Macro Exam 3 Chapters 14,15, and 16
Identify the mechanisms by which monetary policy affects GDP and the price level
Monetary policy affects the economy through a complex cause effect chain: policy decisions affect commercial bank reserves; changes in reserves affect the money supply; changes in the money supply alter the interest rate; changes in the interest rate affect investment; Changes in investment affect aggregate demand; changes in aggregate demand affect the equilibrium real GDP and the price level.
Identify the main subsets of the financial services industry in the US and provide examples of some firms in each category
The main categories of the US financial services industry are commercial banks, thrifts, insurance companies, mutual fund companies, pension funds securities firms, and investment banks. The reassembly of the wreckage from the financial crisis of 2007-2008 has further consolidated the already-consolidating financial services industry and has further blurred some of the lines between the subsets of the industry. In response to the financial crisis, Congress passed the Wall Street Reform and Consumer Financial Protection Act of 2010.
Define the monetary multiplier, explain how to calculate it, and demonstrate its relevance
The multiple by which the banking system can lend on the basis of each dollar of excess reserves is the reciprocal of the reserve ratio. This multiple credit expansion process is reversible.
Discuss the makeup of the Federal Reserve and its relationship to banks and thrifts.
The US banking system consists of the Board of Governors of the Federal Reserve System, the 12 Federal Reserve Banks, and some 6,000 commercial banks and 8,500 thrift institutions (mainly credit unions). The Board of Governors is the basic policymaking body for the entire banking system. The directives of the Board and the Federal Open Market Committee (FOMC) are made effective through the 12 Federal Reserve Banks, which are simultaneously central banks, quasi-public banks, and bankers' banks
Discuss why the US banking system is called a "Fractional reserve" System
Modern banking systems are fractional reserve systems: only a fraction of checkable deposits are backed by currency
Describe the multiple expansion of loans and money by the entire banking system
The commercial banking system as a whole can lend by a multiple of its excess reserves because the system as a whole cannot lose reserves. Individual banks, however, can lose reserves to other banks in the system.
List and describe the components of the US money supply
There are two major definitions of the money supply. M1 consists of currency and checkable deposits; M2 consists of M1 plus savings deposits, including money market deposit accounts, small-denominated (less than 100,000) time deposits, and money market mutual fund balances held by individuals.
Describe the balance sheet of the federal reserve and the meaning of its major items
The consolidated balance sheet of the federal reserve system lists the collective assets and liabilities of the 12 federal reserve banks. The assets consist largely of Treasury notes, treasury bills, and treasury bonds. The major liabilities are reserves of commercial banks, treasury deposits, and federal reserve notes outstanding. The balance sheet is useful in understanding monetary policy because open- market operations increase or decrease the Fed's assets and liabilities.
List and explain the goals and tools of monetary policy
The goal of monetary policy is to help the economy achieve price stability, full employment, and economic growth. The four main instruments of monetary policy are open market operations, the reserve ratio, the discount rate, and interest on reserves.
Explain the effectiveness of monetary policy and its shortcomings.
The advantages of monetary policy include its flexibility and political acceptability. In recent years, the Fed has used monetary policy to keep inflation low while helping limit the depth of the recession of 2001, to boost the economy as it recovered from that recession, to help stabilize the banking sector in the wake of the mortgage debt crisis, and to promote recovery from the severe recession of 2007-2009. Today, nearly all economists view monetary policy as a significant stabilization tool. Monetary policy has two major limitations and potential problems: recognition and operation lags complicate the timing of monetary policy; in severe recession, the reluctance of banks to lend excess reserves and firms to borrow money to spend on capital goods may contribute to a liquidity trap that limits the effectiveness of an expansionary monetary policy.
Describe the federal funds rate and how the fed directly influences it
The federal funds rate is the interest rate that banks charge on another for overnight loans of reserves. The prime interest rate is the benchmark rate that banks use as a reference for a wide range of interest rate on short-term loans to businesses and individuals. The fed adjusts the federal funds rate to a level appropriate for economic conditions. Under an expansionary monetary policy, it purchases securities from commercial banks and the general public to inject reserves into the banking system. This lowers the federal funds rate to the targeted level and also reduces other interest rates (such as the prime rate). Under a restrictive monetary policy, the fed sells securities to commercial banks and the general public via open market operations. Consequently, reserves are removed from the banking system, and the federal funds rate and other interest rates rise.
