ECON Exam 2

Changes in First Bank's Balance Sheet after the Fed's Purchase of a U.S. Treasury Bond Immediate Impact Assets: Reserves +100 m Securities -100 m Liabilities: nothing AFTER the Extension of a Loan: Assets: Reserves +100 m Securities -100 m Loans +100 m Liabilities: Checkable Deposits +100m AFTER Withdrawal by the borrower Assets: Reserves 0 Securities -100 m Loans +100 m Liabilities: Checkable Deposits 0

-Note that after the OMP, ER increased by the amount of the purchase in A and it was entirely available for loans -After the loan was extended and it was deposited in the checkable deposits, R included both RR and ER in B As a result of a $100 m purchases of securities from a bank by the Fed o M1 increases by $100,000 o Checkable deposits increase by $100,000 in B o Cash increases by $100,000 in C

What makes the private sector incapable of doing what we have entrusted to the government?

-Presence of externalities or public goods -Economic and financial systems, when left on their own, are prone to episodes of extreme volatility

Why did the first bank of us (1791) and second bank of us (1816) fail?

-These banks failed mainly due to the politics of that time - Politicians and lobbyists representing agricultural interests of the southern states were apprehensive of centralization of financial power

What are the 4 tools that affect money supply:

1) Open market operations 2) Changes in the discount rate ) Changes in the interest rate on banks' reserve balances 4) Changes in reserve requirements

Central Bank's Balance Sheet Banker's Bank Assets: 1. Liabilities 1.

1. Loans 1. Accounts of the commercial banks (reserves)

Central Bank's Balance Sheet Government's Bank Assets: 1. 2. Liabilities: 1. 2.

1. Securities 2. Foreign Exchange Reserves 1. Currency 2. Government's Account

o So for every dollar increase in reserves, deposits increase by

1/r^D

How many Federal Reserve Districts

12

Federal Open Market Committee # Board of Governors # Federal Reserve Banks #

12 7 12

The country has been divided into ____ Federal Reserve districts with a Federal Reserve Bank located in a major city within each __________. No district coincides with a single state. This ensures that a particular state is not overly represented and each district has jurisdiction over a balanced mix of industries and _____________ activities.

12 district economic

How many central banks in world?

170

Federal Reserve System Act started in

1914

No central bank between 1836 and _______, which there were frequent financial crisis and bank failures during that period

1914

Most of the central banks in the world were created in the ______ century Answers: 20th 19th 21st 16th

20th

There are __________ branches of the Fed, namely, the Board of Governors, the Federal Reserve Banks, and the Federal Open Market Committee, with overlapping responsibilities that provide __________ and _____________

3 checks balance

How do changes in the discount rate affect the money supply?

An increase in the amount of discount loans increases the money supply by the amount of the increase in the discount loans times the money multiplier M = m × (C + DL + NBR)

In its role as the government's bank, what are the functions a central bank performs? Briefly explain each of these functions.

Answer: As the government's bank, a central bank performs the following functions: i) It issues currency on behalf of the government. Having the monopoly over the issuance of currency gives it control over inflation ii) The central bank conducts monetary policy in order to controls the availability of money and credit. Most central banks go about this by adjusting short-term interest rates. iii) The central bank manages the finances of the government. The government has accounts with the central bank.

What are the main arguments for central bank independence? Is the Fed independent? How do you know? Explain. Answer: There are several arguments in support of central bank independence (3)

By making the central bank independent, the politicians can take some of their daily pressures off their shoulders

The main asset held by a central bank in its role as the Banker's Bank is: a. Foreign exchange reserves b. Currency c. Loans d. Securities

C. Loans

Currency to deposit ratio C=cxD

C=c x D

Who is the Federal Reserve or the Fed?

