STUDY MACRO

Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp rise in the inflation rate. What change in the Federal funds rate would you recommend? How would your recommended change get accomplished? What impact would the action shave on the lending ability of the banking system, the real interest rate, investment spending, aggregate demand, and inflation?

:To reduce inflation, the Federal funds rate should be raised. This would be accomplished typically through open-market operations (selling bonds), but could also be achieved with an increase in the reserve ratio or discount rate.The restrictive monetary policy would reduce the lending ability of the banking system, increase the real interest rate, reduce investment spending, reduce aggregate demand, and reduce inflation

Explain the links between changes in the nation's money supply, the interest rate, investment spending,aggregate demand, real GDP, and the price level.

A change in the nation's money supply (achieved by changing reserves in the banking system) will cause an opposite change in the interest rate. A reduction in the money supply will make funds increasingly scarce and drive up their price (interest rate). The interest rate and investment spending are also inversely related. A rising interest rate will make some investments (capital spending projects) unprofitable, so spending on those will decline. Investment spending is part of aggregate demand, so they will move together, as will real GDP. A decline in spending (AD) will reduce inflationary pressure (and will reduce prices if they are downwardly flexible).

What do the distinctions between short-run aggregate supply and long-run aggregate supply have in common with the distinction between the short-run Phillips curve and the long-run Phillips curve? Explain.

In a short-run aggregate supply, nominal wages are set (unresponsive to price-level changes) based on the expectation that price level will continue, whereas in the long-run aggregate supply, a rise in price level results in higher nominal wages and shifts the short-run aggregate supply curve to the left (and vice versa). In the short-run Phillips Curve, you assume nominal wages have been set (like the short-run aggregate supply), and you assume that inflation will continue such that it has, and that higher product prices raise business profits. In the long-run Phillips Curve, there is no apparent long-run tradeoff between inflation and unemployment; thus, both the long-run aggregate supply and the long-run Phillips curve are uniform

Which of the following Fed actions will increase bank lending?

The Fed lowers the discount rate from 4 percent to 2 percent.

Distinguish between the Federal funds rate and the prime interest rate. Why is one higher than the other?Why do changes in the two rates closely track one another?

The Federal funds interest rate is the interest rate banks charge one another on overnight loans needed to meet the reserve requirement. The prime interest rate is the interest rate banks charge on loans to their most creditworthy customers. The Federal funds rate is lower than the prime interest rate for a number of reasons. Federal funds are loaned overnight, so lenders don't have to wait long for repayment. The reserves loaned would otherwise generate no interest, so even loaning at the lower Federal funds rate is beneficial to lenders. Interest rates also depend on risk. It is less risky to lend overnight to other banks than it is to lend for longer periods to non-bank businesses and households.Both rates are related to the relative scarcity or availability of reserves. If there are less reserves available for lending, the price to borrow those reserves (the interest rate) will rise whether the customers are banks, businesses, or households.

money supply (M1)

currency held by the public, plus balances in transactions accounts Cash, Checking Accounts Traveler checks.

151 Use commercial bank and Federal Reserve Bank balance sheets to demonstrate the impact of each of the following transactions on commercial bank reserves: (a) Federal Reserve Banks purchase securities from private businesses and consumers. (b) Commercial banks borrow from the Federal Reserve Banks. (c) The Board of Governors reduces the reserve ratio.

in the tables below, columns "a" through "c" show the changes caused by the answers to the questions. It is assumed the initial reserve ratio is 20 percent. Thus, as the first column shows, the commercial banks are initially completely loaned up. The answers are not cumulated: We return to the first column each time to show the resulting change in column a, b, or c. If you would rather not use numbers, it would be acceptable to substitute with + or - signs, using symbols to represent numbers. For example, part (a) could read "the Fed purchases Ôx dollars' worth of securities," and instead of the $2 billion changes on the balance sheet, you would indicate + x . (a) It is assumed the Fed buys $2 billion worth of securities. This increases demand deposits and commercial bank reserves by $2 billion. With demand deposits of $202 billion, required reserves are $40.4 billion, (= 20 percent of $202 billion). Therefore, excess reserves are $1.6 billion (= $42 billion $40.4 billion) and the banking system can increase the money supply (by making loans) by $8 billion more (= $1.6 billion x 5). (b) It is assumed the commercial banks borrow $1 billion from the Fed. The commercial banks may now increase the money supply (through making loans) by $5 billion (= $1 billion x 5). (c) Changing the reserve ratio, in itself, does not change the balance sheets. However, if we assume the reserve ratio has been decreased from 20 percent to 19 percent, required reserves are now $38 billion (= 19 percent of $200 billion) and the commercial banks can now increase the money supply (through making loans) by $10.53 billion [= $2 billion x (1/0.19)]. Proof: 19 percent of $210.53 billion is $40 billion.