Chapter 15 Econ
If the Fed believes the inflation rate is about to increase, it should
use a contractionary monetary policy to increase the interest rate and shift AD to the left.
If the Fed believes the economy is about to fall into recession, it should
use an expansionary monetary policy to lower the interest rate and shift AD to the right.
When interest rates on Treasury bills and other financial assets are low, the opportunity cost of holding money is.....so the quantity of money demanded will be
low; high
As interest rates decline, stocks become a
more; rise
Congress broadened the Fed's responsibility since
the 1930s as a result of the Great Depression.
As the interest rate increases,
consumption, investment, and net exports decrease; aggregate demand decreases.
When the Fed conducts monetary policy, the most relevant interest rate is the
short-term nominal interest rate.
What is the disadvantage of holding money?
Money, in the form of currency or checking account deposits, earns either no interest or a very low rate of interest.
Is there an economic connection between the president's desire for a weaker dollar and his desire that the Federal Reserve keep interest rates low? Briefly explain.
Yes, when the Federal Reserve keeps interest rates low, it makes the dollar weaker because investing in the United States is less attractive.
Which of the following is not one of the monetary policy goals of the Federal Reserve ("the Fed")?
a high foreign exchange rate of the U.S. dollar relative to other currencies
Does the Fed's dual mandate require it to attain a zero percent unemployment rate? Briefly explain.
No, because even when the economy is at full employment, there is still a natural rate of unemployment.
Does the Fed's dual mandate require it to attain a zero percent inflation rate? Briefly explain.
No, because price stability is sufficient.
A student says the following: "I understand why the Fed uses expansionary policy but I don't understand why it would ever use contractionary policy. Why would the government ever want the economy to contract?"
above potential GDP and the price level is rising.
With an expansionary monetary policy, investment, consumption, and net exports all ________, which results in the aggregate demand curve shifting to the ________, increasing real GDP and the price level.
increase; right
If the Fed is too slow to react to a recession and applies an expansionary monetary policy only after the economy begins to recover, then
inflation will be higher than if the Fed had not acted.
In terms of the economy, "just as the party gets going" refers to a situation in which real GDP
is greater than potential GDP, which will result in an increase in the inflation rate.
One of the goals of the Federal Reserve is price stability. For the Fed to achieve this goal,
the rate of inflation should be low, such as 1% to 3%, and should be fairly consistent.
Additionally, the federal funds rate is
very important for the Fed's monetary policy because the Fed uses the federal funds rate as a monetary policy target since it can control the rate through open market operations.
In early 2017, according to the Wall Street Journal President Donald Trump said: "the U.S. dollar 'is getting too strong' and he would prefer the Federal Reserve keep interest rates low." The article also quoted the president as saying: "It's very, very hard to compete when you have a strong dollar..." Source: Gerard Baker, Carol E. Lee, and Michael C. Bender, "Trump Says Dollar 'Getting Too Strong,' Won't Label China a Currency Manipulator," Wall Street Journal, April 12, 2017. What did President Trump mean by a "strong dollar"?
. A "strong dollar" is when it takes more units of a foreign currency to buy a dollar.
What is a banking panic?
A situation in which many banks experience runs at the same time.
Why would a strong dollar make it hard for U.S. firms to compete?
A strong dollar raises the cost of U.S. goods to buyers in foreign countries.
Why would a cut in the Selic rate be an appropriate policy action at a time when the inflation rate was falling and the economy was struggling?
A. Lowering the Selic rate would decrease other interest rates, which would increase aggregate demand and stimulate the economy.
In the figure to the right, which of the following events is most likely to cause a shift in the money demand (MD) curve from MD 1 to MD 2 (Point A to Point C)? MD1->MD2 Right
Increase in real GDP or increase in the price level
Which of the following is a monetary policy target used by the Fed?
Interest rate.
What do economists mean by the demand for money?
It is the amount of money—currency and checking account deposits—that individuals hold.
What is the advantage of holding money?
Money can be used to buy goods, services, or financial assets.
If the Federal Reserve is late to recognize a recession and implements an expansionary policy too late, the result could be an increase in inflation during the beginning of the next phase. Even though the goal had been to reduce the severity of the recession, the poor timing caused another problem: inflation. This is an example of what type of policy?
