Chapter 16: Interest Rates & Monetary Policy

List several advantages of monetary policy over fiscal policy.

-can be quickly altered -the congressional deliberations may delay the application of fiscal policy for months, but the Fed can buy or sell securities from day to day -less political -less political pressure because they serve 14 yrs. -policy changes are more subtle and less likely to be noticed

Explain the purpose of interest rates.

-interest is the price paid for the use of money -also the price that borrowers need to pay lenders for transferring purchasing power to the future -the amount of money that must be paid for the use of $1 for 1 year

Describe the inverse relationship between bond prices and interest rates

when the interest rate increases, bond prices fall when the interest rate falls, bond prices rise the price of bonds is determined by bond demand and bond supply

Discuss the relative importance of monetary policy tools.

1. Open-market operations are most important, including repurchase agreements. This decision is flexible because securities can be bought or sold quickly and in great quantities. Reserves change quickly in response. 2. The reserve ratio is rarely changed since this could destabilize banks' lending and profit positions. 3. Changing the discount rate has become a passive tool of monetary policy. During the financial crisis of 2007-2008, banks borrowed billions as the discount rate was decreased by the Fed. 4. During the financial crisis, banks became more reluctant to borrow from the Fed, so the Fed created the term auction facility, allowing banks to borrow anonymously. It was so effective; many believe this will be the Fed's primary tool when the banking system requires quick injections or withdrawals of reserves.

Illustrate how raising or lowering the discount rate can increase or decrease the money supply.

An increase in the discount rate signals that borrowing reserves is more difficult and will tend to shrink excess reserves. A decrease in the discount rate signals that borrowing reserves will be easier and will tend to expand excess reserves.

Describe the market for money and what determines the equilibrium rate of interest.

An increase in the supply of money will lower the equilibrium interest rate a decrease in the supply of money will raise the equilibrium interest rate

Define the asset demand for money (Da)

Asset demand is money kept as a store of value for later use. Asset demand varies inversely with the interest rate, since that is the price of holding idle money

Recognize the major asset (securities) and major liability (bank reserves) in the consolidated balance sheet of the Fed.

Assets: -Securities -Loans to Commercial banks Liabilities: -reserves of the commercial banks -treasury deposits -federal reserve notes

Discuss actions taken by the Fed during and after the financial crisis of 2007-2008.

During: in August, they lowered the discount rate by half a percentage point; in September 2007 & April 2008, it lowered the target for the federal funds rate from 5.25 to 2% After: moved towards a zero interest rate policy--keeping short-term interest rates near zero to stimulate the economy; Quantitative easing--Feds buy more securities form banks and businesses; Operation Twist: Purchasing long-term bonds and selling short-term bonds.

Use a cause-effect chain to explain the links between a change in the money supply and a change in the equilibrium level of GDP when there is an expansionary monetary policy and a restrictive monetary policy.

Expansionary monetary policy: An increase in the money supply will lower the interest rate, increasing investment, aggregate demand, and equilibrium GDP. Restrictive monetary policy: shrinking the money supply and increasing the interest rate will increase the equilibrium GDP

Explain how changes in the money supply affect the interest rate.

If the quantity demanded exceeds the quantity supplied, people sell assets like bonds to get money. This causes bond supply to rise, bond prices to fall, and a higher market rate of interest. If the quantity supplied exceeds the quantity demanded, people reduce money holdings by buying other assets like bonds. Bond prices rise, and lower market rates of interest result

Describe how raising or lowering the reserve ratio can increase or decrease the money supply

Raising the reserve ratio increases required reserves and shrinks excess reserves. Any loss of excess reserves lowers banks' lending ability and, therefore, the potential money supply by a multiple amount of the change in excess reserves. Lowering the reserve ratio decreases the required reserves and expands excess reserves. Gain in excess reserves increases banks' lending ability and, therefore, the potential money supply by a multiple amount of the increase in excess reserves.

Describe the problems with lags and cyclical asymmetry in monetary policy.

Recognition and operational lags impair the Fed's ability to quickly recognize the need for policy change and to affect that change in a timely fashion. Although policy changes can be implemented rapidly, there is a lag of at least three to six months before the changes will have their full impact.

Explain how the Fed can expand the money supply by buying government securities and contract the money supply by selling government securities

When the Fed buys securities, bank reserves will increase and the money supply potentially can rise by a multiple of these reserves.

Explain some recent developments in monetary policy to restore normalization to monetary policy.

With the economy improved, the Feds will try and raise interest rates and try to reduce the number of securities held

Explain the zero lower bound problem for monetary policy

Zero-bound is a situation that occurs when a central bank has lowered short-term interest rates to zero or nearly zero

open market operations

consists of buying government bonds (US Securities) from or selling government bonds to commercial banks and the general public

interest on reserves

is the rate at which the Federal Reserve Banks pay interest on reserve balances, which are balances held by DIs at their local Reserve Banks.

Define the transactions demand for money. (Dt)

the demand for money as a medium of exchange Transactions demand is money kept for purchases and will vary directly with GDP

reserve ratio

the fraction of bank deposits that a bank holds as reserves

the discount rate

the minimum interest rate set by the Federal Reserve for lending to other banks.

Describe the relationship between the federal funds rate and the prime interest rate

the prime interest rate is higher than the federal funds rate because the prime interest rate is higher than the federal funds rate because the prime rate involves longer more frisky loans than overnight loans between banks

Describe the actions the Fed can take to pursue an expansionary monetary policy.

The Fed may use an expansionary monetary policy if the economy is experiencing a recession and rising rates of unemployment. lower interest rate to bolster borrowing and spending, which will increase aggregate demand and expand real output.

Describe the actions the Fed can take to pursue a restrictive monetary policy

1. The initial step is for the Fed to announce a higher target for the Federal funds rate, followed by the selling of bonds to soak up reserves. Raising the reserve ratio and/or discount rate is also an option. 2. Reducing reserves will produce results opposite of what we saw for an expansionary monetary policy. 3. Restrictive monetary policy results in higher interest rates, including the prime rate.

Explain how the Fed can expand the money supply with repos with banks and decrease the money supply with reverse repos.

???? This policy tool falls under open-market operations but is different in the sense that a repo or reverse repo is a temporary exchange of assets rather than the outright purchase or sale of the asset (security).

Explain why the federal funds rate is the focus of monetary policy.

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Explain how raising or lowering the interest paid on excess reserves affects bank lending.

increase in the interest rate on excess reserves at the Fed reduces bank lending decrease in the interest rate on excess reserves at the Fed increases bank lending.

Identify the four tools of monetary policy

open-market operations the reserve ratio the discount rate interest on reserves

Describe the Fed's use of quantitative easing.

the Fed's response to the zero lower bound problem was this. quantitate easing looks exactly like open market operations, with the Fed purchasing bonds in order increase the amount of reserves in the banking system Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply. The fed uses it in March 2009 and November 2010