Macroeconomics - FTC1(ch11-18) - additional textbook questions for review

What is a bank's balancing act?

A bank makes a profit by borrowing from depositors at a low interest rate and lending at a higher interest rate. The bank must hold enough reserves to meet depositors' withdrawals. The bank's balancing act is to balance the risk of loans (profits for stockholders) against the security for depositors.

Explain how the Fed's actions change aggregate demand and real GDP.

A lower real interest rate (and exchange rate) and greater quantity of money and loanable funds increase aggregate expenditure and the AD curve shifts to AD0 + ΔE. A multiplier effect increases aggregate demand and the AD curve shifts to AD1. Real GDP increases and recession is avoided

If the​ deficit-reduction plan includes a cut in transfer payments and a rise in taxes of the same​ amount, the policy will​ ______ the budget deficit and​ ______ real GDP.

Answer: decrease; decrease The government budget balance equals tax revenues minus outlays. Transfer payments are a government outlay. When transfer payments decrease and taxes​ increase, the government budget deficit decreases. A decrease in transfer payments decreases aggregate demand and a rise in taxes decreases aggregate demand. And a decrease in aggregate demand decreases real GDP.

The United States is at full employment. Suppose that union wage settlement push the money wage upward by 10%. What is the effect of this event on Aggregate Supply?

Anything that increases potential GDP increases Aggregate Supply and shifts AS curve rightward.

How do banks create new deposits by making loans, and what factors limit the amount of deposits and loans that they can create?

Banks can make loans when they have excess reserves. When a bank makes a loan, it creates a new deposit for the person who receives the loan. The amount of deposits created (loans made) is limited by the banks' excess reserves, its desired reserve ratio, and the currency drain ratio.

What is core inflation and how does it differ from total PCE inflation?

Core inflation excludes the changes in the prices of food and fuel. The total PCE inflation rate includes the changes in all consumer prices. The core inflation rate fluctuates less than the total PCE inflation rate.

The required reserve ratio in the United States​ ______, which is​ ______ than the required reserve ratio in China on May​ 15, 2007. (from the news clip - it was 21% in China)

Currently the required reserve ratios in the United States range from zero to 3 percent on checkable deposits below a specified​ level, to 10 percent on deposits in excess of the specified level. This is much lower than the required reserve ratios of 21 percent to 21.5 percent in China.

A bank's deposits and assets are $320 in checkable deposits, $896 in savings deposits, $840 in small time deposits, $990 in loans to businesses, $400 in outstanding credit card balances, $634 in government securities, $2 in currency, and $30 in its reserve account at the Fed. Calculate the bank's loans, securities, and reserves.

Loans are $990 + $400 = $1,390. Securities are $634. Reserves are $30 + $2 = $32.

During the fourth quarter of 2008, the Fed doubled the monetary base but the quantity of money (M2) increased by only 5 percent. Why did M2 not increase by much more than 5 percent? What would have happened to the quantity of M2 if the Fed had kept the monetary base constant?

M2 equals the money multiplier, (1 + C/D)/(R/D + C/D), multiplied by the monetary base. (R/D is the banks' desired reserve ratio and C/D is the currency drain ratio). M2 didn't increase by more because the banks increased their desired reserve ratio, R/D, which decreased the money multiplier. If the Fed had kept the monetary base unchanged, M2 would have decreased because the money multiplier decreased.

Why does the Fed not target the quantity of money?

The Fed does not target the quantity of money because it believes that the demand for money is too unstable and fluctuations in demand would bring unwanted fluctuations in interest rates, aggregate demand, real GDP, and the inflation rate.

What are the three alternative monetary policy strategies that the Fed could have adopted and why is discretionary monetary policy not one of them?

The Fed could have adopted three alternative monetary policy strategies: an inflation targeting rule, a k-percent money targeting rule, and a nominal GDP targeting rule. A rule-based monetary policy beats discretionary monetary policy because it provides a more secure anchor for inflation expectations, which in turn makes long-term contracts in labor and capital markets more efficient.

The economy has slipped into recession and the Fed takes actions to lessen its severity. What action does the Fed take? Illustrate the effects of the Fed's actions in the money market and the loanable funds market.

The Fed lowers the federal funds rate, which lowers the short-term interest rate, and increases the supply of money (Figure 1). The supply of loans and the supply of loanable funds increase. The real interest rate falls.

If the Fed makes an open market sale of $1 million of securities, who can buy the securities? What initial changes occur if the Fed sells to a bank?

The Fed sells securities to banks or the public, but not the government. The initial change is a decrease in the monetary base of $1 million. Ownership of the securities passes from the Fed to the bank, and the Fed's assets decrease by $1 million. The bank pays for the securities by decreasing its reserves at the Fed by $1 million. The Fed's liabilities decrease by $1 million. The bank's total assets are unchanged, but it has $1 million less in reserves and $1 million more in securities.