Procyclical policy
The European Central Bank (ECB) issued the following statement after its June 2017 monetary policy meeting on monetary policy: Regarding non-standard monetary policy measures, the Governing Council confirms that the net asset purchases, at the current monthly pace of euro60 billion, are intended to run until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. Source: European Central Bank, "Monetary Policy Decisions," Press Release, June 8, 2017, www.ecb.europa.eu/press/pr/date/2017/html/ecb.mp170608.en.html. What is this non-standard monetary policy of net asset purchases called? The Federal Reserve
Quantitative easing. has attempted to use this non-standard monetary policy of net asset purchases you identified above.
Which one of the following is not one of the monetary policy goals of the Fed?
Reduce income inequality.
A column in the Wall Street Journal referred to policy actions aimed at "fulfilling both sides of the Fed's dual mandate." Source: Steven Russolillo, "The Key to a More Hawkish Fed," Wall Street Journal, December 14, 2016. Which of the following gave the Fed a dual mandate?
The Employment Act of 1946.
Which of the following best explains how the Federal Reserve acts to help prevent banking panics?
The Fed acts as a lender of last resort, making loans to banks so that they can pay off depositors.
Why would the Fed intentionally use contractionary monetary policy to reduce real GDP?
The Fed intends to reduce inflation, which occurs if real GDP is greater than potential GDP.
Why does the Fed's actions to increase or decrease the rate you identified above attract so much attention?
This rate ultimately has a substantial effect on many other interest rates.
How does lowering the target for the federal funds rate "pour money" into the banking system?
To increase the money supply, the Fed buys bonds on the open market, which increases bank reserves.
The Fed now needs to rely on these two new policy tools to change the federal funds rate because
banks were not loaning out excess reserves.
William McChesney Martin, who was Federal Reserve chairman from 1951 to 1970, was once quoted as saying, "The role of the Federal Reserve is to remove the punchbowl just as the party gets going." When he said "to remove the punchbowl," he meant to engage in
contractionary policy.
In the figure to the right, the opportunity cost LOADING... of holding money ▼ when moving from Point A to Point B down ward on the money demand curve.
decreases
Figure C illustrates (MD1->MD2 left)
more widespread use of mobile wallets.
The Fed's two new policy tools are
paying interest on bank reserve holdings and paying interest on repurchase and reverse repurchase agreements.
Figure A illustrates (MD1->MD2 Right)
real GDP increases.
The federal funds rate is
the interest rate that banks charge each other for overnight loans.
What is "Operation Twist"?
the Fed's program to purchase $400 billion in long-term Treasury securities while selling an equal amount of shorter-term Treasury securities.
Which of these variables are the main monetary policy targets of the Fed?
the money supply and the interest rate
For the Fed to succeed in reducing the severity of business cycles, it must act precisely when a recession or an acceleration of inflation can be seen in the economic data.
False
In 2017, one article in the Wall Street Journal had the headline: "Federal Reserve Expected to Deliver Rate Increase." Source: David Harrison, "Federal Reserve Expected to Deliver Rate," Wall Street Journal, June 14, 2017. What rate was the headline likely referring to?
Federal funds rate.
In response to the severity of the financial crisis, the Fed started to rapidly reduce the target range for the federal funds rate in September 2007 and, from December 2008 to December 2015, held the target range between 0% and 0.25%.
The Fed successfully held the actual federal funds rate within that target range over the seven-year period by conducting open market operations to increase or decrease bank reserves quickly.
The reason for this may have been a lack of
borrowers
The Fed expects that controlling that one interest rate would allow it to meet its goals for inflation and unemployment because lower short-term interest rates
encourage lending and stimulate economic activity.
The Fed's strategy of increasing the money supply and lowering interest rates in order to increase real GDP is called
expansionary monetary policy.
An article in the Wall Street Journal notes that before the financial crisis of 2007minus2009, the Fed "managed just one short-term interest rate and expected that to be enough to meet its goals for inflation and unemployment" Source: Jon Hilsenrath, "Easy-Money Era a Long Game for Fed," March 17, 2013 The short-term interest rate the article is referring to is the
federal funds rate.
The interest rate that banks charge each other for overnight loans is called the
federal funds rate.
real GDP increases. (MS1 <- MS2 left)
he Fed selling Treasury securities.
But the real problem was that banks were not
lending the reserves.
