Macro Ch. 15 & 16

Problems with monetary policy

-Lags -Cyclical asymmetry (monetary policy can stop borrowing and lending in its tracks when rates increase; it cannot force borrowers to borrow or lenders to lend when rates decrease) -Pro-cyclical bank bias (banks squeeze excess reserves to a minimum during good times and hang on to safe excess reserves at Fed during slow times)

Moral Hazard

-What occurs when banks and other financial institutions take on too much risk, hoping that the Fed and regulators will later bail them out -Institutions that are "too big to fail" have too little incentive to make responsible financial investments

What are some things the Fed will try to predict/monitor to estimate the effects of its actions on AD?

-Will banks lend out all the new reserves or will they lend out only a portion, holding the rest as excess reserves? -How quickly will increases in the monetary base translate into new bank loans and thus larger increases in M1 and M2? -Do businesses want to borrow? How low do short-term interest rates have to go to stimulate more investment borrowing? -If businesses do borrow, will they promptly hire labor and capital, or will they just hold the money as a precaution against bad times?

When Fed decreases IOER...

-banks pull reserves out of their Fed account -banks increase excess reserves and loans increase -money supply down and interest rates down

When Fed increases IOER...

-banks put excess reserves into their Fed account -loans to businesses and HHs dry up -money supply down and interest rate up

When the Fed buys bonds...

-demand for bonds increases -price of bonds increases -interest rates decrease

What are the 3 ways commercial banks can use customer deposits?

-make business and household loans -buy government bonds -reserves held at the Fed or cash in the vault

What were problems associated with why the Fed did not raise rates sooner during the 2001 recession?

1.) Few people expected that a fall in housing prices would wreak as much havoc as it did 2.) It's not always easy to identify when a bubble is present 3.) Monetary policy is a crude means of "popping" a bubble, because it affects the whole economy

1.) Suppose that the Federal Reserve Bank wants to address high levels of unemployment in the economy. To do so, it would likely seek to increase _______. 2.) If the Federal Reserve Bank is able to instigate the growth it desires, it will likely come at the cost of increasing ___________. 3.) Suppose the Federal Reserve Bank achieves the growth it wants, but also experiences negative consequences. As a result, it will seek to decrease ____________ at the risk of leading the economy into a _____________.

1.) aggregate demand 2.) inflation 3.) inflation; recession

One of the most difficult policy decisions faced by the Federal Reserve Bank (the Fed) is how to use monetary policy in response to a real negative shock such as a severe drought. Please answer the questions and assume that the Federal Reserve Bank decides to address the negative real shock by focusing on inflation instead of recession. 1.) As a result of the real negative shock, the inflation rate in the economy will __________. 2.) To remedy this situation, the Federal Reserve will seek to ____________ aggregate demand. 3.) The Fed is likely to ____________ the money supply in order to impact aggregate demand. 4.) If the Fed takes this approach, the real growth rate will _________ from the point to which it was shifted by the real negative shock.

1.) increase 2.) decrease 3.) decrease 4.) decrease

Which statement is TRUE? -If banks want a reserve ratio of 1/10, then when the Federal Reserve increases reserves by $1,000, deposits must ultimately increase by $100 -When banks are confident that depositors will not want to withdraw their cash or when loans seem profitable, they want a reserve ratio that is relatively high -The money multiplier tells us how much deposits expand with each dollar decrease in reserves -If depositors start visiting the ATM a lot more often, banks will want to have a higher reserve ratio

If depositors start visiting the ATM a lot more often, banks will want to have a higher reserve ratio

Liquid Asset

an asset that can be used for payments or, quickly and without loss of value, be converted into an asset that can be used for payments

Illiquid asset

an asset that is worth a lot in the future but it can only be sold today at a much lower price (a bank can be illiquid but not insolvent)

Insolvent institution

an institution that has liabilities that are greater than its assets

Change in money supply =

change in reserves x money multiplier

Monetary base (MB)

currency and total reserves held at the Fed

M1

currency plus checkable deposits

market confidence

one of the Federal Reserve's most powerful tools is its influence over expectations, not its influence over the money supply

