Money and Banking Chapter 18 and 20

What are the biases in the CPI?

Consumers' buying patterns change all the time. There is significant difficulty taking into account improvements in the quality of goods and services included in the CPI.

Countries A and B both have the same money growth rate and in both countries, real output is constant. In Country A velocity is constant while in Country B velocity has fallen. In which country will inflation be higher? Country A or Country B Explain why. The fall in velocity In Country B reflects XXXX in money demand. This XXX the inflationary pressures from the rise in the stock of money.

Country A Increase, Reduces

Explain why we observed a fall in the velocity of M2 during the financial crisis of 2007-2009. The XXXX in uncertainty during the financial crisis drove investors to hold a XXXX portion of their assets in the form of money. XXXX money holding relative to the level of economic activity means that each dollar has to be used XXXX times, XXXX velocity.

Increasing Larger Increased Fewer Lowering

Benefits of a larger balance sheet.

Influences the prices of a variety of securities and it supplies a large volume of high-quality liquid assets

Three good features of monetary policy

It is easily observable by everyone. It is controllable and quickly changed. It is tightly linked to the policymakers' objectives.

In the first half of 1997, the Bank of Thailand maintained a fixed exchange rate of 26 Thai baht to the U.S. dollar, but Thai interest rates were substantially higher than those in the United States and Japan. Thai bankers were borrowing money in Japan and lending it in Thailand. a. Why was this transaction profitable? Bankers could borrow money in XXXX at a low rate, and lend in XXXX b. What risks were associated with this method of financing? There was the risk that the baht could XXXX ,making it more costly to repay the money borrowed in Japan. c. Describe the impact of a depreciation of the baht on the balance sheets of Thai banks involved in these transactions When the baht XXXX the costs to the Thai banks of repaying their loans which caused their reserves to

Japan Thailand Depreciate Depreciated Rose Shirink

Central Bank role in the lending process

Lender of the last resort.. Making loans when on one else can. Will also be the most expensive

Goals of Monetary policy makers

Low and stable inflation High and stable growth A stable financial system Stable interest and exchange rates

Federal Reserve buying of mortgage-backed securities is an example of a targeted asset purchase. Explain how the Fed's actions are intended to work. by purchasing mortgage-backed securities (MBS), the Fed sought to XXXX mortgage rates in order to XXXX home sales, XXXX house prices, and XXXX housing construction.

Lower Increase Raise Promote

what is the equation of exchange?

MV = PV Money Growth + Velocity of Money = Inflation + Real Growth

Assuming the country is open to international capital flows, which of the following combinations of monetary and exchange-rate policies are viable? Option a:. A domestic interest rate as a policy instrument and a floating exchange rate. Option b: A domestic interest rate as a policy instrument and a fixed exchange rate. Option c: The monetary base as a policy instrument and a floating exchange rate.

Options a and c are both viable. They combine independent domestic monetary policy with a floating exchange rate and so are feasible options with international capital mobility.

An important supplementary tool for monetary policy used by the Fed XXX

Overnight reverse repo (ON RRP) rate. Serves to keep the market federal funds rate close to the IOER rate. Can be used to set a floor under the market federal funds rate

Paying interest on reserves allows a central bank to control what?

Price and Quantity of money Price: It can adjust the target range for the federal funds rate and IOER rate without changing the size or composition of its balance sheet Quantity: It can adjust the size and composition of its balance sheet without changing the target range for the federal funds rate or IOER rate

What are the 3 types of of loans that the Fed makes?

Primary Credit Secondary Credit Seasonal Credit

Suppose you see the following newspaper headline: "Japan's Finance Ministry Sells Yen for U.S. Dollars." What is the objective of this policy? If the policy goal is achieved, what will happen to the prices of Japanese imports to the United States? What will happen to the prices of U.S. goods purchased by residents of Japan? The policy intervention by Japanese authorities XXXX the quantity of yen relative to dollars in the foreign exchange market. This XXXX the price of the yen, which is the same thing as of the dollar, which will make Japanese goods XXXX in the U.S. and will make U.S. goods XXXX for Japanese citizens.

Raises Lowers An appreciation Cheaper More Expensive

You need to purchase Japanese yen and have called two brokers to get quotes. The first broker offered you a rate of 125 yen per dollar. The second broker, ignoring market convention, quoted a price of 0.0084 dollars per yen. To which broker should you give your business?

The First Broker

What happens when QE and TAP have vastly expanded the amount of reserves and assets on the central bank's balance sheet?