The article also notes that after the financial crisis, "the Fed is working through a broader spectrum of interest rates."
longer term Treasury rates and mortgage rates.
The Fed is said to have a" dual mandate" because
maintaining price stability and high employment are the two most important goals of the Fed that are explicitly mentioned in the Employment Act of 1946.
The difference between what was expected and what actually occurred illustrates that the formulation of economic policy
relies on economic forecasting that is subject to frequent revisions and errors.
With a __________, the Fed buys a security from a financial firm, which promises to buy it back from the Fed the next day.
repurchase agreement
The Fed gave up targeting the money supply because
the relationship between monetary aggregates and other economic variables was becoming unreliable.
How can investment banks be subject to liquidity problems?
they often borrow short term, sometimes as short as overnight, and invest the funds in longer-term investments.
In mid-2017, an article in the Wall Street Journal noted that: "The Federal Reserve's interest-rate increases aren't having the desired effect of cooling off Wall Street's hot streak...where stocks have rallied to records this year..." Source: David Harrison, "Fed's Effort to Guide Markets Falls," Wall Street Journal, June 11, 2017. Is cooling off rapid increases in stock prices part of the Fed's dual mandate? Are such increases a concern for the Fed? Briefly explain.
No, this is not part of the Fed's dual mandate of price stability and high employment. Yes, rapidly rising stock prices could be a concern for the Fed because it has a goal of stable financial markets.
Which of the following statements is correct?
A. Changes in the federal funds rate usually will result in changes in both short-term and long-term interest rates on financial assets. B. The effect of a change in the federal funds rate on long-term interest rates is usually smaller than it is on short-term interest rates. C. A majority of economists support the Fed's choice of the interest rate as its monetary policy target, but some economists believe the Fed should concentrate on the money supply instead. D. All of the above are true.
An investment blog said about Fed Chair Janet Yellen, "She is arguably the world's most powerful woman, and perhaps the most powerful person in the world. Can you name anybody with more might"? Source: Barbara Friedberg, "Fed Chief Janet Yellen: The Most Powerful Woman in the World," log.personalcapital.com, September 17, 2014. This assessment
A. is generally accepted by economists because of the influence the Fed chair has on monetary policy and the effect monetary policy has on inflation, employment, and financial stability.
Based on the European Central Bank's statement do you expect that the inflation rate is above or below the ECB's inflation target? Briefly explain.
A. Below, because the ECB's use of this non-standard monetary policy is intended to increase the money supply.
An article in the Wall Street Journal in 2017 discussed the decision by Brazil's central bank to cut the Selic rate, which is the equivalent in Brazil of the federal funds rate in the United States. According to the article, the cut occurred "as the country's inflation rate continues to fall quickly and the economy still struggles." Source: Jeffrey T. Lewis, "Brazil Cuts Its Benchmark Rate a Full Percentage Point," Wall Street Journal, April 12, 2017. In what sense do you think the Brazilian economy was "struggling" when this article was published?
B. The cut in the Selic rate suggests that Brazilian real GDP was below its potential.
Who is able to borrow and lend at that rate?
Banks are able to borrow and lend from each other at that rate.
What is "quantitative easing"?
What is "quantitative easing"?
In response to problems in financial markets and a slowing economy, the Federal Open Market Committee (FOMC) began lowering its target for the federal funds rate from 5.25 percent in September 2007. Over the next year, the FOMC cut its federal funds rate target in a series of steps. Writing in the New York Times, economist Steven Levitt observed, "The Fed has been pouring more money into the banking system by cutting the target federal funds rate to 0 to 0.25 percent in December 2008." Source: Steven D. Levitt, "The Financial Meltdown Now and Then," New York Times, May 12, 2009. What is the relationship between the federal funds rate falling and the money supply increasing?
To decrease the federal funds rate, the Fed must increase the money supply.
