EC 302 Chapter 14

If the money multiplier is​ 10, the sale of​ $1 billion of securities by the Fed on the open market causes a

$10 billion decrease in the money supply

If the money multiplier is 10, the sale of $1 billion of securities by the Fed on the open market causes a

$10 billion decrease in the money supply.

Vault cash is equal to $2 million, deposits by depository institutions at the central bank are $1 million, the monetary base is $15 million, and bank deposits are $35 million. Currency held by the nonbank public is

$12 million

Assume that the currency—deposit ratio is 0.2 and the reserve—deposit ratio is 0.1. The Federal Reserve carries out open-market operations, purchasing $1 million worth of bonds from banks. This action will increase the money supply by

$4 million

The money supply is $10 million, currency held by the nonbank public is $2 million, and the reserve—deposit ratio is 0.2. Bank deposits are equal to

$8 million

The money supply is​ $10 million, currency held by the nonbank public is​ $2 million, and the​ reserve-deposit ratio is 0.2. Bank deposits are equal to

$8 million

Was the money multiplier stable during the Great Recession? Why would an unstable money multiplier pose a problem for monetary policy?

The money multiplier was not stable during the Great Recession. The money multiplier declined sharply, because the currency—deposit ratio and especially the reserve—deposit ratio both rose dramatically, as people increased their demand for currency, and banks increased their demand for excess reserves. Instability in the money multiplier creates instability in the money supply for a given monetary base.

The United States

does not formally use inflation​ targeting, but does use some policies used by countries that target inflation.

How has the Taylor rule performed historically?

fairly​ well; when the Fed has set the fed funds rate below that called for by the Taylor​ rule, inflation has often increased and when the Fed has followed the Taylor​ rule, inflation has been stable

In response to an unanticipated easing of monetary policy, the Fed funds rate ________ at first, then ________ after 6 to 12 months.

falls; returns most of the way to its original value

The primary purpose of the discount window is to

fulfill the bank's lender of last resort role

The Taylor rule is:

i ​= π ​+ 0.02​ + 0.5y​ + 0.5 ​(π−​0.02).

The notion of a zero lower bound refers to the __________ that ___________ will become negative

improbability; nominal interest rates

In the Keynesian​ model, suppose the Fed sets a target for the money supply. If the IS curve shifts to the​ left, and the Fed wants to keep output​ unchanged, what should the Fed​ do?

increase the money supply

The main goal of the creation of the Term Auction Facility and the Term Securities Lending Facility described in the article was to

increase the supply of available credit.

The Fed can reduce the money supply by reducing

the monetary base

As a result of those changes during the Great​ Depression,

the monetary base rose and the money multiplier fell.

Changes in reserve requirements directly and immediately affect

the money multiplier

The Taylor rule relates

the nominal Fed funds rate to inflation over the past year and the deviation of output from​ full-employment output.

The currency—deposit ratio is determined by

the public

Suppose the Fed has just learned that some foreign economies are headed for recession, which will reduce U.S. exports. This is an economic shock that shifts the IS curve down. What would you do in response to the shock if you want to keep the economy at full-employment equilibrium under each of the following cases? (a) You use the classical (RBC) model. (b) You use the Keynesian (efficiency wage) model. (c) You use the extended classical model with misperceptions. In each case, show the IS—LM—FE diagram associated with your answer.

(a) Do nothing, let P adjust. (b) Increase the money supply, shifting LM to the right. (c) Do nothing if the IS shift was anticipated; could increase money supply if the IS shift was unanticipated and the money supply change would be unanticipated; or you could inform people about the IS shock, so they would build it into their expectations.

The money supply is $12.5 million, currency held by the nonbank public is $2.5 million, and the reserve—deposit ratio is 0.25. (a) What is the quantity of bank deposits? (b) What is the quantity of bank reserves? (c) What is the quantity of the monetary base? (d) What is the money multiplier (give a number)?

(a) Since M = C + D, D = $10 million. (b) Since R = 0.25 × D, R = $2.5 million. (c) BASE = C + R = $5 million. (d) multiplier = M/BASE = 2.5.

Suppose the Fed cares only about keeping the economy close to full-employment output. The Fed can target the real money supply (thus keeping the LM curve fixed) or it can target the real interest rate, changing the money supply and shifting the LM curve however is necessary to prevent a change in the real interest rate. (a) Which is the best policy if the main shocks to the economy are shocks to the IS curve? Explain why. Illustrate with a diagram. (b) Which is the best policy if the main shocks to the economy are shocks to real money demand? Explain why. Illustrate with a diagram.

(a) Target the real money supply, since targeting r would lead to larger fluctuations in output. (b) Target the real interest rate to offset shocks to money demand and stabilize output.

Assume that the currency—deposit ratio is 0.5. The Federal Reserve carries out open-market operations, purchasing $1 million worth of bonds from banks. This action increased the money supply by $2 million. What is the reserve—deposit ratio?

0.25

Assume that the​ reserve-deposit ratio is 0.4. The Federal Reserve carries out​ open-market operations, purchasing​ $1,000,000 worth of bonds from banks. This action increased the money supply by​ $1,750,000. What is the​ reserve-deposit ratio?

0.4

How would each of the following events affect the U.S. money​ supply? 1. Banks decide to hold more excess reserves.​ (Excess reserves are reserves over and above what banks are legally required to hold against​ deposits.) This would cause ___________ in the money supply. 2. People withdraw cash from their bank accounts for Christmas shopping. This would cause _________ in the money supply. 3. The Federal Reserve sells gold to the public. This would cause ________ in the money supply. 4. The Federal Reserve reduces the interest rate it pays on deposits of depository institutions held at the Fed. This would cause _________ in the money supply. 5. A financial crisis leads people to sell many of their stocks and deposit the proceeds in bank​ accounts, which are federally insured. This would cause ________ in the money supply. 6. The Federal government sells​ $20 billion of new government bonds to the Federal Reserve. The proceeds of the sale are used to pay government employees. This would cause __________ in the money supply. 7. The Federal Reserve sells some of its government securities in Tokyo for yen. This would cause ___________ in the money supply.