Who is the Fed's chief executive, and what are the Fed's main policy tools?

The Fed's chief executive is the Chairman of the Board of Governors, currently Ben Bernanke. The Fed's main policy tools are required reserve ratios, the discount rate, and open market operations. In unusual times, extraordinary crisis measures are an additional tool.

What is the Fed and what is the FOMC?

The Federal Reserve (Fed) is the U.S. central bank—a public authority that provides banking services to banks and the U.S. government and that regulates the quantity of money and the banking system. The FOMC is the Federal Open Market Committee—the Fed's main policy-making committee.

Which countries practice inflation targeting? How does this monetary policy strategy work and does it achieve a lower inflation rate?

The countries that practice inflation targeting are the United Kingdom, Canada, Australia, New Zealand, Sweden, and the European countries that use the euro. Inflation targeting works by announcing a target inflation rate, setting the overnight interest rate (equivalent to the federal funds rate) to achieve the target, and publishing reports that explain how and why the central bank believes that its current policy actions will achieve its ultimate policy goals. Eurozone and New Zealand have missed their inflation targets, but the other inflation targeters have achieved their goals.

What is the Fed's monetary policy instrument and what influences the level at which the Fed sets it?

The federal funds rate is the Fed's monetary policy instrument and the inflation rate and output gap are two of the influences on the level at which the Fed sets the federal funds rate.

What are the institutions that make up the banking system?

The institutions that make up the banking system are the Fed, commercial banks, thrift institutions, and money market funds.

What is the monetary base?

The monetary base is the sum of coins, Federal Reserve notes (dollar bills), and banks' reserves at the Fed.

When the Fed increased the monetary base between 2008 and​ 2011, the component that increased most was​ ______. The reserves that the banks borrow from the Fed​ ______.

The monetary base more than doubled but currency holdings barely​ changed, so bank reserves were the only component of the monetary base to increase. Borrowed reserves temporarily skyrocketed but eventually returned to an amount close to zero. Correct Answer: banks' reserves; increased initially and then returned to an amount close to zero

What are the objectives of U.S. monetary policy?

The objectives of U.S. monetary policy are to achieve stable prices (interpreted as a core inflation rate of about 2 percent per year) and maximum employment (interpreted as full employment).

What are the Fed's policy tools?

The required reserve ratio, discount rate, open market operations, and extraordinary crisis measures

Suppose that at the end of December 2009, the monetary base in the United States was $700 billion, Federal Reserve notes were $650 billion, and banks' reserves at the Fed were $20 billion. Calculate the quantity of coins.

To calculate the quantity of coins, we use the definition of the monetary base: coins plus Federal Reserve notes plus banks' reserves at the Fed. Quantity of coins = Monetary base − Federal Reserve notes − Banks' reserves at the Fed. So at the end of December 2009, Quantity of coins = $700 billion − $650 billion − $20 billion = $30 billion.

The Fed's most important tasks?

To influence the interest rate and regulate the amount of money circulating in the United States

A bank's deposits and assets are $320 in checkable deposits, $896 in savings deposits, $840 in small time deposits, $990 in loans to businesses, $400 in outstanding credit card balances, $634 in government securities, $2 in currency, and $30 in its reserve account at the Fed. Calculate the bank's total deposits, deposits that are part of M1, and deposits that are part of M2.

Total deposits are $320 + $896 + $840 = $2,056. Deposits that are part of M1 are checkable deposits, $320. Deposits that are part of M2 include all deposits, $2,056.

List the sequence of events in the transmission from a rise in the federal funds rate to a change in the inflation rate.

When the Fed raises the federal funds rate, other short-term interest rates rise and the exchange rate rises; the quantity of money and supply of loanable funds decrease and the long-term real interest rate rises; consumption, investment, and net exports decrease; aggregate demand decreases; and eventually the real GDP growth rate and the inflation rate decrease.

If the Fed makes an open market sale of $1 million of securities, what is the process by which the quantity of money changes? What factors determine the change in the quantity of money?

When the Fed sells securities to a bank, the bank's reserves decrease by $1 million. The bank's deposits do not change, so the bank is short of reserves. The bank calls in loans and deposits decrease by the same amount. The desired reserve ratio and the currency drain ratio determine the decrease in the quantity of money. The larger the desired reserve ratio or the currency drain ratio, the smaller is the decrease in the quantity of money.

Pam buys​ $1,000 worth of American Express​ traveler's checks and charges the purchase to her American Expresscharges the purchase to her American Express cardcard. The immediate effect on M1 and M2 is​ ______.

both M1 and M2 increase by $1,000 (note: because M1 is a part of M2)

Along an aggregate supply curve, the money wage rate is fixed. So when the price level rises...

the real wage rate falls, and a fall in the real wage rate increases the quantity of labor employed and increases the quantity of real GDP supplied.