Central Bank of the US

A central bank's balance sheet will categorize the following as a liability: a. Currency b. Loans c. Securities d. Foreign exchange reserves

Currency

Central Bank's Liabilities:

Currency (Federal Reserve Notes) Government Accounts Reserves

Monetary Base (aka high power money) Equals

Currency + Reserves

Monetary Base

Determined by central bank

What are excess reserves? What are the factors that determine how much a bank would like to hold in excess reserves? Briefly explain.

Excess reserves are the reserves that bank hold over and above the required reserves. The amount of excess reserves a bank would like to hold depends on the costs and benefits of holding them:

Balance Sheet Changes after the Fed Purchases a German Govt. Bond Federal Reser's Balance Sheet: Assets: ______________ ______________ _____________ +1 billion (bond) Liabilities: _______________ +1 billion Banking System's Balance Sheet Assets: __________ +1 billion ___________ -1 billion (bond) change MB=changeC (currency)+changeR (reserves) = 0 + 1 billion = 1 billion MB Increases by 1 billion

Federal Reser's Balance Sheet: Assets: Foreign Exchange Reserves +1 billion (bond) Liabilities: Reserves +1 billion Banking System's Balance Sheet Assets: Reserves +1 billion Securities -1 billion (bond) change MB=changeC (currency)+changeR (reserves) = 0 + 1 billion = 1 billion MB Increases by 1 billion

Balance Sheet Changes after the Fed Purchases a U.S. Treasury Bond Federal Reser's Balance Sheet: Assets: _______________ +1 billion (Treasury Bond) Liabilities: ________________ +1 billion Banking System's Balance Sheet Assets: ______________ +1 billion ______________ -1 billion (Treasury Bond) change MB=changeC (currency)+changeR (reserves) = 0 + 1 billion = 1 billion MB Increases by 1 billion

Federal Reser's Balance Sheet: Assets: Securities +1 billion (Treasury Bond) Liabilities: Reserves +1 billion Banking System's Balance Sheet Assets: Reserves +1 billion Securities -1 billion (Treasury Bond) change MB=changeC+changeR = 0 + 1 billion = 1 billion MB Increases by 1 billion

Balance Sheet Changes after the Fed Makes a Discount Loan Federal Reserve's Balance Sheet Assets: ______________ ___________ +100 million Liabilities: _____________ +100 million Banking System's Balance Sheet Assets: _____________ +100 million Liabilities _____________ _____________ +100 million change MB= change C (currency) + change R (reserves) =0 + 100 million = 100 million MB increases by 100 million

Federal Reserve's Balance Sheet Assets: Discount Loans +100 million Liabilities: Reserves +100 million Banking System's Balance Sheet Assets: Reserves +100 million Liabilities Discount Loans +100 million change MB= change C (currency) + change R (reserves) =0 + 100 million = 100 million MB increases by 100 million

Central Banks Roles

Government's Bank and Banker's Bank

Monetary Base (Central Bank) Increase= 1. Required Reserve to Deposit Ratio (Central Bank) Increase= 2. Excess Reserve to Deposit Ratio (Commercial Banks) Increase= 3. Currency to Deposit Ratio (Nonbank public) Increase =4.

Impact on M 1. Increase 2. Decrese 3. Decrease 4. Decrease

Money Supply

M1 or M2

The Board of Governors of the Fed performs each of the following functions, except: Answers: Analyzing financial and economic conditions Setting the reserve requirement Administer consumer credit protection laws Making discount loans

Making discount loans

What are the main arguments for central bank independence? Is the Fed independent? How do you know? Explain. Answer: There are several arguments in support of central bank independence (2)

Monetary policy is too technical to be formulated by elected officials who do not necessarily have the specialized training or skills.

What are the main arguments for central bank independence? Is the Fed independent? How do you know? Explain. Answer: There are several arguments in support of central bank independence (1)

Monetary policy often requires long time horizons to be effective. Politicians are often motivated by re-elections. Therefore, if the central bank is run by politicians, their time horizons would follow the election cycles. Thus, they would conduct expansionary monetary policy just before the election, which will create jobs in the short-run but would lead to inflation in the long-run. After the election, they would tend to go for contractionary monetary policy to contain inflation.