Two tools Fed uses to control money supply and interest rates

open market operations (buying and selling short-term T-bills) and paying interest on reserves held by banks at the Fed

If Fed lowers the interest rate it pays on excess reserves (IOER)...

private borrowing and lending increase & money supply grows more quickly

If Fed raises the interest it pays on excess reserves (IOER)...

private lending and borrowing decrease & money supply grows less quickly

Reserve Ratio (RR or DR)

ratio of reserves to deposits (determined by bank preference and Fed requirements)

Functions of the Federal Reserve

-Issue currency -Set reserve requirements -Lend money to banks (when needed) -Collect checks -Act as a fiscal agent for U.S. government -Supervise 4,900 banks -Control the money supply and interest rates -Bring calm to financial markets

When the Fed sells bonds...

-demand for bonds decreases -price of bonds decreases -interest rates increase

What two difficulties make it hard for the Fed to get monetary policy right all the time?

1.) The Federal Reserve must operate in real time when much of the data about the state of the economy is unknown. 2.) The Federal Reserve's control of the money supply is incomplete and subject to uncertain lags.

What are the two options of action after a negative shock to AD?

1.) Wait it out ("Classical" or "Laissez-faire" approach; wait out a recession until input prices fall and SRAS shifts back to LRAS) 2.) Fed can combat slow growth with monetary policy by buying short/long term bonds (lower IOER, increases rate of growth of money supply, reduces interest rates and encourages more borrowing)

Fractional Reserve Banking

A system where banks hold only a fraction of deposits in reserve, lending the rest (reserves held at Fed or in vault)

Who is on the Federal Open Market Committee?

12 individuals (7 members of Board of Governors, president of New York Federal Reserve Bank, and 4 remaining presidents of Federal Reserve Banks)

Which is FALSE? -Banks earn profit on deposits -The money multiplier is the amount the money supply expands with each dollar increase in reserves -The money supply will increase by more than the initial change in reserves -Banks hold reserves according to the law and the Federal Reserve as well as to meet ordinary depositor demands for currency and payment services

Banks earn profit on deposits (Banks earn profits on loans funded through deposits)

Taylor Rule

FFR = FFR* + INF + 0.5(INF-INF*) + 0.5(Y-Y*) FFR = feder funds rate FFR* = real target rate INF = inflation rate INF* = target Y = real output Y* = target

True or False: The Fed Funds rate is the interest rate banks pay when they borrow directly from the Fed.

False (this is the discount rate)

Rank the different types of bank accounts according to their liquidity. -Savings Account -Certificate of Deposit (CD) -Checking Account

Highest Liquidity to Lowest: -Checking Account -Savings Account -Certificate of Deposit (CD)

M2

M1 plus savings accounts, money market mutual funds, and other liquid assets

Of the following events that would occur as a part of the Fed using monetary policy to decrease aggregate demand, which would occur third? -Investment borrowing decreases -Short-term interest rates increase -The monetary base decreases -The Fed sells bonds in an open market operation

Short-term interest rates increase (First, selling bonds in open market operations would decrease the money supply (MB decrease is second), which raises short-term interest rates, causing less borrowing and investing)

Money Multiplier (MM)

The amount the money supply expands with each dollar increase in reserves; MM = 1/RR.

Discount rate

The interest rate on the loans that the Fed makes to banks

Which is TRUE? -The money supply will increase by more than the initial change in reserves -The money multiplier is the amount the money supply shrinks with each dollar increase in reserves -Banks hold reserves only to meet ordinary depositor demands for currency and payment services -Banks earn profit on deposits

The money supply will increase by more than the initial change in reserves

What is one of the reasons that banks keep their accounts at the Federal Reserve? -They want a safe place to hold their money -It would be too inconvenient for banks to hold their own accounts -The Federal Reserve charges lower account maintenance fees than do the banks themselves -Interest paid by the Federal Reserve exceeds the returns from any other type of investment

They want a safe place to hold their money (Some banks are also required by law to hold accounts with the Federal Reserve)

What is a liquidity trap? -When nominal interest rates cannot be lowered any further. -When deflation occurs because growing debt obligations cause a decrease in aggregate demand. -When increasing price levels result in fixed-income earners "drowning" as expenses grow while income remains constant. -When expansionary monetary policy results in a rapidly increasing price level.