The central bank may need to sell a large volume of assets to reduce reserve supply sufficiently to raise the policy rate target. QE and TAP are way more difficult to sell, historically

A small Eastern European economy asks your opinion about whether it should pursue the path to joining the European Economic and Monetary Union (EMU) or simply "euroize" (i.e., dollarize by using the euro for all domestic transactions). What advice would you give?

The economy should join the EMU rather than "euroize." Membership in the EMU would give the economy a say in monetary policy decisions and a share in the seignorage revenue from the printing of the euro

4 inputs to the Taylor Rule

The natural rate of interest A measure of inflation A measure of the inflation gap A measure of the output gap

Differences between the ECB's refinancing operations and the Fed's daily open market operations:

The operations are done at all the National Central Banks (NCBs) simultaneously. Hundreds of European banks participate in the ECB's weekly auctions. Because of the differences in financial structure in different countries, the collateral that is accepted in refinancing operations differs from country to country. (The ECB and the NCBs accept tens of thousands of different marketable assets as collateral, including not only government-issued bonds but also privately issued bonds and bank loans.)

Lucas critique

The problem is that when policymakers change the way they make policy, everyone changes the way they act

Consensus of monetary policy makers

The reserve requirement is not useful as an operational instrument Central bank lending is necessary to ensure financial stability Short-term interest rates are the conventional tool to use to stabilize short-term fluctuations in prices and output.

four leading conventional monetary policy tools

The target federal funds rate range The interest rate on excess reserves (IOER rate) The discount rate The reserve requirement

Relationship between velocity of money and cost of holding money

There is a relationship. Using the relationship from the 1980s as a basis for policymaking in the 1990s and thereafter would not have produced the desired result.

Forward guidance

This is when the central bank communicates intentions regarding the future path of monetary policy. This is the simplest of the 3 other unconventional rules for the Taylor Rule To stimulate economic activity, forward guidance aims at lowering the long-term interest rates that affect private spending.

General Situations of the Taylor Rule

When inflation rises above its target level. (The response is to raise interest rates.) When output falls below the target level. (The response is to lower interest rates.) If inflation is currently on target and there is no output gap, (The target federal funds rate should be set at the natural rate of interest plus target inflation.) A 1 percentage point increase in the inflation rate raises the target federal funds rate 1½ percentage points. for each percentage point output is above potential. (Interest rates will go up half a percentage point)

Targeted asset purchases (TAP)

When the central bank alters the mix of assets it holds on its balance sheet in order to change their relative prices in a way that stimulates economic activity. Sift the composition of the balance sheet toward selected assets in order to boost their relative price and stimulate economic activity. This can impact both the cost and availability of credit Most complicated to do out all 3 measures. The impact of TAP is likely to be greater in thin, illiquid markets. To be larger the bigger the difference between the yield on the asset that the central bank buys and the yield on the asset that the central bank sells.

Quantitative easing (QE)

When the central bank supplies aggregate reserves beyond the quantity needed to lower the policy rate to its target (usually zero or lower). At a market federal funds rate equal to the interest on excess reserves, an addition to aggregate reserves no longer reduces the funds rate Very difficult to predict the results An increase in the supply of reserves (QE) may simply lead banks to hold more of them rather than provide additional loans. one of the problems with QE is that if there is uncertainly among the banks, there will now know how much to hold

inflation Targeting

focuses on the objective of low and stable inflation Monetary Policy strategy that involves public announcement of a numerical inflation target and underscores the central bank's commitment to price stability.

Central banks that have a hierarchical mandate with inflation targeting basically are saying:

hitting the inflation target comes first, everything else comes second.

unconventional policy tools

Massive purchases of risky assets in fragile markets Communicating its intent to keep interest rates low over an extended period

Fisher's conclusion on the velocity of money

in the long run, the velocity of money is stable, so that controlling inflation means controlling the growth of the money aggregates.

Why is inflation higher than money growth in high‑inflation countries and lower than money growth in low‑inflation countries? At very high levels of inflation, the velocity of money XXXXX dramatically as people rush to spend their currency before it loses value; this causes inflation to be higher than money growth. Inflation is lower than money growth in low-inflation countries because part of the growth of money is XXXX by economic growth.

Rises Offset

Reserve Requirements

Set in 1935 minimum level of reserves banks must hold either as vault cash or on deposit at the Fed.

How is the price of Money determined?

Supply and Demand

Why would a bank seek secondary Credit?

Temporary short fall of reserves They cannot find any lending from anyone else

Secondary Credit

available to institutions that are not sufficiently sound to qualify for primary credit.

Reserve demand becomes horizontal at the IOER rate because:

banks will not make loans at less than the IOER rate.

How are target rates set?

by the FOMC and the market federal funds rate, at which transactions between banks take place.

The reserve requirement does not meet all of the criteria of a good monetary policy tool, because it:

cannot be quickly changed.