M = C + D = c × D + D = (c + 1)×D

Money Multipier

Money supply= _________ _________x ___________ ___________

Money Multiplier Monetary Base

Member banks of the Federal Reserve System include: Answers: Only nationally chartered banks All state chartered banks with assets exceeding $100 million Nationally chartered banks and state chartered banks that decide to join Nationally chartered banks and all state chartered banks

Nationally chartered banks and state chartered banks that decide to join

Current law regarding the Fed's Board of Governors stipulates that: Answers: No more than three governors can come from the same district No more than two governors can come from the same district Every district must have at least one governor on the board No more than one governor can come from the same district

No more than one governor can come from the same district

Buying and selling U.S. Treasury Securities for the Fed's own portfolio is called: a. Managing the float b. Discount buying c. Open market operations d. Reserve adjustment

Open Market Operations

Total Reserves Excess Reserves Required Reserves

R ER (RR=r^d D)

Labeling the excess reserve-to-deposit ratio, e (=ER/D), we can rewrite the reserve equation as: R = RR + ER

R = RR + ER = r^D×D + e×x D D = (r^D + e)×D

Monetary base= ___________+ ____________ ________ _____ ________________ _________-

Reserves+ Currency held by nonbank pblic

Function of Federal Open Market Commttee

Target Federal Funds Rate Meet 8 times a year

The discount rate is the interest rate: Answers: The Fed charges banks who borrow from it Banks charge each other for overnight loans on their excess deposits at the Fed The U.S. Treasury charges banks that need emergency funds The FDIC charges banks who need to borrow from it to meet depositor demands

The Fed charges banks who borrow from it

Is the Fed independent? How do you know? Explain.(1) (2) (3)

The Fed is fiscally independent: it earns most of its income from the interest payments on the government bonds that it holds. It also earns revenue by providing services to the banks and financial institutions, international organizations, and foreign governments. -The monetary policy decisions made by the FOMC are not reversible by anybody outside the Fed. -The governors are appointed for nonrenewable 14-year terms.

The three branches of the Federal Reserve System include each of the following, except: Answers: The Board of Governors The Federal Deposit Insurance Corporation The Federal Open Market Committee The twelve regional Federal Reserve Banks

The Federal Deposit Insurance Corporation

What are the economic rationales for the existence of a central bank? Explain (2)

The following economic rationales are put forward for the existence of a central bank: Economic and financial systems, when left on their own, are prone to episodes of extreme volatility. Thus, to monitor and regulate the financial system, there is a need for government intervention.

What are the economic rationales for the existence of a central bank? Explain

The following economic rationales are put forward for the existence of a central bank: a) Like national defense, financial and economic stability is a public good that - due to the free rider problem - will be undersupplied if there is no external intervention. Thus, the existence of a government agency will ensure that financial and economic stability prevails.

What are excess reserves? What are the factors that determine how much a bank would like to hold in excess reserves? Briefly explain. (1)

The higher is the interest rate on loans, the lower are bank's excess reserves. The interest rate on loans is the opportunity cost of holding reserves for the bank and, therefore, there is an inverse relationship.

What are excess reserves? What are the factors that determine how much a bank would like to hold in excess reserves? Briefly explain. (2)

The higher is the interest rate on reserves, the higher are their excess reserves. In this case, the interest rate on reserves (the deposit rate) is the return on excess reserves and, therefore, there is a positive relationship. The greater is the bank's concern over the possibility of deposit withdrawals, the higher are its excess reserves.

What are the operational components of central bank independence? What is the most well documented fact about the relationship between central bank independence and inflation?

The operational components of "central bank independence" are: a) Monetary policymakers must be free to control their own budgets (fiscal independence) so that politicians cannot influence their decisions b) The bank's policies must not be reversible by people outside the central bank. It is a well-documented fact that the countries that have independent central banks also have low inflation.

