Chapter 36

A bank currently has $100,000 in checkable deposits and $15,000 in actual reserves. If the reserve ratio is 20 percent, the bank has ________ in money-creating potential. If the reserve ratio is 14 percent, the bank has __________ in money-creating potential. $5,000; $1,000 $20,000; $14,000 $3,000; $2,100 -$5,000; $1,000

-$5,000; $1,000 Explanation - $5,000; $1,000: If the reserve ratio is 20 percent, the bank has - $5,000 in money-creating potential. If the reserve ratio is 14 percent, the bank has $1,000 in money-creating potential. To see why this is true, first consider the case where the bank has a reserve ratio of 20 percent. Given that it has $100,000 in checkable deposits, the reserve ratio of 20 percent implies that the bank must keep $20,000 (= 0.20 × $100,000) worth of reserves. But given that it only has $15,000 of actual reserves on hand, the bank is short $5,000 worth of reserves. In order to get that money, the bank will have to reduce the volume of its outstanding loans by $5,000. As it does so, the money supply will be reduced by $5,000 as there will be $5,000 less of checkable-deposit money circulating in the economy. Thus, the bank's current situation of being short $5,000 of reserves implies that its money-creating potential is - $5,000. Next, consider the case where the required reserve ratio is 14 percent. Given that the bank has $100,000 in checkable deposits, this reserve ratio implies that the bank must keep $14,000 (= 0.14 × $100,000) worth of reserves. But the bank's actual reserves of $15,000 exceed that amount by $1,000. Thus, the bank has $1,000 of excess reserves that could be lent out and thereby used to create $1,000 of new checkable-deposit money. Consequently, the bank's money-creating potential in this scenario is $1,000.

Which of the following Fed actions will increase bank lending? Instructions: You may select more than one answer. Click the box with a check mark for correct answers and click to empty the box for the wrong answers. The Fed reverse repos $10 billion worth of Treasury bonds to non-bank financial firms.unanswered The Fed raises the discount rate from 5 percent to 6 percent.unanswered The Fed lowers the discount rate from 4 percent to 2 percent.unanswered The Fed raises the reserve ratio from 10 percent to 11 percent.unanswered

The Fed lowers the discount rate from 4 percent to 2 percent. Explanation Bank lending will rise when the Fed lowers the discount rate from 4 percent to 2 percent. If the Fed lowers the discount rate from 4 percent to 2 percent, more banks will borrow money from the Fed, thereby increasing their reserves. Because reserves only generate profits if they are lent out, these higher reserves will tend to increase bank lending. By contrast, the three other answers are incorrect because they will cause bank reserves to contract. For example, if the Fed raises the discount rate from 5 percent to 6 percent, banks will borrow less money from the Fed, thereby reducing reserves relative to what they were when banks were borrowing more at the lower 5 percent interest rate. With less reserves, banks will reduce their lending. If the Fed reverse repos $10 billion, it will cause the money to contract because the Fed is essentially borrowing away the cash that non-banks would otherwise have lent to banks in the federal funds market, thus reducing the amount that banks could borrow for their reserves. Finally, if the Fed raises the reserve ratio from 10 percent to 11 percent, it will increase the fraction of bank reserves that they must keep on hand, unloaned. Thus, raising the reserve ratio directly reduces the lending capacity of banks as they can now only lend a smaller fraction of their reserves.

True or False: A liquidity trap occurs when expansionary monetary policy fails to work because an increase in bank reserves by the Fed does not lead to an increase in bank lending.

True Explanation True: This statement is true because situations in which monetary policy fails because increases in reserves do not lead to increases in lending are indeed referred to as liquidity traps. Liquidity traps are very difficult for the Fed to deal with because they imply that the Fed loses most of its normal ability to stimulate the economy. As we have discussed in earlier chapters, banks can create money by making loans. The Fed uses policies that increase bank reserves as a way of attempting to get banks to make more loans and increase the money supply out in the economy—with the idea that a larger amount of money will lower interest rates and thereby stimulate aggregate expenditures and aggregate demand. But if banks won't lend, the Fed's attempts to stimulate the economy by increasing bank reserves will not work. In such situations, policymakers have to rely heavily on fiscal policy, as was the case in the 2007-2009 recession when the economy experienced a liquidity trap.

a. The federal funds rate is the interest rate that banks charge one another on overnight loans, whereas the prime interest rate is the interest rate that banks charge on loans to their most creditworthy customers. the interest rate that banks charge on loans to their most creditworthy customers, whereas the prime interest rate is the interest rate banks charge one another on overnight loans. the interest rate that the government charges for government loans, whereas the prime interest rate is the interest rate banks charge on loans to their most creditworthy customers. the interest rate that the Fed charges banks for a loan, whereas the prime interest rate is the interest rate banks charge one another on overnight loans. b. The federal funds rate is not comparable to the prime interest rate, since the lenders are different. lower than the prime interest rate because federal funds are loaned overnight. nearly the same as the prime interest rate because they are both short-term loans. higher than the prime interest rate because it is more risky to lend overnight. c. Changes in the federal funds rate and the prime interest rate closely track one another because both rates are related to the relative scarcity or availability of reserves. there are fewer prime rate reserves available for lending. all interest rates will be equal whether the customers are banks, businesses, or households. the Fed arranges this to be the case.