The Fed can _____ in the economy.

change both interest rates and the supply of money

steady the financial system and the economy after the crisis, the Fed utilized its three of its XXX

conventional policy tools

quantitative easing

making large-scale asset purchases to increase the supply of reserves far beyond the level needed to keep the federal funds rate near zero

What is the quantity theory of money and what does it tell us?

money growth translates directly into inflation It tells us why high inflation and high money growth go together It explains the tendency for moderate- and low-inflation countries to fall below the 45-degree line

What is the Federal funds rate?

overnight lending rate.

Hierarchical mandate

price stability comes first and everything else comes second

What are the three Conventional policy tools?

The target range for the federal funds rate The interest rate on excess reserves (IOER rate) The rate for discount window lending

If velocity were constant at 2 while M2 rose from $6 trillion to $9 trillion in a single year, what would happen to nominal GDP? Nominal GDP would rise by: XXXX If real GDP rose 2 percent, what would be the level of inflation? Inflation would equal: XXXX

50% 48%

Typical time frame to man an effective interest rate

6 - 8 weeks

two criteria for the use of money growth as a direct monetary policy target

A stable link between the monetary base and the quantity of money A predictable relationship between the quantity of money and inflation.

European Central bank "tool kit"

An overnight interbank rate (equivalent to the federal funds rate) A rate at which the central banks lends to commercial banks (equivalent to the discount rate) A reserve deposit rate (equivalent to the IOER) A reserve requirement

In 2002, the Federal Reserve changed its discount lending procedures. Which of the following statements is correct?

Before 2002 the Fed discouraged banks from borrowing and actually created volatility in the market for reserves.

ECB Deposite rate facility

Banks with excess reserves at the end of the day can deposit them overnight in the at a interest rate substantially below the target-refinancing rate. Rate is set by the ECB Governing council deposit facility places a floor under the market interest rate charged on loans made by the banks

Check my work Check My Work button is now disabled1Item 6 Item 6 10 points Which of the following factors would increase the transactions demand for money? Option i: Lower nominal interest rates Option ii: A fall in nominal income Option iii: Rumors that a computer virus had invaded the ATM network

Both options i and iii would increase the transactions demand for money. Lower nominal interest rates would reduce the opportunity cost of holding money, while a computer virus in the ATM network would lead to worries about the system closing down. Both of these factors will increase the transactions demand for money.

Describe the impact of financial innovations on the demand for money and velocity. Financial innovations XXXX the demand for money and XXXX velocity

Reduce Increase

Suppose that, driven by waves of national pride, consumers across the world (including in the United States), decide to buy home-produced products where possible. Explain how the demand and supply curves for dollars be affected? A fall in foreign demand for U.S. goods would shift the XXX curve for dollars to the XXXX while the fall in U.S. demand for foreign goods would shift the XXXX curve for dollars to the XXXX What can you say about the impact on the equilibrium dollar exchange rate? As the economy of the world outside the U.S. is larger than the U.S. economy, you might expect the XXXX shift to dominate, leading to XXXX of the dolar

Demand Left Supply Left Demand A Depreciation

Refer to the diagram below and explain how the central bank could use its control over the quantity of money to target a particular level of interest rate in the face of changes in velocity. Suppose there is a fall in velocity and so the money XXXX curve shifts to the XXX. The central bank could XXXX the stock of money in the economy to shift the money XXXX curve to the XXXX and restore the target interest rate.

Demand Right Increase Supply Right

Suppose the interest rate on a one-year U.S. bond were 10 percent and the interest rate on an equivalent Canadian bond were 8 percent. If the interest-rate parity condition holds, is the U.S. dollar expected to appreciate or depreciate relative to the Canadian dollar over the next year? You would expect the U.S. dollar to XXXX Explain your choice. If the interest parity condition holds, the return on the two bonds should be XXXX. or this to happen, given the interest rates on the two bonds, the holder of the Canadian bond must XXX or this to happen, given the interest rates on the two bonds, the holder of the Canadian bond must

Depreciate Equal Gain

European System of Reserve requirements

Designed to give the ECB tight control over short term money. Typically works well

Assuming steady demand, and an increase in the money supply, what would that due to the price of money?

Drives the price of money down (Inflation)

Costs of holding a larger balance sheet

Exposes the central bank to interest-rate and credit risk May displace private intermediaries and make the allocation of capital less efficient Threat to central bank independence

Explain how money growth reduces the purchasing power of money. By increasing the supply of money, holding demand for money constant, the value of each dollar relative to goods and services in the economy will XXXX. The price of money in terms of goods and services has XXXX

Fall Fallen

ECB's marginal lending facility equivalent to the FED

Fed's primary credit facility ECB offers loans that are way above the Target - Refinancing rate

Normal income proportion to money demand

Nominal income is roughly proportional to money demand

If the market federal funds rate were below the target rate, the response from the Fed would likely be to:

sell U.S. Treasury securities.

