the bank is automatically granted an increased reserve balance with the Fed. Thus, the new reserves can be used to support additional loans. Through this process, the money supply increases.

M1, M2, M3

are measurements of the United States money supply, known as the money aggregates.

Reserve requirements (RR)

are the amount of funds that a bank holds in reserve to ensure that it is able to meet liabilities in case of sudden withdrawals. Example of a RR is .10 (or 10%)

When did the monetarist approach become influential?

during the 1970s and early '80s.

Equation underlying the monetarist theory/Equation of Exchange

expressed as MV = PQ. *M is the supply of money *V is the velocity of turnover of money (i.e., the number of times per year that the average dollar in the money supply is spent for goods and services) *P is the average price level at which each of the goods and services is sold *Q represents the quantity of goods and services produced.

Liability

is an obligation to, or something that you owesomebody else. They are defined as a company's legal financial debts or obligations that arise during the course of business operations.

Interest Rate

is the amount of interest paid per unit of time, expressed as a percentage of the amount borrowed.

Federal Open Market Committee FOMC

is the branch of the Federal Reserve Board that determines the direction of monetary policy. The FOMC meets several times a year to discuss whether to maintain or change current policy.

Interest

is the payment made for the use of money, and it is often called the price of money.

Riskless rate

is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.

M2 money supply

known as broad money. It includes M1, plus so called near moneys, such as savings accounts, small time deposits, and money market mutual fund shares.

Real Interest Rate Formula

nominal interest rate - inflation rate

Monetarism

school of economic thought that maintains that the money supply (the total amount of money in an economy, in the form of coin, currency, and bank deposits) is the chief determinant on the demand side of short-run economic activity.

Milton Friedman's view on the original'ss of inflation and recession

the rate of growth of the money supply. Inflation happens when the government prints too much money, and recession happens when it prints too little. He rejects the Keynesian fiscal policy cure.

Easy money policy

used to expand the economy and fight recession