ECON 211 FINAL

Explain why the federal funds rate is the focus of monetary policy

Short term interest rate that the Fed can most directly influence

Explain how changes in the money supply affect the interest rate.

- An increase in the supply of money will lower the equilibrium interest rate - A decrease in the supply of money will raise the equilibrium interest rate

Describe the actions the Fed can take to pursue an expansionary monetary policy

- Before 2008- involved Fed lowering the target federal funds rate and then using open-market operations to buy bonds as necessary to adjust bank reserves to hit the target - After 2008 - massive open-market bond purchases undertaken to increase bank reserves

List several advantages of monetary policy over fiscal policy

- It is speedier and more flexible than fiscal policy since the Fed can buy and sell securities daily. - It is less political. Fed board members are isolated from political pressure, since they serve 14-year terms, and policy changes are more subtle and not noticed as much as fiscal policy changes. It is easier to make good, but unpopular decisions.

Explain how raising or lowering the interest paid on excess reserves affects bank lending

- Lower interest rate = increase in bank lending - Higher interest rate = decrease in bank lending

Describe how raising or lowering the reserve ratio can increase or decrease the money supply

- Raise = decrease -- less money to lend out - Lower = increase -- more money to lend out

Describe the causes of recent trade deficits in the United States

---- From 2001 to 2007, the U.S. economy grew more rapidly than the economies of several major trading nations. This growth of income has boosted U.S. purchases of foreign goods. In contrast, Japan, and some European nations, suffered recessions or slow income growth during this period. ---- Large trade deficits with China have emerged ($366 billion in 2015, which is 82 percent larger than the combined deficits with Mexico, Germany, and Japan). China's fixed exchange rate of its currency and its low standard of living have contributed to the U.S. deficit with China. ---- Until the recession of 2007-2009, a declining savings rate and the rising investment rate in the United States have contributed to U.S. trade deficits and an increase in foreign investment in the United States.

Describe the depreciation and appreciation of a nation's currency under a flexible-exchange-rate system

----If the demand for a nation's currency increases (other things equal), that currency will appreciate; if the demand declines, that currency will depreciate ----If the supply of a nation's currency increases, that currency will depreciate; if the supply decreases, that currency will appreciate ----If a nation's currency appreciates, some foreign currency depreciates relative to it

Discuss actions taken by the Fed during and after the financial crisis of 2007-2008

----In response to the financial crisis, which began in the summer of 2007, the Fed decreases the discount rate by a half percentage point in August 2007 and decreased the federal funds rate from 5.25 percent to 2 percent between September 2007 and April 2008. As discussed in chapter 32, the Fed introduced the term auction facility in December 2007. ----Between October 2008 and December 2008, the Fed decreases the federal funds rate to 0-0.25 percent where it remained through September 2013, and the prime interest rate fell from 7.33 percent in December 2007 to 3.25 percent through 2013.

Describe the problems with lags and cyclical asymmetry in monetary policy

----Recognition and operational lags impair the Fed's ability to quickly recognize the need for policy change and to affect that change in a timely fashion. Although policy changes can be implemented rapidly, there is a lag of at least three to six months before the changes will have their full impact. ----Cyclical asymmetry may exist: a restrictive monetary policy works effectively to reduce inflation, but an expansionary monetary policy is not always as effective in stimulating economy from recession. You can pull on a string to effectively shift the AD to the left, but you cannot push on a string to shift the AD to the right

Define a nation's balance of payments

--The sum of all transactions that take place between its residents and the residents of all foreign nations. These transactions include merchandise exports and imports, tourist expenditures, and interest plus dividends from the sale and purchases of financial assets abroad. --The balance of payments account is subdivided into two components: ------The current account ------Capital and financial account

Illustrate how raising or lowering the discount rate can increase or decrease the money supply

-Lowering the discount rate = money supply increase due to more borrowing - Increasing the discount rate = decrease money supply due to less borrowing

Explain the economic implications of recent trade deficits in the United States

1. A trade deficit means that the United States is receiving more goods and services as imports from abroad than it is sending out as exports. The gain in present consumption may come at the expense of reduced future consumption. 2. A trade deficit is considered "unfavorable" because it must be financed by borrowing from the rest of the world, selling off assets, or dipping into foreign currency reserves. In 2015, foreigners owned $7.4 trillion more assets in the United States than Americans owned in foreign assets. 3. Therefore, the current consumption gains delivered by U.S. trade deficits could mean permanent debt, permanent foreign ownership, or large sacrifices of future consumption. These sacrifices may be minimized if higher economic growth results as foreign investment expands our capital base.

Identify the six principal determinants of the demand for and supply of a foreign currency and explain how they alter exchange rates.

1. Changes in tastes or preferences for a country's products would shift the demand for the currency as well. 2. Relative income changes will cause changes in the demand and supply of currencies. Rising incomes increase the demand for imports, which increases the supply of that country's currency and the demand for other countries currencies. 3. Relative inflation rate changes will cause changes in the demand and supply of currencies. If American inflation is higher relative to British inflation, this will increase the demand for British goods and pounds; conversely, it will reduce the supply of pounds as British purchase fewer American goods. The theory of purchasing power parity asserts that exchange rates will change to maintain a uniform price in one currency, e.g., dollars, for each product across countries. 4. Changes in relative real interest rates will affect the demand and supply of currencies. Higher U.S. interest rates attract foreign savings; hence, they raise the demand for dollars and reduce the supply of dollars as U.S. investment dollars may remain in this country. 5. Speculation is another determinant. If one believes the value of a currency is about to fall, it will increase the supply of that currency and reduce its demand. Likewise, if one believes the value of a currency is about to rise, it will increase its demand and reduce its supply as people want to hold that currency. Note that such predictions can be self-fulfilling prophecies, since the change in demand is in the direction of the prediction. (Table 21.2 summarizes the determinants of exchange rates.)