a. the interest rate that banks charge one another on overnight loans, whereas the prime interest rate is the interest rate that banks charge on loans to their most creditworthy customers. b. lower than the prime interest rate because federal funds are loaned overnight. c. both rates are related to the relative scarcity or availability of reserves. Explanation a. The federal funds interest rate is the interest rate banks charge one another on overnight loans needed to meet the reserve requirement. The prime interest rate is the interest rate banks charge on loans to their most creditworthy customers. b. The federal funds rate is lower than the prime interest rate for a number of reasons. Federal funds are loaned overnight, so lenders don't have to wait long for repayment. The reserves loaned would otherwise generate no interest, so even loaning at the lower federal funds rate is beneficial to lenders. Interest rates also depend on risk. It is less risky to lend overnight to other banks than it is to lend for longer periods to nonbank businesses and households. c. Both rates are related to the relative scarcity or availability of reserves. If there are fewer reserves available for lending, the price to borrow those reserves (the interest rate) will rise whether the customers are banks, businesses, or households.

Suppose the Federal Reserve sets the reserve requirement at 10 percent, banks hold no excess reserves, and no additional currency is held. Instructions: Enter your answers as whole numbers. Include any negative signs if necessary. a. What is the money multiplier? b. By how much will the total money supply change if the Federal Reserve changes the amount of reserves by -50 million? $ million c. Suppose the Federal Reserve wants to decrease the total money supply by $600 million. By how much should the Federal Reserve change reserves to achieve this goal? $ million

a. 10 b. $ -500 million c. $ -60 million Explanation a. Depending on the data that you have, the money multiplier can be found by taking 1/rr, where rr is the reserve requirement in decimal form, or by taking the total change in the money supply divided by the change in reserves. In this case, we are given a reserve requirement of 10 percent. Therefore, we can find the money multiplier by taking 1/rr, which is equal to 1/0.1 = 10. b. When we know the money multiplier, we can find the total change in the money supply by taking the money multiplier times the change in reserves. If the money multiplier is 10 and reserves decrease by $50 million, then the total change in the money supply can be found by taking 10 × -$50 million = -$500 million. Therefore, the money supply changes by a total of -$500 million. c. Because the total change in the money supply equals the money multiplier times the change in reserves, we can use this relationship to find the change in reserves given the total change in the money supply and the money multiplier. This uses the same relationship only with different information. The total change in the money supply desired is a $600 million decrease, and with the reserve requirement at 10 percent, we know the money multiplier is 10. Thus, putting in the information, we have -$600 million = 10 × change in reserves. Using algebra to find the change in reserves, we take the -$600 million and divide it by 10 such that -$600 million/10 = -$60 million. Therefore, the Federal Reserve would need to change reserves by -$60 million to achieve its goal.

Refer to the table for Moola given below to answer the following questions. Money Supply Money Demand Interest RateI nvestment at Interest (Rate Shown)Potential Real GDPActual Real GDP at Interest (Rate Shown) $500 . 500 . 500 . 500 . 500 $800 . 700 . 600 . 500 . 400 2% . 3 . 4 . 5 . 6 $50 . 40 . 30 . 20 . 10 $350 . 350 . 350 . 350 . 350 $390 . 370 . 350 . 330 . 310 Instructions: Enter your answers as whole numbers. a. What is the equilibrium interest rate in Moola? b. What is the level of investment at the equilibrium interest rate? c. Is there either a recessionary output gap (negative GDP gap) or an inflationary output gap (positive GDP gap) at the equilibrium interest rate and, if either, what is the amount? d. Given money demand, by how much would the Moola central bank need to change the money supply to close the output gap? e. What is the expenditure multiplier in Moola?

a. 5% b. $20 c. Recessionary output gap of $20 d. Increase the money supply by $100 e. 2 Explanation a. The equilibrium interest rate occurs at the interest rate where the quantity of money supplied equals the quantity of money demanded. Thus, the equilibrium interest rate is 5 percent. b. Investment at this interest rate is $20. c. At the interest rate of 5 percent, potential GDP is $350 and actual GDP is $330. Since actual GDP is less than potential GDP, there is a recessionary (negative) GDP gap. The gap is the difference, so the amount of the recessionary gap is $20. d. To eliminate the recessionary gap, that is to move actual GDP to $350 so that it equals potential GDP, the central bank will need to increase the money supply to $600. This is an increase of $100. e. To find the expenditure multiplier, we can divide the change in actual GDP by the change in investment. Multiplier = ($350 - $330)/($30 - $20) = $20/$10 = 2.