The Federal Reserve System: What the Reserve Banks Do • Government's Bank o Issue currency o Maintain the _____________ account o Manage the Treasury debt • Bankers' Bank o Hold reserve deposits o Operate the payments system o Make discount loans at the _____________ _________ o Supervise and regulate financial institutions o Collect, analyze, and publish data

Treasury's discount rate

"A discount loan has the same effect on monetary base as does an open market purchase." Do you agree? Explain using an example and showing the relevant Taccounts. Between these two actions, is one preferred to the other by the Fed? Why or why not?

Yes, I do. We compare an open market purchase of $1,000 from a bank with a discount loan of $1,000 to the bank.

Is the Fed independent? How do you know? Explain.

Yes, the Federal Reserve is an independent central bank. By examining whether the Fed fits into the operational definition of central bank independence, we can evaluate its independence from political pressure.

"The Federal Reserve System resembles the U. S. Constitution in that it was designed with many checks and balances." Do you agree? If so, discuss at least three distinctive features of the structure and organization of the Fed that provide with these checks and balances. If not, explain why. (3 points) Answer: The following features of the structure and organization of the Fed provide the checks and balances to its operations:

a) There are three branches of the Fed, namely, the Board of Governors, the Federal Reserve Banks, and the Federal Open Market Committee, with overlapping responsibilities that provide checks and balances. b) The country has been divided into 12 Federal Reserve districts with a Federal Reserve Bank located in a major city within each district. No district coincides with a single state. This ensures that a particular state is not overly represented and each district has jurisdiction over a balanced mix of industries and economic activities. c) The Federal Reserve Banks are federally chartered banks and private, nonprofit organizations, owned by the commercial banks in their districts. d) Each Federal Reserve Bank is run by a nine member board of directors that includes 6 directors who are elected by the member banks and represent the interest of the banks and other segments of the regional economy. The remaining 3 members are appointed by the Board of Governors and they represent public interest.

An open market sale of U.S. Treasury securities by the Fed will cause the Fed's balance sheet to show: a. A decrease in the asset of securities and a decrease in the liability of reserves b. An increase in the liability of reserves c. No change in the size of the balance sheet, just the composition of assets will change from securities to cash d. An increase in the asset category of securities and the liability category of reserves

a. A decrease in the asset of securities and a decrease in the liability of reserves

Which of the following have the same impact on the Fed's balance sheet? a. An open market purchase and an increase in loans by the Fed to banks b. An open market sale and an increase in foreign exchange reserves c. An open market purchase and a decrease in foreign exchange reserves d. An increase in loans by the Fed to banks and a decrease in foreign exchange reserves

a. An open market purchase and an increase in loans by the Fed to banks

During the holiday season in December, people use more currency than usual. To offset this increase in demand for money, the Fed increases the money supply through a. defensive open-market operations. b. dynamic open-market operations. c. discount loans for profit. d. discount loans for business needs.

a. defensive open-market operations.

Three branches with overlapping responsibilities o Board of Governors o Federal Reserve Banks o Federal Open Market Committee Additionally, o A series of __________ committees o Member (private) _________

advisory banks

Reserves are: a. Assets of the central bank and liabilities of the commercial bank b. Assets of the commercial banks and liabilities of the central bank c. Liabilities of the commercial and central banks d. Assets and liabilities for the central bank

b. Assets of the commercial banks and liabilities of the central bank

Who is/are on the demand side of the market for reserves? a. The Fed b. The banks c. Non-bank public d. Large corporations in need of short-term loans

b. The banks

Secondary credit provided by the Fed is designed for: a. banks who qualify for a lower interest than what is available under primary credit b. banks that are in trouble and cannot obtain a loan from anyone else c. banks that want to borrow without putting up collateral d. foreign banks

