ECON CH 10

The Fed acts as a

"lender of last resort"

What are the three traditional tools with which the fed can change the size of the money supply?

1

What are the three main sources of demand for borrowed money?

1. Investors 2. Consumers 3. Governments

What are the 4 ways the fed can change the money supply?

1. Open Market Operations (Buying/Selling bonds) 2. Change the Discount Rate 3. Change the Required Ratio Rate 4. Quantitative Easing

Bank regulation basics:

1. Required Reserves 2. Bank Capital (Min. nw as a % of assets) 3. Deposit Insurance 4. Bank Supervision (Loans Risky?)

Why might the Fed want to change the size of the money supply AKA ( How monetary policy affects the business cycle)

1. The Demand for Loanable Funds

How many federal reserve districts are there?

12

Price of Oil rises suddenly & significantly Draw the effect BEFORE fed action

> SRAS shift left

What is a bank run?

A bank run is when a bank's depositors rush to withdraw their funds from the bank. As you know, most of a bank's deposits have been loaned out, and only a fraction of them are on reserve. So even if the bank is healthy, it will not be able to pay all of its depositors at once. This can lead to a banking panic, as fear causes bank runs on other banks. Reserves flow out of the banking system and the money supply collapses.

What would be the effect of increasing the reserve requirements of banks on the money supply?

An increase in reserve requirements would reduce the supply of money, because excess reserves will fall and the money multiplier will be smaller.

In a program of deposit insurance as it is operated in the United States, what is being insured and who pays the insurance premiums

As the name implies, deposit insurance insures deposits. The intent is to prevent bank runs. Even if a bank fails, its depositors will receive their money because of the insurance. Banks pay the insurance premiums.

The fed only supervises __________ __________ ____________ (Companies that own several banks) Other banks are supervised by the _________ ___ __ ________

Bank Holding Companies comptroller of the currency

In government programs of bank supervision, what is being supervised?

Banks' balance sheets are being supervised. The supervisors want to make sure that the banks' loans are not too risky and that they each have a positive net worth.

Max Potential change in the money supply is =

Change in excess reserves * (1/R)

Three things fed can do to manipulate the money supply

Change the discount rate Change the required reserve ratio Sell (dec)/ Buy Bonds (inc excess reserves)

Explain how contractionary monetary policy works. What effect should it have on equilibrium real GDP and the price level?

Contractionary monetary policy decreases the money supply. All else equal, that will increase interest rates. All else equal, higher interest rates should decrease investment and consumption. That, in turn, will decrease aggregate demand. Lower aggregate demand will decrease both equilibrium real GDP and the price level.

Why does contractionary monetary policy cause interest rates to rise?

Contractionary policy reduces the supply of loanable funds in the economy. A lower supply leads to a higher interest rate.

The term "moral hazard" describes increases in risky behavior resulting from efforts to make that behavior safer. How does the concept of moral hazard apply to deposit insurance and other bank regulations?

Deposit insurance is intended to make the banking system safer by preventing bank runs. But if a bank knows that deposit insurance will cover its deposits if it goes broke, it may be tempted to take excessive risks in the hope of making large profits. If the risks pay off, it makes a lot of money; if the risks cause it to fail, somebody else pays to clean up the mess. Thus, the deposit insurance might cause banks to take more risks, which makes the banking system less safe.

When bank runs occur what happens to deposits, reserves & In turn the money supply?

Deposits and reserves shrink SO The money supply shrinks

How do expansionary and contractionary monetary policies affect the quantity of money?

Expansionary monetary policy increases the money supply. Contractionary monetary policy reduces the money supply.

Explain how expansionary monetary policy works. What effect should it have on equilibrium real GDP and the price level?

Expansionary monetary policy increases the money supply. All else equal, that will reduce interest rates. All else equal, lower interest rates should increase investment and consumption. That, in turn, will increase aggregate demand. Higher aggregate demand will increase both equilibrium real GDP and the price level.

Why does expansionary monetary policy causes interest rates to drop?

Expansionary policy increases the supply of loanable funds in the economy. A higher supply leads to a lower interest rate

What effect does contractionary monetary policy have on equilibrium? Draw it, what happens?

I goes up, Q goes down.

What is the lender of last resort?

In the U.S., the Federal Reserve is the lender of last resort. In a bank run, even a healthy bank will lack the funds to pay all of its depositors at once. The Federal Reserve will step in and loan the bank all the funds it needs to pay its depositors.

Suppose: the Fed wants to reduce the amount of funds available to loan. It will act to reduce excess reserves. It can do so by:

Increase discount rate Selling Bonds Increase required reserve rate ratio

Recall the relationship between interest and investment. What happens to the lines when there is pessimistic expectations

Investment shifts left, int rates fall

Of the three main sources of demand for borrowed money, which two are sensitive to changes in interest rates?

Investors and Consumers

Which Federal Reserve district includes Iowa?

Iowa is in district seven; its Federal Reserve Bank is in Chicago.

