Chapter 16 The Federal Reserve and Monetary Policy

How are the real and nominal interest rates connected in the short-run?

A change in the nominal interest rate tends to change the real interest rate by the same amount in the short run.

How does monetary policy impact real GDP and the price level?

An expansionary monetary policy at full employment can temporarily increase the real GDP, but in the long run, only the price level will rise.

How can the Fed restrain the economy?

If the Fed wants to restrain the economy (decrease aggregate demand), it will lower the money supply by selling government bonds, increasing the reserve ratio, and/or raising the discount rate.

How can the Fed stimulate the economy?

If the Fed wants to stimulate the economy (increase aggregate demand), it will increase the money supply by buying government bonds, lowering the reserve ration, and/or raising the discount rate.

What is the most important function of a central bank?

Of the six major functions of a central bank, the most important is its role in regulating the money supply.

How do changes in income change the money market equilibrium?

Rising incomes increase the demand for money and lead to a new, higher equilibrium interest rate, ceteris paribus.

What is expansionary monetary policy?

The Fed engages in expansionary monetary policy to combat a recessionary gap. By increasing the money supply, the Fed can lower in the interest rate.

How is the Fed tied to Congress and the executive branch?

The POTUS appoints members of the Federal Reserve Board of Governors to a 14-year term, with only one appointment made every two years. The president also selects the Chair of the Federal Reserve Board, who serves a four-year term. The only other government intervention in the Fed can come from legislation passed in congress.

What is the equation of exchange?

The equation of exchange is expressed as M x V = P x Q , where M is the money supply, V is the velocity of money, P is the average level of prices of final goods and services, and Q is real GDP in a given year.

What is the quantity theory of money and prices?

The equation of exchange is particularly useful tool when analyzing the effects of a change in the money supply on the price level or inflation rate in the aggregate economy. The relationship between the money supply and the price level.

What is contractionary monetary policy?

The fed engages in contractionary monetary policy to combat inflationary gaps. In order to combat inflation, the Fed engages in an open market sale of bonds, decreasing the money supply and raising the interest rate.

Who controls the Federal Reserve System?

The federal reserve system consists of 12 Federal Reserve Banks. Although these banks are independent institutions, they act largely in unison on major policy decisions. The Federal Reserve Board of Governors and the Federal Open Market Committee are the prime decision makers for the U.S. monetary policy.

What are the three major tools of the Fed?

The three major tools of the Fed are open market operations, changing reserve requirements, and changing the discount rate.

What is the velocity of money?

The velocity of money (V) represents the average number of times that a dollar is used in purchasing final goods or services in a one-year period.

How does the Fed's buying and selling of bonds affect RGDP in the short-run?

When the Fed sells to the private sector, bond purchasers take the money out of their checking accounts to pay for the bonds, and those banks' reserves are reduced by the size of the check. The reduction in bank reserves leads to a higher interest rate and a reduction in aggregate demand, at least in the short run.