Chapter 15: Federal Reserve Bank and Monetary Policy

The Federal Reserve could reduce the money supply by

-selling government bonds in the open market. -raising the discount rate.

List and explain the six methods that the Fed can use to change the money supply. Be sure to distinguish between an increase and a decrease in the money supply.

1. (most important method) OPen market operations a. Buying and selling Treasury Bonds on the open marketT-bills or T-bonds) b. if Fed Wants to increase money supply = purchases these bonds from banks and pays for these bonds by increasing the money reserves that banks can lend out c. Inverse relationship between price of bond and interest rate d.Fed buys bond in open market =increases the demand for bonds =increases the price of bonds = lowers the interest rate 2. Change the discount rate a. Rate that a bank pays the Fed it if borrows money directly from the FEd rather than from another bank b. Raise money supply = lowers discount rate c. Newly borrowed money = banks will decrease their interest rates = to make more businesses and households to borrow more money 3. Change the required reserve ratio a. The amount of deposit that banks must hold as required reserves (determined by the Federal Reserve) b. If want to RAISe money supply = lower the required reserves (allowing banks to lend out more of their reserves) 4. Pay interest on excess reserves held at the Fed a. If want to increase money supply = LOWER interest rate that it pays on excess reserves held at Fed (makes banks want to make more loans) 5.Auction facility a.Fed auctions off huge amounts of money to banks so they can make more loans b. INCREASE money supply = make more money available at each auction 5. Quantitative easing a. Same as open market operations b. Financial assets involved = long term T-notes and T-bonds c. If want to increase money supply = buy more of these long term bonds paying for them w/ reserves that banks can now lend out d. Lower the money supply = do the opposite

Using the Taylor Rule calculate the optimal federal funds rate, FFR*, when the actual inflation rate is 15%, the average FFR is 2%, the Federal Reserve Bank target rate of inflation is 2%, the actual RGDP is at 17 trillion, and the full employment RGDP is 15 trillion. Does your answer make sense? Explain!

15+2+½(15-2)= 23.5 (my calculations) Since the actual inflation rate is much greater than the target and the actual RGDP is greater than the full employment level, our economy is in an inflation. Thus, we need a higher FFR which requires the FED to decrease money supply and increase the interest rate. However, in real world 23.5% interest rate can be way too high to reach, so monetary policy itself hardly bring the economy back to the full employment level.

Which of the following best describes the cause-effect chain of contractionary monetary policy?

A decrease in the money supply will raise the interest rate, decrease investment spending, and decrease aggregate demand and GDP.

Which of the following groups serve on the Federal Open Market Committee (select all that apply)?

All members of the board of governors five of the regional federal reserve bank presidents

Compare two situations:Year 1. Real GDP increases, and at the same time, interest rates increase.Year 2. Real GDP increases, and at the same time, interest rates decrease. What is a possible explanation for the difference?

An increase in spending may have caused the increase in GDP in year 1; an increase in the money supply may have caused the increase in GDP in year 2. explanation:A rise in interest rates and GDP must have been caused by something that increased income without increasing the money supply. This would result in higher interest rates. An increase in planned spending might have caused this. In the year 2 scenario, expansionary monetary policy reduces interest rates and can increase real GDP.

What monetary policy would intend to hold down inflation?

Decrease the money supply to shift the aggregate demand curve leftward

Monetary Policy in Action

Monetary Policy in Action 1. The Federal Reserve Bank uses the Taylor rule to determine the optimal federal funds rate (FFR*) given the current state of the economy. 2. The Fed adjusts the money supply to make the equilibrium rate the same as the FFR* target rate, and when the FFR changes so do most of the other interest rates, including the prime rate. 3.The new prime rate causes a change in the level of investment spending along the Investment demand function. 4.this new level of spending shifts the AD curve to bring the economy back to full employment.

Assume that the economy is currently producing a level of real GDP above the full employment level of real GDP, and the government lowers taxes as part of a new economic policy. Which of the following monetary policies should the Federal Reserve undertake if it wants to encourage the economy to go to a full employment level of output?

Raise the federal funds rate target explanation:If the economy is already producing above the full employment level of real GDP, there is already upward pressure on prices. A tax decrease will shift aggregate demand out putting further upward pressure on prices. To offset this pressure, the federal reserve needs to reduce aggregate demand. One way to do so is to raise the federal funds rate target.

When the Federal Reserve announces that it is increasing the federal funds rate, we would expect to see banks do which of the following?