b. banks that are in trouble and cannot obtain a loan from anyone else

The types of loans the Fed makes consist of each of the following, except: a. Primary credit b. Conditional credit c. Seasonal credit d. Secondary credit

b. conditional credit

Defensive open-market operations are undertaken when ___________________ a. the Fed wants to actively change monetary policy as directed by FOMC b. there are temporary changes in the market demand for reserves c. the banks would want to borrow from the Fed d. the nonbank public withdraw cash

b. there are temporary changes in the market demand for reserves

Federal funds loans are: a. secured loans between banks and the Fed b. unsecured loans c. collateralized loans between banks d. guaranteed by the FDIC

b. unsecured loans

Open market operations are the ________________ ________ _______________ of government securities in the secondary market • Conducted at Open Market Trading Desk (the Desk) of Federal Reserve Bank of New York

buying and selling

Vault cash is: a. Equal to the total amount of reserves and is an asset of the central bank b. Not reserves but is a liability of the central bank c. A part of reserves and an asset of commercial banks d. Not reserves but is an asset of central bank

c. A part of reserves and an asset of commercial banks

At the market federal funds rate that equals the deposit rate a. The reserves demand curve becomes perfectly inelastic b. The reserves supply curve becomes perfectly elastic c. The reserves demand curve becomes perfectly elastic d. The reserves supply curve becomes perfectly inelastic

c. The reserves demand curve becomes perfectly elastic

The demand curve for reserves is ____________sloping and then horizontal at __________ a. upward; the interest rate paid on reserves b. downward; the primary credit discount rate c. downward; the interest rate paid on reserves d. upward; the primary credit discount rate

c. downward; the interest rate paid on reserves

An increase in the interest rate on reserves ____________ banks to hold more excess reserves and therefore _________ money is available for making loans and money supply _________ a. discourages; less; decreases b. encourages; less; increases c. encourages; less; decreases d. encourages; more; increases

c. encourages; less; decreases

The Federal Reserve Banks are federally chartered banks and private, nonprofit organizations, owned by the ______________ __________in their districts.

commercial bank

Extend a discount loan: initiated by :

commercial banks

Central banks _________________: it has the monopoly over the issuance of currency.

create money

If Bank A sells a $100,000 U.S. Treasury bond to the Fed, monetary base will: a. Increase by less than $100,000 b. Not change c. Decrease by less than $100,000 d. Increase by $100,000

d. Increase by $100,000

Which of the following is not true of monetary base? a. It equals currency plus reserves b. Money and credit in the economy is based on it c. It is also known as high-powered money d. It is constant over time

d. It is constant over time

The money supply in an economy equals a. monetary base plus money multiplier. b. monetary base divided by money multiplier. c. money multiplier divided by monetary base. d. money multiplier multiplied by monetary base.

d. money multiplier multiplied by monetary base.

The amount of nonborrowed reserves equals a. the monetary base plus the amount of discount loans. b. the amount of reserves plus the amount of discount loans. c. the amount of reserves minus the sum of the amount of discount loans and currency. d. the monetary base minus the sum of the amount of discount loans and currency

d. the monetary base minus the sum of the amount of discount loans and currency

Money Multiplier

depends on decisions by people, banks, and the central bank

The central bank does not control the money supply _____________, but ________________ through adjustments to its monetary base

directly indirecty

Federal Reserve System-Invoke the emergency powers to lend to nonbanks/ shadow banks

emergency powers

Central Bank- It does not control the government's budget. For example, in the U.S. o That is determined by Congress and the president through

fiscal policy

The Central Bank's Balance Sheet: Assets • Foreign Exchange Reserves o Held in the form of bonds issued by foreign governments o These reserves are used in ________________ ______________ ______________

foreign exchange interventions

Open-Market Operations • The Desk buys or sells from primary ________________ ______________ ______________, which are large investment banks and brokers that meet certain capital requirements and agree to actively transact

