Chapter 16 ECON 202

if all excess reserves have already been lent out...

decline in commercial bank reserves will decrease money supply by multiple amt due to monetary multiplier working in reverse

objective 4

define the Fed's dual mandate & explain logic behind Taylor rule

which tool of monetary policy did the Fed use during the financial crisis to help banks meet reserve ratio

discount rate

when pursuing a restrictive monetary policy, the Fed must be careful to take into account...

downward price stickiness & its effect on the size of the multiplier

input prices, productivity & legal-institutional environment determine...

economy's aggregate supply

objective 1

explain how equilibrium interest rate is determined

objective 3

explain the goals & tools of monetary policy

aggregate demand is determined by...

factors that influence consumption spending, investments, net exports & government expenditures

in the bullseye chart, the amt by which actual unemployment & inflation differ from Fed's target rates is..

found by looking at position of the red dot relative to the center

reserve ratio

fraction of checkable deposits that each commercial bank must hold as reserves at local Fed bank or vault

when Fed buys gov bonds, demand for them increases...

gov bond prices rise, interest yields decline

total money demand =

horizontal sum of transactions demand & the asset demand for money

total demand of money (Dm) is found by...

horizontally adding (sum of) the asset demand for money to the transaction demand for money

when Fed banks purchase securities from commercial banks, they...

increase reserves in banking system, which increases lending ability of commercial banks

interest on excess reserves (IOER)

interest rate paid by Fed bank on excess reserves

federal funds rate

interest rate that depository institutions—banks, savings and loans, and credit unions—charge each other for overnight loans

transactions demand is vertical b/c...

it is assumed to depend on nominal GDP rather than on interest rate

to reduce checkable deposits, bank could...

let outstanding loans mature & be repaid w/o extending new credit (reduces money supply)

basic determinant of the transactions demand for money =

level of nominal GDP

an increase in money supply will...

lower equilibrium interest rate

asset demand for money c(Da) slopes downward b/c...

lower interest rates reduce opp cost of holding money

repo (repurchase agreement) =

makes a loan of money in exchange for gov bonds being posted as collateral

Fed has relied mostly on

open-market operations & changes in the IOER (interest on excess reserves) rate to manage the money supply

Taylor Rule =

predict what nominal interest rates should be given specific conditions of inflation & economic slack 3. puts twice as much weight on closing unemployment gap as it does on closing inflation gap

when interest rates fall, the cost of being liquid & avoiding capital losses declines therefore...

public increases the amt of financial assets that it wants to hold as money

Fed engages in expansionary monetary policy when it increases the money supply to...

reduce interest rates & increase investment spending + real GDP

appreciation of the dollar would

reduce price of imported resources, lower input prices & increase aggregate supply

Fed can also manipulate ______ to influence lending ability of commercial banks

reserve ratio

Fed requires that commercial banks hold...

reserves against their checkable deposits

repos involve Fed lending money into financial system...

reverse repos involve Fed borrowing money out of financial system

to increase reserves, bank might sell...

some of its bonds, adding the proceeds to its reserves (reduces money supply)

if current points lies to the northeast or southwest of the center of the bullseye...

state of economy will suggest opposite monetary policy stances

dual mandate

states that Fed's 2 highest objectives should be full employment + stable prices

Fed engages in restrictive monetary policy when it reduces...

the money supply to increase interest rates & reduce investment spending/inflation

equilibrium interest rate/price of money is determined where...

total money demand intersect money supply

when Fed banks sell securities in open market to commercial banks...

1. Fed banks give up securities the commercial banks acquire 2. commercial banks pay for those securities by drawing checks against their deposits/reserves

Fed pursues 2 targets simultaneously:

1. achieving full-employment rate of unemployment (4-5%) 2. achieving Fed's target rate of inflation (set at 2%/year)

SE center of bullseye

1. actual inflation is less than 2 % 2. actual unemployment is higher than 4.3% 3. economy is operating below potential output 4. expansionary monetary policy is appropriate

change in reserve ratio affects money-creating ability of banking system in 2 ways:

1. changes amt of excess reserves 2. changes size of monetary multiplier

main weaknesses of monetary policy =

1. cyclical asymmetry 2. liquidity trap 3. time lags 4.recognition/operational lags

restrictive monetary policy (tight money policy) Fed would...

1. decrease bank reserves to reduce lending 2. raise interest rates to decrease investment spending

if current combination of actual employment/inflation is to the NW of the center of the bullseye

1. economy is probably overheating & a restrictive monetary policy is in order 2. actual inflation is falling downward, toward 2% 3. actual unemployment rises upward toward 4.3%

increase money supply by...

1. lower reserve ratio 2. lowering discount rate 3. buy bonds

interaction of aggregate supply & demand result in the levels of which of the following...