How is the secondary discount rate set?

set above the primary discount rate due to the riskiness of the loan

minimum bid rate by the ECB

set by the Governing Council as the minimum interest rate accepted at these refinancing auctions

What is the interest rate set on Primary Credit

spread above the IOER rate called the primary discount rate.

Velocity Stability

table in the long-run but not in the short-run.

What does the equation of exchange tell us?

that the quantity of money multiplied by its velocity equals the level of nominal GDP.

overnight cash rate

the European analog to the market federal funds rate

Zero lower bound

the idea that a nominal interest rate cannot fall below zero

Effective lower bound

the nominal interest rate level below which intermediaries and their customers will switch from bank deposits to holding cash.

velocity of money

the number of times each dollar is used. More frequently each dollar is used, the higher the velocity of money.

natural rate of interest

the real short-term interest rate that prevails when the economy is using resources normally. - Taylor rule originally used to be 2%

what is the opportunity cost for M2?

the yield on three-month U.S. Treasury bill minus the return on holding M2.

Taylor Rule

tracks the actual behavior of the target federal funds rate and relates it to the real interest rate, inflation, and output. Natural rate of interest + Current inflation + ½ (Inflation gap) + ½ (Output gap)

Federal funds loans are:

unsecured loans.

Repurchase of agreements (repo)

which ECB, through the National Central Banks, provided reserves to banks in exchange for securities, and then reversed the transaction up to three weeks later.

precautionary demand for money

holding money to insure ourselves against unexpected expenses. Rises with Risks

Which of the following factors would increase the portfolio demand for money? Option i: A financial crisis is looming Option ii: You expect future interest rates to rise Option iii: A new website allows you to liquidate your stock holdings quickly and cheaply

Both options i and ii would increase the portfolio demand for money. If future interest rates are expected to rise, bond prices will fall, making money relatively more attractive. The prospect of a financial crisis will increase the relative riskiness of alternative assets, thus increasing the portfolio demand for money.

Consider a country where the level of excess reserves fluctuates widely and unpredictably. Would such a country be a good candidate for a money growth rule to guide monetary policy? Yes. No. Explain your answer.

No To be effective at controlling inflation, a money growth rule requires a stable link between the monetary base and monetary aggregates, such as M1 and M2. This would not be the case here, since the volatile reserve-deposit ratio would cause fluctuations in the money multiplier.

What caused the instability of money demand over these three decades?

One reason has to do with the introduction of financial instruments that paid higher returns than money, but could still be used as a means of payment. A second explanation has to do with changes in mortgage refinancing rates.

How might the Federal Reserve exit from the unconventional policies it employed during the financial crisis of 2007-2009 without causing inflationary problems?

The Fed could tighten monetary policy without selling assets by raising the deposit rate it pays on reserves. As the deposit rate sets a floor to the market funds rate, the fed funds rate would rise to this level even if reserve supply is unchanged.

The central bank of a country facing economic and financial market difficulties asks for your advice. The bank cut its policy interest rate to the effective lower bound, but it wasn't enough to stabilize the economy. Drawing on the actions taken by the Federal Reserve during the financial crisis of 2007-2009, what might you advise this central bank to do?

You should advise the central bank to use unconventional monetary policy tools such as quantitative easing, where aggregate reserves are provided beyond the level needed to lower the policy rate to zero, or credit easing, a policy in which the central bank alters the composition of its balance sheet. The central bank could also inform markets of its commitment to keep interest rates low (forward guidance).

Primary Credit

extended on a very short-term basis, usually overnight, to institutions that the Fed's bank supervisors deem to be sound.

Suppose that the Chinese central bank has been intervening in the foreign exchange market, buying U.S. dollars in an effort to keep its own currency, the yuan, weak. If China decided to allow the yuan to float freely, what would you expect to happen to each of the following? U.S. exports to China would XXXX b. U.S. imports from China would XXXX c. The U.S. trade deficit with China would XXXX

increase decrease narrow

discount lending

lending by the Federal Reserve Banks to commercial banks. Usually small lending not including financial recession

Seasonal Credit

used primarily by small agricultural banks in the Midwest to help in managing the cyclical nature of farmers' loans and deposits. In recent years, there has been a push to remove this credit as it is easier to access money from larger commercial banks

Dual mandate

which the goal of price stability and maximum employment are equal. This is the current strategy that the FED Employes