government securities dealers

Losing control over printing money means losing control over _____________

inflation

Central Banks-Provide loans during times of financial stress: _____________ _____________ -Manage the payments system

lenders of last resort

*Fed sells securities --____________ reserves -- fed funds rate↑ -- M ↓

less

MB = C + R = c×D + (r^D + e)×D = (c + rD + e)×D

monetary base multiplier all together

Control availability of money and credit o Most central banks go about this by adjusting short term interest rates:____________ ______________

monetary policy

*Fed buys securities - ________ reserves - fed funds rate ↓ --M ↑

more

Each Federal Reserve Bank is run by a _________ member board of directors that includes ____ directors who are elected by the member banks and represent the interest of the banks and other segments of the regional economy. The remaining __ members are appointed by the Board of Governors and they represent public ____________

nine 6 3 interest

The __________ __________ ___ __________ _______________ include bankers, other business leaders, and people who represent public interests

nine member Board of Directors

Decision by an individual to withdraw cash from their bank: initiated by the

nonbank public

Federal Reserve System- • Three branches with overlapping responsibilities

o Board of Governors o Federal Reserve Banks o Federal Open Market Committee

M = C + D MB = C + R R = RR + ER

o Money equals currency C plus checkable deposits D o The monetary base MB equals currency plus reserves in the banking system R, and o Reserves equal required reserves RR plus excess reserves ER.

• The amount of excess reserve a bank holds depends on the costs and benefits of holding them

o The higher the interest rate on loans, the lower are banks' excess reserves o The greater banks' concern over the possibility of deposit withdrawals, the higher their excess reserves o The higher the interest rate on reserves, the higher are their excess reserves

To bring actual federal funds rate close to the target rate, _________ ____________ operations are conducted

open market

Fed influences money supply by affecting banks' reserves, mainly through open-market _______________ The Fed's main asset is its portfolio of ______ ______________ _______________

operations U.S. Treasury securities

Open Market Operations-The Desk buys or sells from __________ _____________ _____________ ______________ which are large investment banks and brokers that meet certain capital requirements and agree to actively transact

primary government securities dealers,

As the government's bank, a central banks does all of the following except Answers: it controls the availability of money and credit in the economy provides loans to the commercial banks during times of financial stress manages finances of the government creates money by printing currency bills

provides loans to the commercial banks during times of financial stress

The Federal Reserve System: Federal Reserve Banks • Reserve Banks are part __________ and part private • Federally chartered banks but private, nonprofit organizations, owned by the commercial banks in their districts • Overseen by both their own boards of directors and the ___________ _______ _________________ • The ________ member Board of Directors include bankers, other business leaders, and people who represent public interests • The president is appointed for a five-year term by the bank's board of directors with the approval of the BOG

public Board of Governors nine

Board of Governors Functions: -Set the ___________ requirement -Administer consumer _________ protection laws -Supervise and regulate the Reserve Banks -Along with the ___________ Banks, regulate and supervise the banking system -Invoke the emergency powers to lend to nonbanks/ shadow banks -Analyze financial and economic conditions -Collect and publish detailed statistics

reserve credit reserve

Members of the Board of Governors of the Fed: Answers: can be reappointed after their term expires must leave office when there is a new administration elected serve one non-renewable fourteen-year term are appointed for life, though they can resign at any time

serve one non-renewable fourteen-year term

How many members are on the Board of Governors of the Federal Reserve System? Answers: Twelve, one for each district Seven Nine Fourteen

seven

One reason it took so long to have a central bank in the United States is that: Answers: it wasn't needed states feared centralization of power state currencies worked fine there was no agreement about its location

states feared centralization of power

Open Market Operation: Buying or selling of a security initiated by :

the central bank

• Foreign Exchange Intervention: Buying or selling of foreign exchange reserves initiated by:

the central bank

M is Money Multiplier is

the quantity of money M = m x MB