Identify and explain the main factors that contributed to the financial crisis of 2007-2008
The financial crisis of 2007-2008 consisted of an unprecedented rise in mortgage loan defaults, the collapse or near-collapse of several major financial institutions, and the generalized freezing up of credit availability. The crisis resulted from bad mortgage loans together with declining real estate prices. It also resulted from underestimation of risk by holders of mortgage backed securities and faulty insurance securities designed to protect holders of mortgage backed securities from the risk of default.
Identify the functions and responsibilities of the Federal Reserve and explain why Fed independence is important
The major functions of the fed are to issue Federal Reserve Notes, set reserve requirements and hold reserves deposited by banks and thrifts, lend money to financial institutions, and serve as the lender of last resort in national financial emergencies, provide for the rapid collection of checks, act as the fiscal agent for the federal government, supervise the operations of the banks, and regulate the supply of money in the best interests of the economy. The Fed is essentially an independent institution, controlled neither by the president of the United States nor by congress. This independence shields the Fed from political pressure and allows it to raise and lower interest rates (via changes in the money supply) as needed to promote full employment, price stability, and economic growth.
Explain the basics of a bank's balance sheet and the distinction between a bank's actual reserves and its required reserves
The operation of a commercial bank can be understood through its balance sheet, where assets equal liabilities plus net worth. Commercial banks keep required reserves on deposit in a Federal Reserve Bank or as vault cash. These required reserves are equal to a specified percentage of the commercial bank's checkable-deposit liabilities. Excess reserves are equal to actual reserves minus required reserves. Banks lose both reserves and checkable deposits when checks are drawn against them.
Discuss how the equilibrium interest rate is determined in the market for money
The total demand for money consists of the transactions demand for money plus the asset demand for money. The amount of money demanded for transactions varies directly with the nominal GDP; the amount of money demanded as an asset varies inversely with the interest rate. The market for money combines the total demanded for money with the money supply to determine equilibrium interest rates. Interest rates and bond prices are inversely related.
Identify and explain the functions of money
Anything that is accepted as a medium of exchange, a unit of monetary account, and store of value can be used as money
Describe how a bank can create money
Commercial banks create money- checkable deposits, or checkable-deposit money- when they make loans. They convert IOUs which are not money, into checkable- deposits, which are money. Money is destroyed when lenders repay bank loans. The ability of a single commercial bank to create money by lending depends on the size of its excess reserves. Generally speaking, a commercial bank can lend only an amount equal to its excess reserves. Money creation is thus limited because, in all likelihood, checks drawn by borrowers will be deposited in other banks, causing a loss of reserves and deposits to the lending bank equal to the amount of money that is has lent. Rather than making loans, banks may decide to use excess reserves to buy bonds from the public. in doing so, banks merely credit the checkable- deposits accounts of the bond sellers, thus creating checkable deposit money. Money vanishes when banks sell bonds to the public because bond buyers must draw down their checkable deposit balances to pay for the bonds. Banks earn interest by making loans and by purchasing bonds; they maintain liquidity by holding cash and excess reserves. The fed pays interest on excess reserves. Nevertheless, banks often can obtain higher interest rates by lending out excess reserves. These loans are made in the federal funds market, and the interest paid on the loans is called the federal funds rate
Discuss the actions of the US Treasury and the Federal Reserve that helped keep the banking and financial crisis of 2007-2008 from worsening
In 2008 Congress passed the Troubled Asset Relief Program (TARP), which authorized the US Treasury to spend up to 700 billion to make emergency loans and guarantees to failing financial institutions through a series of newly established Fed facilities. The TARP loans and the Fed's lender of last resort actions intensify the moral hazard problem. This is the tendency of financial investors and financial firms to take on greater risk when they assume they are at least partially insured against loss.
Describe what "backs" the money supply, making us willing to accept it as payment
Money represents the debts of government and institutions offering checkable deposits (commercial banks and thrift institutions) and has value because of the goods, services, and resources it will command in the market. Maintaining the purchasing power of money depends largely on the government's effectiveness in managing the money supply
