072 - Chapter 72 - The Central Bank & Monetary Policy

President James Garfield said:

'He who controls the money supply of a nation controls the nation.' Very similar to the quote below: The actual quote which is attributed to Mayer Amschel Rothschild is: "Permit me to issue and control the money of a nation, and I care not who makes its laws!"

A money market account at the bank offers a 4% nominal interest rate, while inflation is expected to be 3%. What is the real interest rate for this account?

1% {Explanation - The real interest rate here is 4% - 3% = 1%.}

If a country has a money supply of 20 billion dollars, a real GDP of 100 billion dollars, and a price level of 1, then what's the velocity of money in this country?

5 {Explanation - Using the formula, you get 20 billion * V = 1 * 100 billion. Solving for V, you get V = 5.}

In the country of Athenia, banks charge 10% interest on all loans. If the general price level has been increasing at a rate of 2% per year, what is the real rate of interest in Athenia?

8% {Explanation - Subtracting the inflation percentage, you get 10% - 2% = 8%.}

The real interest rate for a consumer loan is 5%, and the expected inflation rate is 3%. What is the nominal interest rate on this consumer loan?

8% {Explanation - To find the nominal rate, you add the inflation to the real interest rate. You get 5% + 3% = 8%.}

How would economists graphically illustrate a decrease in the money supply?

A leftward shift of the vertical money supply curve. {Explanation - A decrease in the supply of money by the Federal Reserve, or contractionary monetary policy, occurs when the Fed decreases the money supply by selling U.S. bonds. Some of the cash that was in the money market is removed, and the market reaches a new equilibrium at a higher interest rate. Economists show this as a leftward shift of aggregate demand.}

What's hyperinflation?

A rise in prices exceeding 50% per month. {Explanation - Hyperinflation is a rise in prices exceeding 50% per month.}

If the Federal Reserve suddenly decreases the growth rate of the money supply from 6% to 4% per year, what is likely to happen to aggregate demand and real Gross Domestic Product in the short-run?

Aggregate demand will decrease and real GDP will decline. {Explanation - A decrease in the supply of money by the Federal Reserve, or contractionary monetary policy, will cause an increase in interest rates. This increase in interest rate will reduce investments and borrowing, which in turn leads to a lower level of real GDP and a leftward shift of aggregate demand.}

The Federal Reserve achieves its monetary goals by doing which of the following?

Controlling the money supply and interest rates {Explanation - By controlling the amount of money in circulation, as well as interest rates, the Fed is able to achieve its goals.}

Which of the following is FALSE regarding the Federal Reserve?

FALSE: It issues debit cards. {Explanation - The Federal Reserve does all of the following, except issue debit card. It is NOT a bank for individual use.}

Which of the following is FALSE regarding real interest rates?

FALSE: Real interest rates are determined in the money market (THIS IS NOT TRUE) {Explanation - The false statement here is the one about interest rates being determined by the money market.}

The Fed is responsible for:

Holding deposits of banks Acting as the lender of last resort to commercial banks Regulating the money supply Supervising the banking system Providing check-clearing services

Which of the following is an INACCURATE description of The Federal Reserve?

INACCURATE: It is the US mint. (IT IS NOT THE US MINT!) {Explanation - The Federal Reserve is different from the US Mint. The Mint is a federal agency, which actually prints money. The Federal Reserve was created by Congress in order to create stability in the financial system.}

money supply is the foundation of an economy

In order to achieve the three objectives of maximum employment, price stability and moderate interest rates, the Fed controls the money supply, and the money supply changes the interest rate.

Why does the Federal Reserve require commercial banks to maintain reserves with them?

It gives the Federal Reserve more control over the money supply and interest rates. {Explanation - One of the ways the Fed gets control over the money supply and is able to control interest rates is by having banks keep some of their money at the bank. This is why the Fed is also called The Banker's Banks.}

How does an increase in the money supply impact economic output within the US economy?

Lower interest rates encourage additional borrowing and investment, leading to higher aggregate demand. {Explanation - An increase in the money supply occurs when the Fed buys U.S. government bonds and pays with cash. The interest rate falls, which leads to an increase in investments and borrowing, along with an increase in real GDP and higher aggregate demand.}

What are some of the objectives of the Fed?

Maximize employment, stabilize prices, and moderate interest rates {Explanation - The Fed wants to make sure there that people are employed, prices are stable, and that there are moderate interest rates, which encourage sustainable output.}

Quantity Equation Formulas

Nominal GDP = M * V In English, this means that economic output (which is Gross Domestic Product) is equal to how big the money supply is - that's the M - multiplied by the velocity of money, which is how many times the same dollar gets spent throughout the year, and that's the V.

If all other factors remain equal, what would happen to interest rates when the amount of money circulating in the economy is increased?

The interest rate would decline. {Explanation - An increase in the supply of money by the Federal Reserve, or expansionary monetary policy, occurs when the Fed increases the money supply by using U.S. government bonds and paying with cash. When the money supply increases, the money market reaches a new equilibrium at a lower interest rate. The lower interest rate leads to an increase in investment and an increase in real GDP.}

How can government overspending cause hyperinflation?

To cover the costs of the overspending, the government borrows from a central bank, which causes the money supply to rise, making the money worth less. {Explanation - When a government overspends, it must borrow from a central bank to make up the difference, leading to a rapid rise in the money supply.}

The Fed's monetary policy has the greatest positive effect on real Gross Domestic Product under what set of conditions?

When interest rates are low and the interest rate has a large effect on investment spending. {Explanation - The Fed's monetary policy has the greatest effect on real GDP when interest rates are low and when investments are highly sensitive to interest rates. Low-interest rates create an incentive for businesses to borrow and invest. This new investment will then lead to economic growth.}

money supply

a stock of safe assets that households and businesses can use to make payments or to hold as short-term investments

quantity theory of money

a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate

M * V = P * Y

in English, this means that the money supply times the velocity of money is equal to the price level times real GDP.

hyperinflation

inflation that is out of control; a rise in prices exceeding 50% per month; a country's currency can quickly lose most of its value until it becomes nearly worthless

three main objectives of the Fed

maximum employment, price stability, and moderate interest rates through control of the money supply, and the money supply changes the interest rate

expansionary monetary policy

monetary policy that increases aggregate demand; An increase in the supply of money by the Federal Reserve; An increase in the money supply leads to a lower interest rate, higher levels of investment, and greater economic output

contractionary monetary policy

monetary policy that reduces aggregate demand (tight money policy)

Federal Reserve Notes

paper currency issued by the Fed that eventually replaced all other types of federal currency

Economists use the _____ to explain the link between inflation and the money supply.

quantity theory of money {Explanation - In order to explain the link between inflation and the money supply, economists use what's called the quantity theory of money.}

In order to adjust a nominal interest rate for inflation, which of the following formula should be used?

r = n - i {Explanation - Adjusting a nominal interest rate for inflation involves subtracting the inflation percentage from the nominal interest rate.}

Fisher equation

real interest rate = nominal interest rate - inflation rate

The Federal Reserve (called the Fed for short)

the central bank of the United States. Founded in 1913 by an act of Congress called the Federal Reserve Act, it's considered the government's bank as well as the banker's bank

Hyperinflation is usually associated with:

the growth rate of the money supply {Explanation - In the long run, inflation is determined by the growth rate of the money supply.}

nominal interest rate

the interest rate as usually reported without a correction for the effects of inflation; the interest rate in terms of dollars, so it's not adjusted for inflation

real interest rate

the interest rate corrected for the effects of inflation; the rate of interest after adjusting for inflation