a. The basic objective of monetary policy is to increase employment and stabilize exchange rates. eliminate inflation and lower interest rates. assist the economy in achieving a full-employment, noninflationary level of total output. maintain steady exchange rates and lower inflation. b. A major strength of monetary policy is its speed and flexibility. its long-term consequences. the relatively short appointments of members of the Fed's Board of Governors. the rule used to manage the economy. c. Monetary policy is easier to conduct than fiscal policy because monetary policy has a much shorter administrative lag than fiscal policy. monetary policy is easier to understand. the Fed has more control of the economy. the economy responds better to monetary policy than to fiscal policy.

a. assist the economy in achieving a full-employment, noninflationary level of total output. b. its speed and flexibility. c. monetary policy has a much shorter administrative lag than fiscal policy. Explanation a. The basic objective of monetary policy is to assist the economy in achieving a full-employment, noninflationary level of total output. b. The major strengths of monetary policy are its speed and flexibility compared to fiscal policy, the Board of Governors is somewhat removed from political pressure, and its successful record in preventing inflation and keeping prices stable. The Fed is given some credit for prosperity in the 1990s and early 2000s. c. Monetary policy is formed by the seven members of the Board of Governors. Fiscal policy requires the consent of both houses in Congress and the president. One of the implications is that monetary policy has a much shorter administrative lag than fiscal policy.

a. When economists say that monetary policy can exhibit cyclical asymmetry, this means recessions are shorter than inflations. expansionary and restrictive monetary policy cannot both be used for economic expansion and contraction. expansionary and restrictive monetary policy do not have the same potential for economic expansion and contraction. the Fed is only able to deal with inflation. b. Cyclical asymmetry is important to policymakers because monetary policy is more effective in fighting inflation than recession. recessions are shorter than inflations. monetary policy is more effective in fighting recession than inflation. fiscal policy is more effective in fighting inflation than recession.

a. expansionary and restrictive monetary policy do not have the same potential for economic expansion and contraction. b. monetary policy is more effective in fighting inflation than recession. Explanation a. Cyclical asymmetry refers to the condition that a restrictive monetary policy is relatively potent at contracting economic activity, while an expansionary monetary policy is relatively weak at stimulating an economy. The weakness in expansionary monetary policy results when, even though the Fed increases liquidity (reserves) in the system, potential borrowers are unwilling to spend (often because of uncertainty over general weakness in the economy). b. Cyclical asymmetry is important to policymakers because it suggests that while monetary policy can effectively fight inflation, it may not be as successful in bringing an economy out of a recession. As Japan learned in the 1990s, expansionary monetary policy may be inadequate, and an expansionary fiscal policy may be necessary to stimulate recovery.

Suppose that you are a member of the Board of Governors of the Federal Reserve System. The post 2008 economy is experiencing a sharp rise in the inflation rate. a. In this case, the federal funds rate should be set equal to the discount rate. decreased. set at zero. increased. b. You recommend a contraction of the money supply by increasing the reserve ratio, decreasing the discount rate, or selling bonds. decreasing the reserve ratio or discount rate, or buying bonds. increasing the reserve ratio or discount rate, or selling bonds. decreasing the reserve ratio, increasing the discount rate, or buying bonds. c. You recommend a contraction of the money supply, which would increase the lending ability of the banking system, decrease the real interest rate, and increase investment spending, aggregate demand, and inflation. reduce the lending ability of the banking system, increase the real interest rate, and reduce investment spending, aggregate demand, and inflation. reduce the lending ability of the banking system, decrease the real interest rate, and increase investment spending, aggregate demand, and inflation. increase the lending ability of the banking system, decrease the real interest rate, and reduce investment spending, aggregate demand, and inflation.

a. increased. b. increasing the reserve ratio or discount rate, or selling bonds. c. reduce the lending ability of the banking system, increase the real interest rate, and reduce investment spending, aggregate demand, and inflation. Explanation a. To reduce inflation, the federal funds rate should be raised. b. A sharp rise in the inflation rate can be reduced through a contraction of the money supply. This would be accomplished typically through open-market operations (selling bonds), but could also be achieved with an increase in the reserve ratio or discount rate. c. The restrictive monetary policy would reduce the lending ability of the banking system, increase the real interest rate, reduce investment spending, reduce aggregate demand, and reduce inflation.