The current chair of the fed is

Jerome Powell

Why is it important for the members of the Board of Governors of the Federal Reserve to have longer terms in office than elected officials, like the President?

Longer terms insulate the Board from political forces. The Federal Reserve's independence prevents drastic swings in monetary policy with every new administration and allows policy decisions to be made only on economic grounds

Fighting an overheated economy - if AD is too high and rising, there will be inflation. Monetary policy can be used to control AD - Draw it The economy is operating beyond its long run potential. This is not sustainable and will lead to rising prices because resources are in excess demand

MS down -> i goes up -> C down , I down, AD down

Counter Cyclical Monetary Policy - Draw it after fed action of exp. monetary policy

MS goes up -> I goes down -> C goes up I goes up -> AD goes up Y goes up, P goes up, Employment goes up, Unemployment goes down

Contractionary Monetary Policy effect on AD

M^s goes down, I goes up -> C goes down, I goes down, -> AD goes down

How is bank regulation linked to the conduct of monetary policy?

Monetary policy involves control over the money supply. Banks play a key role in the money creation process. If the banking system fails, monetary policy is not possible.

Credit unions are supervised by the

National Credit Union Administration

Suppose we are at point A theres is a recession Ordinarily; The fed would rely on traditional expansionary monetary policy Ms goes up -> i goes down -> C and I goes up -> AD goes up But what can be done if the rate of interest (i) is at zero? What can the fed do ?

Negative interest rates are not realistic Banks will not pay people to borrow money SOOOO How CAN the fed boost AD? The traditional tools CANT work TbC 09/13

Counter Cyclical Monetary Policy - Draw it before fed action

Note that the economy is well below full employment.

Draw the supply for loanable funds

Notice the slope of the supply line.

Given the danger of bank runs, why do banks not keep the majority of deposits on hand to meet the demands of depositors?

On most days deposits and withdrawals are roughly balanced. Banks make their money from issuing loans and charging interest. The more money that is stored in the bank's vault, the less is available for lending and the less money the bank stands to make.

Explain what would happen if banks were notified they had to increase their required reserves by one percentage point from, say, 9% to10% of deposits. What would their options be to come up with the cash?

One option is that when loans the banks have made are repaid, the banks keep the funds as reserves rather than loaning them out again. Another option is for the banks to sell bonds that they own and use the proceeds to increase reserves. Either way, the money supply will fall

Which kind of monetary policy would you expect in response to high inflation: expansionary or contractionary? Why?

One would expect contractionary monetary policy. High inflation means that the money supply is growing too fast and that aggregate demand is too high. Contractionary monetary policy reduces the money supply. All else equal, that will raise interest rates, reduce investment and consumption, and thereby reduce aggregate demand.

Price of Oil rises suddenly & significantly What if the fed tries to restore y to where it was with expansionary monetary policy? Whats the con to this plan? Draw it

TO do this, use expansionary monetary policy MS goes up, I goe sdown, C goes up I goes U -> AD goes up -> Y goes up CAVEAT : -> GDP returns to where it was BUT prices rise even more, more inflation

Why do presidents typically reappoint Chairs of the Federal Reserve Board even when they were originally appointed by a president of a different political party?

The Chairs of the Federal Reserve are not political appointees; they are chosen for their macroeconomic expertise. In addition, reappointing a Chair allows for a continuity of policy

Name and briefly describe the responsibilities of each of the following agencies: FDIC, NCUA, and OCC

The FDIC is the Federal Deposit Insurance Corporation. It collects insurance premiums from banks and pays depositors up to $250,000 if a bank fails and is unable to pay its depositors. The NCUA is the National Credit Union Administration. It supervises credit unions. The OCC is the Office of the Comptroller of the Currency. It supervises banks and savings & loans.

Describe the structure of the Federal Reserve

The Federal Reserve's decision-making body is called the Board of Governors. The Board consists of seven people appointed by the President of the U.S. with the advice and consent of the senate. The appointment is for 14-years; terms are staggered so that one expires every two years. One of the seven is appointed to a four-year term as the Chair. Below the board are 12 Federal Reserve banks, one for each Federal Reserve district. These banks serve as "bankers' banks," i.e., they make loans to, and accept deposits from, commercial banks

If the central bank sells $500 in bonds to a bank that has issued $10,000 in loans and is exactly meeting the reserve requirement of 10%, what will happen to the amount of loans and to the money supply in general?

The bank has to hold $1,000 in reserves, so when it buys the $500 in bonds, it will have to reduce its loans by $500 to make up the difference. A reduction in loans means that deposits in other banks will fall. To put it differently, excess reserves were initially zero, but equal negative $500 after the bond sale. The money supply will fall by $500 x 1/0.1 = $5,000.

Bank runs are often described as "self-fulfilling prophecies." Why is this phrase appropriate to bank runs?

The fear created by the suggestion that a bank might fail can lead depositors to withdraw their money. If many depositors do this at the same time, the bank may not be able to meet their demands and will, indeed, fail.