The following appears in a Federal Reserve publication: "In practice, monetary policymakers do not have up-to-the-minute, reliable information about the state of the economy and prices. Information is limited because of lags in the publication of data. Also, policymakers have less-than-perfect understanding of the way the economy works, including the knowledge of when and to what extent policy actions will affect aggregate demand. The operation of the economy changes over time, and with it the response of the economy to policy measures. These limitations add to uncertainties in the policy process and make determining the appropriate setting of monetary policy...more difficult." Source: Board of Governors of the Federal Reserve System, The Federal Reserve System: Purposes and Functions, Washington, DC, 1994. If the Fed itself admits that there are many obstacles in the way of effective monetary policy, why does it still engage in active monetary policy rather than use a monetary growth rule, as suggested by Milton Friedman and his followers? Policymakers at the Fed believe that
although it is not perfect, active monetary policy is still a stabilizing force in the economy
According to an article in the New York Times, an official at the Bank of Japan had the following explanation of why monetary policy LOADING... was not pulling the country out of recession: "Despite recent major increases in the money supply, he said, the money stays in banks." Source: James Brooke, "Critics Say Koizumi's Economic Medicine Is a Weak Tea," New York Times, February 27, 2002. In the quote, when the official says "the money stays in banks," he is referring to
an increase in the reserves in banks.
If the Federal Open Market Committee (FOMC) decides to increase the money supply, it orders the trading desk at the Federal Reserve Bank of New York to
buy U.S. Treasury securities.
Each year, the president's Council of Economic Advisers prepares and sends to Congress The Economic Report of the President. The report published in February 2008 contained the following summary of the economic situation: "Economic growth is expected to continue in 2008. Most market forecasts suggest a slower pace in the first half of 2008, followed by strengthened growth in the second half of the year."
decreased
An article in the New York Times in 1993 stated the following about Fed Chairman Alan Greenspan's decision to no longer announce targets for the money: "Since the late 1970's, the Federal Reserve has made many of its most important decisions by setting a specific target for growth in the money supply ... and often adjusted interest rates to meet them." If the Fed would no longer have a specific target for the money supply, it would be targeting the
federal funds rate
the interest rate that banks charge each other for overnight loans is called the
federal funds rate
To affect economic variables such as real GDP or the price level, the monetary policy target the Federal Reserve has generally focused on is the
federal funds rate.
Since 1950, the annual inflation rate in the U.S.
has typically been positive, but it has also varied substantially, peaking around 1980, and becoming negative for several months in early 2009 due to the effects of the Great Recession.
Consider the following statement: "The Fed has an easy job. Say it wants to increase real GDP by $200 billion. All it has to do is increase the money supply by that amount." The statement is
incorrect because an increase in the money supply does not affect real GDP directly.
A countercyclical policy is one that
is used to attempt to stabilize the economy
The Fed uses policy targets of interest rate and/or money supply because
it can affect the interest rate and the money supply directly and these in turn can affect unemployment, GDP growth, and the price level.
Which of the following was the Fed's objective in using "quantitative easing" and "Operation Twist"?
o keep interest rates on mortgages low. B. To keep interest rates on 10-year Treasury notes low. C. To increase aggregate demand. D. All of the above.
Suppose that when the Fed decreases the money supply, households and firms initially hold less money than they want to, relative to other financial assets. As a result, households and firms will _________ Treasury bills and other financial assets, thereby _________ their prices, and _________ their interest rates.
sell; decreasing; increasing
An increase in interest rates affects aggregate demand by
shifting the aggregate demand curve to the left, reducing real GDP and lowering the price level.
A former Federal Reserve official argued that at the Fed, "the objectives of price stability and low long-term interest rates are essentially the same objective."
stable prices make it easier to plan for the future, so expectations can be stable, which makes it less costly to make loans.
Figure D illustrates (MS1->MS2) right
the Fed decreasing the required reserve ratio.
An article in the Wall Street Journal in 2015 reported that the interest rate on five-year German government bonds had become negative: "The negative yield means investors are effectively paying the German state for holding its debt." The article quoted an investment analyst as saying: "The negative yield is not scaring investors away." Source: Emese Bartha and Ben Edwards, "Germany Sells Five-Year Debt at Negative Yield for First Time on Record," Wall Street Journal, February 25, 2015. The interest rate on German government bonds became negative when nvestors were willing to buy bonds with a negative interest rate because
the inflation rate exceeded the nominal interest rate. they believed there was no chance that the government would default.
If the price level decreases,
the money demand curve shifts to the left.
If real GDP increases,
the money demand curve shifts to the right.
If the FOMC orders the trading desk to sell Treasury securities,
the money supply curve will shift to the left, and the equilibrium interest rate will rise.
When Congress established the Federal Reserve in 1913, its main responsibility was
to make discount loans to banks suffering from large withdrawals by depositors.