a. The basic determinant of the transactions demand for money is the level of nominal GDP. interest rate. price level. reserve ratio. b. The basic determinant of the asset demand for money is the interest rate. price level. level of nominal GDP. reserve ratio. c. Total money demand is the horizontal sum of the transactions demand for money and the asset demand for money. vertical sum of the transactions demand for money and the asset demand for money. horizontal sum of the consumer demand for money and the producer demand for money. vertical sum of the private demand for money and the public demand for money. d. The equilibrium interest rate is determined at the intersection of the total demand for money curve and the supply of money curve. by the Fed. to fluctuate over time. at the intersection of the aggregate demand and aggregate supply curve. e. Suppose there is an increase in the total demand for money. In this case, the equilibrium interest rate will rise. the equilibrium interest rate will fall. the money supply will rise. the money supply will fall.

a. level of nominal GDP. b. interest rate. c. horizontal sum of the transactions demand for money and the asset demand for money. d. at the intersection of the total demand for money curve and the supply of money curve. e. the equilibrium interest rate will rise. Explanation a. The basic determinant of the transactions demand for money is the level of nominal GDP. The higher this level, the greater the amount of money demanded for transactions. b. The basic determinant of the asset demand for money is the interest rate. The higher the interest rate, the smaller the amount of money demanded as an asset. c. On a graph measuring the interest rate vertically and the amount of money demanded horizontally, the two demands for the money curves can be summed horizontally to get the total demand for money. This total demand shows the total amount of money demanded at each interest rate. d. The equilibrium interest rate is determined at the intersection of the total demand for money curve and the supply of money curve. e. In the diagram below, an increase in the total demand for money will shift money demand to the right, raising the equilibrium interest rate. The money supply is changed by the Fed; it does not change with money demand.

When bond prices go up, interest rates go ___________. up down nowhere

down Explanation Down: When bond prices go up, interest rates go down. This happens because bond prices and interest rates are inversely related. To see why they are inversely related, recall that bonds are promises to repay particular amounts of money at particular points in the future. For instance, suppose that a bond promises to pay exactly $100 in one year. Also suppose that the current price of the bond is $50. Then the bond will yield an interest rate of 100 percent because $50 spent purchasing the bond today will yield a payment of $100 in one year, thereby doubling the owner's money. Next, suppose that the current price is instead $90. Then purchasing the bond today and holding it for a year would yield an interest rate of a little more than 11 percent (because $90 today would become $100 in one year, thereby generating a $10 gain—or a little more than 11 percent of the current purchase price of $90). Because the bond's future payout is fixed at $100, a higher current price implies a lower interest rate while a lower current price implies a higher interest rate.

If there is an increase in the nation's money supply, the interest rate will fall, investment spending will rise, aggregate demand will shift right, and real GDP and the price level will rise. rise, investment spending will fall, aggregate demand will shift right, real GDP will fall, and the price level will rise. rise, investment spending will fall, aggregate demand will shift right, real GDP will rise, and the price level will fall. fall, investment spending will rise, aggregate demand will shift right, real GDP will rise, and the price level will fall.

fall, investment spending will rise, aggregate demand will shift right, and real GDP and the price level will rise. Explanation A change in the nation's money supply (achieved by changing reserves in the banking system) will cause an opposite change in the interest rate. An increase in the money supply will make funds increasingly available and drive down their price (interest rate). The interest rate and investment spending are also inversely related. A falling interest rate will make some investments (capital spending projects) more profitable, so spending on those will increase. Investment spending is part of aggregate demand, so they will move together, as will real GDP. An increase in spending (AD) will increase inflationary pressure (and will increase prices).

A commercial bank sells a Treasury bond to the Federal Reserve for $100,000. Assume that all proceeds from this bond sale are lent out. The money supply: increases by $100,000. decreases by $100,000. is unaffected by the transaction.

increases by $100,000. Explanation Increases by $100,000: The money supply will increase by $100,000. This is true because when the commercial bank sells the Treasury bond to the Fed for $100,000, the Fed creates $100,000 of new money to pay for the bond. That $100,000 will increase the bank's excess reserves and thereby lead the bank to lend more, thus pushing money into the economy.

True or False: In the United States, monetary policy has two key advantages over fiscal policy: (1) isolation from political pressure and (2) speed and flexibility.

true Explanation True: This statement is true because U.S. monetary policy is indeed isolated from political pressure and does have notable advantages over U.S. fiscal policy in terms of speed and flexibility. Monetary policy's political isolation is provided by the Federal Reserve being a quasi-independent part of the government and by making sure that Federal Reserve governors are elected to extremely long, 14-year terms. As a result, the members of the FOMC are largely isolated from political pressures and can thus set monetary policy and interest rates in the way that is best for the economy (rather than in a way that would be best for getting current members of Congress or the president reelected). By contrast, fiscal policy is controlled entirely by Congress and the president and is therefore highly politicized. Monetary policy is also faster and more flexible than fiscal policy because the FOMC can react immediately whenever a crisis strikes whereas it can take many months for a new law regarding fiscal policy to work its way through Congress and then be signed by the president.