Reduce their loans because they have fewer reserves due to the Fed's open market sales. explanation: When the Fed increases the federal funds rate, it sells bonds. Banks and the nonbank public buy these bonds by sending the Fed a check. This reduces the amount of reserves banks have and so banks need to reduce their lending to achieve the required reserve ratio.

Using the Taylor Rule calculate the optimal federal funds rate, FFR*, when the actual inflation rate is 1%, the average FFR is 2%, the Federal Reserve Bank target rate of inflation is 2%, and the economy is in a 2 trillion dollar recession. Does your answer make sense? Explain!

Since the actual inflation rate (1%) is lower than the target rate of inflation (2%) and the actual RGDP is lower than the full employment level, our economy is in a recession. We need a lower FFR which requires the FED to increase the money supply and decrease the interest rate. However, in the real world, the FFR cannot be negative, so the monetary itself can hardly bring the economy back to the full employment level

8. Show graphically the economy in a recession using the AD/AS model. Then using the relevant models, show and explain the use of monetary policy to bring the economy back to full employment.

Step 1: The Fed uses the Taylor Rule to help determine the target federal funds rate, (aka the optimal rate) FFR*. Since the economy is in a recession, it's clear that the optimal federal funds rate will be lower than the current rate. This is because the actual inflation rate will be lower, the inflation gap will be low or even negative, and the GDP gap will be negative since the equilibrium GDP is less than full employment. Step 2: The Fed sees that the optimal FFR is lower than the actual rate so it must lower the equilibrium interest rate. The Fed increases the money supply to MS2 to bring the equilibrium interest rate to the desired rate of 3%. Step 3: Using the Investment demand model, the lower federal funds rate leads to a decrease in the prime rate from 8.25% to 6% to encourage investment spending. Step 4: And, finally, as shown in Figure 15.5 below, this increase in spending shifts the AD curve back to the right, from AD1 to AD2. This brings the economy back to full employment.

9. Show the economy with inflation using the AD/AS model. Using the relevant models, show and explain the use of monetary policy to bring the economy back to full employment.

The Fed would have to decrease the money supply, the FFR has to increase (has to be greater than the actual rate, so it must be higher than the equilibrium interest rate). The high federal funds rate leads to an increase in the prime rate, which will decrease in spending. This will shift the AD curve to the left bringing back the economy to full employment.

What is the Taylor Rule and what is its function?

The Taylor Rule is a guide for the monetary policy makers to use to determine the target federal funds rate (a guide for the Fed to determine how much money the economy requires at any given time; it determines the optimal FFR given the current state of the economy).

What is the investment demand curve and why is it an inverse relationship with the Prime Rate? What factors would shift the investment demand curve?

The investment demand curve measures how much spending will occur at each interest rate. The reason why it is an inverse relationship with the Prime rate is because the Fed buys up bonds in the open market that increases the demand for bonds, which raises the prices of bonds, which lowers the INTEREST rate. That is why the curve is downward sloping because investment demands start to decline as the interest rate increases.

Which is the most accurate sequence of events when the Fed buys T-Bills?

The money supply is increased, which decreases the interest rate, and causes investment spending, output, and employment to increase

Which of the following occurs when monetary authorities raise the excess reserves of commercial banks?

The money supply is increased, which decreases the interest rate, and causes investment spending, output, and employment to increase

The Federal Reserve System was set up to be a ______________ and politically ______________ institution.

decentralized; independent

If the Fed is trying to make the interest rates go down, its objective is to

decrease unemployment.

The most commonly used monetary policy instrument is _________.

open market operations

According to the Taylor rule, if the inflation gap is zero and real GDP rises by one percent above potential GDP, then the Fed should

raise the federal funds rate by half of a percentage point

If the Fed wants to reduce the monetary multiplier, it should

raise the required reserve ratio.

When the federal reserve announces that it is increasing the federal funds rate, it is actually going to ___________.

sell bonds in the open market until the federal funds rate rises to the new target explanantion: The Fed announces a new federal funds rate and then makes it happen by buying or selling bonds to influence interest rates. When the fed sells bonds, bond prices fall and interest rates rise.

A newspaper report that the Federal Reserve will lower the discount rate again this year says that the Fed is trying to

stimulate the economy

To maintain current interest rates, the Fed would buy government bonds in the open market when

the demand for money increases.

The interest rate that the Fed charges banks for loans to them through the traditional channel is called

the discount rate.

The newspaper headline in December, 2019, that the Fed took no action on the federal funds rate indicates that

there appears to be no or little risk of inflation.

The Federal Reserve Banks are quasi-public banks which means that

they are privately owned but managed in the public interest.