What are the main tasks of a central bank like the Federal Reserve?

The main tasks of a the Federal Reserve are: 1. To conduct monetary policy (i.e. control the size of the money supply), 2. To make the financial system stable, and 3. To provide banking services to commercial banks and to the federal government.

Why was quantitative easing used in late 2008 and 2009 instead of the usual tools of monetary policy such as open market operations?

The usual tools of expansionary monetary policy work by reducing interest rates. The rate of interest was already close to zero; it could not be reduced any further. Consequently the Fed had to find another way to boost aggregate demand.

Counter Cyclical Monetary Policy - When the fed takes action of exp. monetary policy, what is the caveat to this working?

There is a potential for this to be less effective than the story suggests, especially in a severe downturn It is possible that C and I will NOT respond to lower interest rates. This is because pessimistic expectations might depress investment.

The negative slope of the interest rate and loanable funds relationship illustrates that

They are more likely to borrow money at lower interest rates

Price of Oil rises suddenly & significantly What if the fed tries to reduce the price level with contractionary monetary policy? Whats the con to this plan? Draw it

To Restore prices to where they were we or the fed would need to reduce AD Via contractionary monetary policy Ms Goes down -> Int rate goes up _> C I go down -. AD goes down CON: Y falls even more Probably more unemployment because GDP fell from a to c

Explain how to use an open market operation to expand the money supply

To expand the money supply, the Fed will buy bonds. That will increase excess reserves. That, in turn, will increase the money supply by the increase in excess reserves times the money multiplier.

Explain how to use the discount rate to expand the money supply.

To expand the money supply, the Fed would reduce the discount rate. The discount rate is the interest rate the Fed charges banks that borrow from it. A lower discount rate makes it more attractive for banks to borrow from it; all the money banks borrow from the Fed are excess reserves. The money supply will rise by the increase in excess reserves times the money multiplier.

Explain how to use the reserve requirement to expand the money supply

To expand the money supply, the Fed would reduce the reserve requirement. A lower reserve requirement increases the money multiplier AND immediately creates more excess reserves. Both of those will increase the money supply

What is the purpose of the fed

To regulate the banking system to promote stability. To determine the size of the money supply To act as a bank to commercial banks and US Treasury

The supply of loanable funds represents the

amount available to be borrowed

The purpose of deposit insurance is to prevent ____ _____

bank runs

The federal reserve banks serve as

bankers' banks They accept deposits from commercial banks and make loans to commercial banks

When the fed wants to increase the money supply it will ______ bonds.

buy

When the fed wants to increase the money supply it will

buy bonds

Suppose the fed wants to increase the volume of fund available to loan. The fed could:

buy bonds, lower the discount rate, or reduce R. These actions would increase excess reserves in the banking system

Stagflation refers to a situation where the price level is rising but real GDP is

falling. It is caused by a leftward shift of the SRAS

The fed will loan money to

healthy banks who have short run liquidity problems due to example from bank runs

Low interest rates then quantity demanded is

high

What effect does expansionary monetary policy (increase in the money supply) have on equilibrium of the supply of loanable funds? Draw it.

i decreases, Q increases The rate of interest falls and more loans are made

To decrease the money supply, the fed can _____ R (required ratio rate)

increase

To decrease the money supply, the fed will _______ the interest rate

increase

How does tight monetary policy affect interest rates?

increases interest rates.

The idea of the structure and roles of the fed is to

insulate the fed from political pressure

Banks are required to buy _____ On their deposits

insurance

The discount rate is the

interest rate that the fed charges on funds loaned to banks

If the local bank borrows excess reserves from the fed it can

loan them out

High interest rates then quantity demanded is

low

With more excess reserves, more funds banks COULD

make more loans.

The lower the discount rate, the

more likely banks will be to borrow from the fed

To increase the money supply The fed can ______ R (required ratio rate)

reduce

To increase the money supply the fed will ____ the discount rate

reduce

How does loose monetary policy affect interest rates?

reduces interest rates

Funds that banks borrow from the fed are all

reserves

When the fed wants to decrease the money supply it will ______ bonds

sell

When the fed wants to decrease the money supply it will

sell bonds

Historically stagflation has happened due to

sharp sudden rise in the price of a key resource Such as oil

What is the board of governors of the fed?

the decision-making body 7 members appointed by the President ( With the advice & consent of the senate) to staggered 14 year terms

Higher interest rates will call fourth additional funds to be lent but

the effect is small

What does quantitative easing mean?

the fed loans money directly to the Federal Government & Others

Price of Oil rises suddenly & significantly What are the two options the fed has?

try to restore y to where it was try to reduce the price level

The demand for loanable funds has to do with anyone who

wants to borrow money

Contractionary Monetary Policy is when the Fed

wants to decrease the money supply

The supply of loanable funds represents

what's available to be borrowed

If the Fed acts to increase the money supply, the supply of loanable funds

will rise.