Chapter 16 Macro

Changing the required reserve ratio is used very rarely.

Changing the amount of reserves in the system has a multiplier effect on the overall money supply and influences the level of interest rates.

Required Reserve Ratio (The Fed can raise or lower the required reserve ratio. This affects the amount of money that banks are able to lend to the public.)

The percentage of deposits that a bank must keep as reserves

interest rate -Determined by the money supply and money demand

The price paid for the use of money

Contractionary Monetary Policy

To slow down inflation, the Fed would conduct an open market sale. Bank reserves decrease. Bank loans decrease, and interest rates increase. These effects tend to lower inflation rates. Similarly, all of these effects would reduce growth of output and employment. If the effect is bigger than planned it could cause recession.

Transactions demand, Dt (it is related to GDP, the higher economic activity the higher the demand for money) Asset demand, Da (the money as store of value) Varies inversely with the interest rate

Why hold money?

Major Policy Tools of the Federal Reserve System

The Required Reserve Ratio The Discount Rate Open Market Operations Term Auction

Contractionary Monetary Policy

-Increase the Required Reserve Ratio This will cause more required reserves to be held Less money will be available to be loaned out. This will decrease the money supply.

Expansionary Monetary Policy

-Lower the Required Reserve Ratio This will free up excess reserves that can then be loaned out. This will increase the money supply.

B. varies inversely with the rate of interest.

1. The asset demand for money: A. is unrelated to both the interest rate and the level of GDP. B. varies inversely with the rate of interest. C. varies inversely with the level of real GDP. D. varies directly with the level of nominal GDP.

C. varies directly with the interest rate.

2. The opportunity cost of holding money: A. is zero because money is not an economic resource. B. varies inversely with the interest rate. C. varies directly with the interest rate. D. varies inversely with the level of economic activity.

A. increases the interest rate and decreases aggregate demand.

3. A contraction of the money supply: A. increases the interest rate and decreases aggregate demand. B. increases both the interest rate and aggregate demand. C. lowers the interest rate and increases aggregate demand. D. lowers both the interest rate and aggregate demand.

C. interest rate will rise.

4. If the amount of money demanded exceeds the amount supplied, the: A. demand-for-money curve will shift to the left. B. money supply curve will shift to the right. C. interest rate will rise. D. interest rate will fall.

A. Decrease in the amount of money held as assets

5. If the interest rate increases, there will be a(n): A. Decrease in the amount of money held as assets B. Decrease in the transactions demand for money C. Increase in the transactions demand for money D. Increase in the amount of money held as assets

B. Federal funds rate

6. In recent years, the Fed often communicated its intentions to restrict or expand monetary policy by announcing a change in targets for the: A. Exchange rate B. Federal funds rate C. Prime interest rate D. Consumer price index

C. Ease monetary policy

7. A newspaper headline reads: "Fed Cuts Federal Funds Rate for Fifth Time This Year." This headline indicates that the Federal Reserve is most likely trying to: A. Reduce inflation in the economy B. Raise interest rates C. Ease monetary policy D. Tighten monetary policy

C. The Federal Reserve buys government securities in the open market

8. The level of GDP will tend to increase when: A. Reserve requirements are increased B. There is an increase in the discount rate C. The Federal Reserve buys government securities in the open market D. The Federal Reserve sells government securities in the open market

C. Its protection from political pressure

9. Which is considered a strength of monetary policy compared to fiscal policy? A. The ability to increase the budget deficit B. The ability to decrease the budget surplus C. Its protection from political pressure D. It is sluggish

Expansionary The Fed buys government securities from commercial banks (or commercial banks sell securities to Fed) and the general public in the "open market". Open market operations are by far the most frequently used tool of the Fed to conduct monetary policy.

An Open Market Purchase

Contractionary When the Fed SELLS government securities to the public, the Fed is paid by check. This removes reserves (DEPOSITS) from the banking system. This DECREASES bank reserves. Decreased bank reserves lead to both fewer bank loans and higher interest rates

An Open Market Sale by the Fed

Expansionary Monetary Policy

Expansionary Monetary Policy Suppose the Fed conducts an open market purchase. Bank reserves increase. Bank loans increase, and interest rates decrease. These effects promote increases in economic growth, total output, and employment. Similarly, all of these effects promote demand-pull inflation.

Inversely related Lower bond price will raise the interest rate

How are Interest rates and bond prices related?

Expansionary A decrease in the discount rate makes it cheaper for banks to borrow from the Fed and encourages banks to borrow from the Fed.

Lower the Discount Rate A decrease in the discount rate sends a SIGNAL to the economy that the Fed wants to stimulate the economy and encourage economic growth.

Expansionary A decrease in the Federal funds rate lowers the cost for violating the required reserve ratio. A decrease in the Federal funds rate encourages banks to increase their loans to stimulate the economy.

Lower the Targeted Federal Funds Rate (Policy Implemented by the FOMC)

Contractionary An increase in the discount rate discourages banks from borrowing from the Fed.

Raise the Discount Rate An increase in the discount rate sends a SIGNAL to the economy that the Fed wants to slow down the economy.

Contractionary An increase in the Federal funds rate raises the penalty for violating the required reserve ratio. An increase in the Federal funds rate discourages banks from making loans.

Raise the Targeted Federal Funds Rate

The Role of the Treasury Department

The Treasury Department collects taxes and pays the bills of the Federal government. If government spending exceeds tax revenue, the government has a DEFICIT. The Treasury needs to BORROW money to cover the deficit. The Treasury issues BONDS and borrows money from the public. (By law, the Treasury cannot borrow directly from the Fed.)

Federal Funds Rate

The interest a bank pays another bank for an overnight loan

Discount Rate The Fed can raise the discount rate (or INCREASE THE PENALTY) to discourage loans. The Fed can lower the discount rate (or DECREASE THE PENALTY) to encourage loans.

The interest rate that banks pay to the Fed when banks need to borrow from the Fed

Open Market Operations This tool is used to increase or decrease the amount of reserves in the system. This influences the overall money supply and the level of interest rates

The purchase or sale of Treasury securities by the Fed in the open market. A Fed PURCHASE of securities increases the money supply. A Fed SALE of securities decreases the money supply.

Term Auction Facility

The term auction facility is another way that the Fed can alter bank reserves. Twice a month, the Fed auctions off the right for banks to borrow reserves for 28- and 84-day periods. This tool allows the Fed to guarantee that the amount of reverses it wishes to lend will be borrowed and, therefore, will be available as excess reserves in the banking system to increase lending.