When nominal interest rates cannot be lowered any further.

What is also known as a Federal Reserve note? -a euro -a U.S. dollar -a 30-year bond -a 10-year Treasury bill

a U.S. dollar (U.S. dollars are liabilities for the Federal Reserve)

Deflation

a decrease in the general level of prices

Disinflation

a reduction in the rate of inflation

Excess reserves =

total reserves - required reserves

Monetary Policy

using the money supply (M1) to impact aggregate demand

Quantitative easing

when the Fed buys longer-term government bonds or other securities

Quantitative tightening

when the Fed sells longer-term government bonds or other securities

Which help(s) to reduce the probability of a liquidity crisis? I. the existence of the FDIC II. the Fed's role as lender of last resort III. the existence of the Federal Open Market Committee -II and III -I, II, and III -I only -I and II

I and II (A liquidity crisis occurs when banks are illiquid, meaning that their short-term liabilities are greater than their short-term assets)

Which of the statements best describes the monetary rule, as proposed by the economist Milton Friedman? -Inflation is kept in check in the long run by keeping the growth of M1 and M2 on a steady path. -An acceptable rate of unemployment is targeted and the money supply is adjusted accordingly. -Inflation is kept in check by increasing the growth of M1 and decreasing the growth of M2 in equal amounts. -Inflation is kept in check by directly manipulating interest rates to decrease bond prices.

Inflation is kept in check in the long run by keeping the growth of M1 and M2 on a steady path.

There are several ways that governments can increase or decrease the money supply. Match the descriptions with the corresponding policy tool (Open Market Operations, Reserve Requirement, Discount Rate, or Quantitative Easing). It's possible that a description does not apply to any of the policy tools. -An increase in the percentage of deposits that banks must keep on hand -An increase in government spending -A central bank purchasing a large quantity of longer-term Treasury Bonds -A government printing more currency -A central bank purchasing existing bonds -An increase in the interest rate that a central bank charges commercial banks for loans

Open Market Operations: -A central bank purchasing existing bonds Reserve Requirement: -An increase in the percentage of deposits that banks must keep on hand Discount Rate: -An increase in the interest rate that a central bank charges commercial banks for loans Quantitative Easing: -A central bank purchasing a large quantity of longer-term Treasury Bonds Not Included: -A government printing more currency -An increase in government spending

If the Fed responds to a negative real shock by increasing the money supply, the real growth rate will: -not change, because money is neutral -be lower than if the negative real shock had not occurred -be lower than if the Fed did not increase the money supply -be higher than if the Fed did nothing

be higher than if the Fed did nothing (however, the rate of inflation will be even higher than if the Fed did nothing)

When the Federal Reserve conducts open market operations, it... -manipulates of the rate at which it loans to member banks. -buys or sells government bonds. -increases or decreases the required reserve ratio. -buys and sells foreign currency.

buys or sells government bonds (money supply increases when Fed buys bonds and decreases when Fed sells bonds)

What are the three main tools the Federal Reserve (Fed) has at its disposal to carry out monetary policy? -conducting open market operations, increasing spending by the federal government, and decreasing taxes -setting the discount rate, increasing taxes, and building highways -paying interest on reserves, conducting open market operations, and controlling money demand -conducting open market operations, setting the discount rate, and paying interest on reserves

conducting open market operations, setting the discount rate, and paying interest on reserves

The central bank can help the inflation rate to decrease after a negative real shock through: -contractionary monetary policy -expansionary monetary policy -expansionary fiscal policy -contractionary fiscal policy

contractionary monetary policy (the problem is that the real growth rate falls even further)(expansionary monetary policy would increase inflation even more)

Which of these statements about liquidity traps is false? -Firms are unlikely to undertake investment during liquidity traps because interest rates are prohibitively high. -The zero bound of interest rates prevents policy makers from taking some actions that could stimulate economic growth. -The United States probably experienced a liquidity trap during the Great Depression. -Expansionary monetary policy is difficult to achieve.