Monetary Multiplier

= 1/ reserve ratio as a decimal

Actual Reserves

= Reserve Ratio + Excess Ratio

Explain how money is used for buying and selling of real and financial assets

A foreign firm may buy a real asset, say an office tower in the United States or a U.S. government bond. Both kinds of transactions involve the "export" of the ownership of U.S. assets from the United States in return for payments of foreign currency (money "capital") inflows. This is recorded as a positive flow in the financial account.

Describe the advantages and disadvantages of flexible exchange rates

Advantage: Have the option to "peg" their exchange rate Disadvantage: 1. Uncertainty and diminished trade may result if traders cannot count on future prices of exchange rates, which affect the value of their planned transactions. 2. Terms of trade may be worsened by a decline in the value of a nation's currency. 3. Unstable exchange rates can destabilize a nation's economy. This is especially true for nations whose exports and imports are a substantial part of their GDPs.

Discuss the relative importance of monetary policy tools.

All four useful in particular situations but open-market operations are clearly the most important of the four tools over the course of a business cycle.

Recognize the major asset (securities) and major liability (bank reserves) in the consolidated balance sheet of the Fed.

Assets- Securities which are federal government bonds. Loans to commercial banks. Liabilities- 1. Reserves of banks held as deposits at Federal Reserve Banks 2. U.S. Treasury deposits of tax receipts and borrowed funds 3. Federal Reserve Notes outstanding, our paper currency

Recognize currency appreciation and depreciation through change in values.

Depreciation means the value of a currency has fallen; it takes more units of that country's currency to buy another country's currency. $3 for 1 pound would be a depreciation of the dollar,compared to the original example of $2 per pound. Appreciation means the value of a currency or its purchasing power has risen; it takes less of that currency to buy another country's currency. $1 = 1 pound would be an appreciation of the dollar relative to the pound.

Describe the actions the Fed can take to pursue a restrictive monetary policy

Higher IOER and reverse repos

Describe the inverse relationship between bond prices and interest rates.

If the quantity demanded exceeds the quantity supplied, people sell assets like bonds to get money. This causes bond supply to rise, bond prices to fall, and a higher market rate of interest.

Explain the zero lower bound problem for monetary policy.

Interest rates less than zero (negative interest rates) encourage consumers to withdraw money from banks, thereby reducing the lending capacity of the banking system.

Use a supply and demand graph to illustrate how a flexible-exchange-rate system works to establish the price and quantity of a currency.

Intersection = exchange rate

Identify the 4 tools of monetary policy.

Open-Market Operation (OMO)- Refer to the Fed's buying and selling of government bonds. Reserve Ratio- It is the fraction of reserves required relative to their customer deposits. Discount Rate- which is the interest rate that the Fed charges to commercial banks that borrow from the Fed. Interest on Excess Reserves- In 2008, federal law was changed so that the Federal Reserve could pay banks interest on excess reserves held at the Fed.

Explain how the Fed can expand the money supply with repos with banks and decrease the money supply with reverse repos

Repo - Fed makes a loan of money in exchange for government bonds being posted as collateral -- If money is paid on time, the Fed returns the bonds to the borrower. If the money is not repaid on time, the Fed keeps the bonds. Reverse Repo - opposite of repo, involve the Fed borrowing money out of the financial system

Describe the Fed's use of quantitative easing.

The Feds response to zero lower bound problem - goal when purchasing QE after 2008 was to buy bonds solely with the intention of increasing the quantity of reserves in the banking system.

Explain the relationship between the current account and the capital and financial account, and why the balance of payments must balance

The current account and capital & financial account must balance because you are trading goods and services for assets.

Explain the purpose of interest rates

The function of interest rates are to reward investors for the risks that they take, being either opportunity costs, or risks of loss on their investment. From that point of vue, interest rates are a necessity because they help allocating the resources in an effective manner throughout the economy.

Describe the relationship between the federal funds rate and the prime interest rate

The prime interest rate is higher than the federal funds rate because the prime rate involves larger, riskier loans than the overnight loans extended between banks in the federal funds market. They closely track one another.

Asset Demand for Money

Varies inversely with the interest rate because of the opportunity cost involved in holding checkable that pay no interest or very low interest

Describe the market for money and what determines the equilibrium rate of interest

can combine the demand for money with the supply of money to determine the equilibrium rate of interest. Intersection of demand and supply = equilibrium.

Transaction Demand for Money

graph is vertical because it is assumed to depend on nominal GDP rather than on the interest rate

Calculate the value of a U.S. dollar in terms of foreign currency.

if the exchange rate is $2 per pound, this implies that 1 pound buys $2 or it takes $2 to buy 1 pound

Calculate the value of a unit of foreign currency in terms of U.S. dollars.

if the exchange rate is $2 per pound, this implies that 1 pound buys $2 or it takes $2 to buy 1 pound