1. output 2. income 3. employment

monetary policy affects economy through cause-effect chain:

1. policy decisions affect commercial bank reserves 2. changes in reserves affect money supply 3. changes in money supply alter interest rate 4. changes in interest rate affect investment 5. changes in investment affect aggregate demand 6. changes in aggregate demand affect real GDP + price lvl

advantages of monetary policy over fiscal policy:

1. flexibility 2. speed 3. isolation from political pressure

expansionary monetary policy (easy money policy) where Feds...

1. increase bank reserve to boost lending 2. lower interest rates to increase investment spending

Fed has 4 main tools of monetary control (by changing amt of reserves in banking system):

1. open-market operations 2. changing required reserve ratio 3. adjusting discount rate 4. altering the interest rates on required & excess bank reserves

3 major liabilities of Fed

1. reserves 2. Treasury deposits 3. Federal Reserve Notes

T or F: currently, the Federal Reserve pays interest on reserves held at the Fed

True, since 2008

Fed is largest single holder of...

U.S. gov securities

equilibrium interest rate in the money market is determined...

at intersection of the total demand for money curve & supply of money curve

changes in reserve ratios do not affect...

balance sheets

most securities are...

bills, notes, & bonds

quantitative easing (QE)

bonds were purchased by central bank in order to increase quantity of excess reserves held by commercial banks + stimulate economy/increase lending

inflation gap

current actual inflation rate - 2% inflation target

unemployment gap

current actual unemployment rate - 4.3 % unemployment rate target

objective 6

explain advantages & shortcomings of monetary policy

when Fed sells gov bonds, additional supply of bonds in market lowers bond prices & raises interest yields...

making gov bonds attractive purchases for banks + public

transaction demand for money depends on...

nominal GDP

zero lower bound problem

nominal interest rate lower than 0 will cause people to withdraw money from checking accts

open-market operations (OMOs)

purchase/sale of securities in open market by a central bank

which aspects are directly controlled by the Fed?

1. interest rates 2. money supply

interest =

1. price paid for the use of money 2. price that borrowers must pay lenders for transferring purchasing power to the future

monetary policy has 2 key advantages over fiscal policy:

1. speed & flexibility 2. isolation from political pressure

public wants to hold some of its wealth as money for 2 reasons

1. to facilitate purchases (transactions) (transactions demand for money) 2. to hold as an asset (store value) (asset demand for money)

objective 7

describe how the various components of macroeconomic theory + stabilization policy fit together

Fed target interest rate =

real risk free interest rate (2) + current actual inflation rate + 0.5 x inflation gap - 1.0 x unemployment gap

the more you pay today for a fixed future amount...

the lower your percentage return

objective 5

explain how monetary policy affects real GDP & price lvl

objective 2

list & explain the items in the Fed's balance sheet

when interest rate increases

bond prices fall

Fed pays interest on required reserves & on...

excess reserves that banks choose to hold at the Fed

asset demand varies inversely with interest rate b/c

opportunity cost involved in holding currency + checkable deposits that pay no interest/very low interest

combing money supply (stock) Sm with total money demand Dm...

portrays the market for money + determines the equilibrium interest rate (ie)

repots are open-market purchases of bonds (increase money supply)

reverse repos are open-market sales of bonds (decrease money supply)

Fed's open-market operations consist of:

bond market transactions in which Fed either (1) buys or sells gov bonds/securities outright (2) utilizes gov bonds as collateral on loans of money

when interest rate decreases

bond prices rise

interest rates & bond prices are...

inversely related

cyclical asymmetry

monetary policy may be more successful in slowing expansions & controlling inflation than dealing with severe recession

Fed banks purchase of gov bonds directly increases...

money supply. Increased amt of checkable deposits

Taylor rule formula/ nominal federal funds rate =

neutral rate + inflation rate + 0.5 (inflation rate - target rate of inflation) + 0.5 (output gap)

Fed's two main/primary assets =

1. securities 2. loans to commercial banks

if monetary multiplier is 5, a $1000 sale of gov securities will result in...

$5000 decline in money supply

interest yield =

(annual fixed interest/bond price) * 100

what is represented by the center of the Fed's bullseye chart?

Fed's target rates for the dual mandate

liquidity trap

adding more reserves to commercial banks at the Fed has little/no effect on lending, borrowing, AD

basic determinant of the asset demand for money =

interest rate

decrease in money supply will...

raise equilibrium interest rate

zero interest rate policy (ZIRP)

Fed aimed to keep short-term interest rates near 0 to stimulate economy

discount rate

Fed banks charging interest on loans granted to commercial banks

reverse repos

Fed posts gov bonds as collateral when borrowing money from financial institutions

quantitative tightening (QT)

Fed sells assets which lowers bond prices, causing interest rates to rise

if red dot (plots actual inflation & unemployment) is located to the NW or SE of the center of the bullseye...

Fed will have no confusion as to the stance of monetary policy; actual inflation/unemployment rates will both suggest the same policy stance