Firms are unlikely to undertake investment during liquidity traps because interest rates are prohibitively high.

Federal Funds Rate

Interest rate banks charge each other for loans

Why does a negative real shock pose difficulties for monetary policy?

Policymakers can reduce inflation or unemployment but not both

Given a best-case scenario, which statement correctly describes the Federal Reserve's behavior? -The Federal Reserve tries to offset a negative shock to aggregate demand with an increase in the money supply -The Federal Reserve tries to offset a positive shock to aggregate demand with an increase in the money supply -The Federal Reserve tries to avoid negative shocks to aggregate demand by increasing the money supply -The Federal Reserve tries to avoid positive shocks to aggregate demand by decreasing the money supply

The Federal Reserve tries to offset a negative shock to aggregate demand with an increase in the money supply

True or False: The Federal Deposit Insurance Corporation (FDIC) protects bank depositors from bank failure.

True

What impact would radical disinflation have on unemployment? -Unemployment would fall in the short run only -Unemployment would rise in the short run only -Unemployment would rise permanently -Unemployment would fall permanently

Unemployment would rise in the short run only (Paul Volcker's disinflation in the 1980s caused a very bad recession but set the stage for 25 years of strong economic growth)

If the Fed responds to a negative real shock by decreasing the money supply, the real growth rate will: -not change, because money is neutral -be higher than if the negative real shock had not occurred -be higher than if the Fed increased the money supply -be lower than if the Fed did nothing

be lower than if the Fed did nothing (however, the rate of inflation will also be lower than if the Fed did nothing)

Classify each scenario as to whether it would increase or decrease the money supply. -The government increases the reserve requirement -The Fed engages in quantitative easing -The central bank buys bonds -The discount rate increases

Increase the money supply: -The central bank buys bonds -The Fed engages in quantitative easing Decrease the money supply: -The government increases the reserve requirement -The discount rate increases

If the Fed is able to use monetary policy to perfectly offset a negative aggregate demand shock and end a recession, all else equal, which statement is TRUE? -The real growth rate in the long run will be lower than it was before the recession -Inflation expectations in the long run will be the same as before the recession -The rate of inflation in the long run will be higher than it was before the recession -Real GDP in the long run will be the same as before the recession

Inflation expectations in the long run will be the same as before the recession (the economy begins at point "a" before the recession and ends up at point "a" in the long run)

Which statement is TRUE? -There is no difference between the deflation of the Great Depression and the disinflation of the 1980s -A credible disinflation increases the unemployment effects of disinflation -Since World War II, the Fed has slowed down the economy six times -If the AD curve shifts left, the Fed can decrease the money supply to move the AD curve back to the right

Since World War II, the Fed has slowed down the economy six times

What are the two types of agencies?

executive (under control of the President) and independent (does not report to executive branch)

Federal Reserve System

government's bank (manages government borrowing & maintains U. S. Treasury account) & banker's bank (regulates banks, manages nation's payment system & holds commercial bank deposits)

What is something that the Federal Reserve does? -keep accounts for private banks -oversee the Internal Revenue Service -print money to pay federal employee salaries -measure GDP

keep accounts for private banks (The Federal Reserve is a bank for private banks)

In the past _____ issued notes that are used as money. Today _____ issue(s) notes that are used as money. -many banks; just one bank -no banks; one bank -many banks; many more banks -just one bank; a handful of banks

many banks; just one bank (That one bank is the Federal Reserve)

Which statement best describes the Federal Reserve timeframe for monetary policy implementation and observable policy effect? -short implementation time with a long lag before observation of effectiveness -long implementation time with a short lag before observation of effectiveness -short implementation time with a short lag before observation of effectiveness -long implementation time with a long lag before observation of effectiveness -short implementation time with a no lag before observation of effectiveness -long implementation time with a no lag before observation of effectiveness

short implementation time with a long lag before observation of effectiveness

Systemic Risk

the risk that the failure of one financial institution can bring down other institutions as well

Negative interest rates

bank pays Fed to hold reserves