1. a decrease 2. a decrease 3. a decrease 4. an increase 5. an increase 6. an increase 7. no change

How many Federal Reserve Banks are​ there?

12

Suppose that in Mysore, the reserve—deposit ratio is res = 0.5 - 2i, where i is the nominal interest rate. The currency—deposit ratio is 0.2 and the monetary base equals 100. The real quantity of money demanded is given by the money demand function L(Y, i) = 0.5Y - 10i, where Y is real output. Currently, the real interest rate is 5% and the economy expects an inflation rate of 5%. The money supply equals

240

From 2008 to 2014, the Fed engage in ________ rounds of quantitative easing.

3

Vault cash is equal to $8 million, deposits by depository institutions at the central bank are $2 million, the monetary base is $30 million, and bank deposits are $100 million. The money multiplier is equal to

4.0

Which one of the following is not a reason why an individual or company would be willing to accept a negative nominal interest​ rate?

Altruism

Which of the following events was instrumental in turning the financial situation in 2007 and 2008 from what could have been a fairly minor problem to a​ full-scale crisis?

Bankruptcy of Lehman Brothers

Which of the following are depository institutions?

Banks and thrifts

Describe the difference between a primary credit discount rate and the secondary credit discount rate, including who can borrow at which rate and how such lending is managed by the Fed.

Banks in good condition can take out a primary credit discount loan, without additional supervision from the Fed. Banks that are not in good condition may be allowed to take out a secondary credit discount loan, which carries a higher interest rate and closer supervision by the Fed.

Last year, the currency—deposit ratio was 0.2 and the reserve—deposit ratio was 0.2. Over the past year, the public changed its currency—deposit ratio, to which the Fed responded by reducing the reserve—deposit ratio to 0.15, to keep the money supply from changing and keeping the same monetary base. Calculate the new currency—deposit ratio. Show your work.

Because neither the money supply nor the monetary base have changed, the money multiplier must remain unchanged. The old money multiplier is (0.2 + 1)/(0.2 + 0.2) = 3. Letting c stand for the new currency—deposit ratio, the new money multiplier equals (c + 1)/(c + 0.15). Since this must equal the old money multiplier, we have: 3 = (c + 1)/(c + 0.15), so 3(c + 0.15) = c + 1, so 3c + 0.45 = c + 1, so 2c = 0.55, so c = 0.275.

In the aftermath of the 2008 financial​ crisis, negative nominal interest rates occurred in a number of countries in __________

Europe

Describe how the real interest rate changes in a Keynesian model if a shock shifts the IS curve down and to the right and the Fed changes its policy to keep output unchanged.

If the Fed is going to keep output unchanged, then it will tighten monetary policy, reducing the money supply to offset the shift of the IS curve. The tighter monetary policy will mean that the real interest rate is higher. The LM curve shifts up and to the left, or the LR curve shifts up.

In the Keynesian model, suppose the Fed sets a target for the money supply. If the IS curve shifts to the left, and the Fed wants to keep output unchanged, what should the Fed do?

Increase the money supply.

What are the major characteristics of an inflation targeting​ regime?

Inflation targeting is a system in which a central bank decides on a specific numerical target for inflation and a plan for achieving it.

The current chair of the Board of Governors of the Federal Reserve System is

Janet Yellen

Monetarists suggest doing which of the following?

Maintain a steady growth rate of the money supply.

The pioneer of inflation targeting was

New Zealand

What types of rules for monetary policy may be sensible for policymakers to consider? What is the advantage of using rules over discretion? What problems might there be with rules?

One possible rule is a constant money growth rule, as proposed by Milton Friedman and the monetarists. It has the advantage of being based on economic theory and using observable data. Following such a rule might be preferable to discretion, because people would understand the Fed's rule and form expectations accordingly, which would in turn reduce the costs of disinflation. The problem with such a rule could come if there were structural changes in the economy, such as a change in money demand. In such a case, the rule's lack of flexibility could cause the Fed to follow inappropriate policies.

Which of the following was not an attempt to lessen the impact of the 2008 financial​ crisis?

Policies designed to shift the IS curve to the left and downward

The failure of a central bank to act as a lender of last resort during a financial crisis may precipitate the following sequence of​ events:

That will lead many banks to try to sell assets​ (their good​ collateral) at​ once, leading to a sharp decline in the prices of the​ assets, which will further weaken the banks and make the financial crisis worse.

Describe, in general terms, the strategy of monetary policy, explaining how monetary-policy tools are used to achieve the goals of monetary policy. What intermediate stages are important in going from tools to goals? What are the links between the different stages? How does the Federal Reserve use this strategy today?

The Fed uses its tools to influence intermediate targets that in turn affect the goal variables. The link between tools and intermediate targets is an economic relationship such as the money multiplier, which relates changes in the monetary base to changes in the money supply. The link between intermediate targets and the goal variables is an economic model. Today the Fed targets the Fed funds rate fairly directly, but watches many indicators to figure out the correct funds rate.

In the financial crisis in 2008, the Federal government created the ________, to purchase financial assets that were thought to be temporarily undervalued, preventing further financial panic.

Troubled Asset Relief Program

The largest asset of the Fed from those on this list is

U.S. treasury securities

The Federal funds market is a market for trading funds between

a bank and another bank

Which of the following characterize inflation targeting as a monetary policy​ strategy?

a. the likelihood that inflation targeting will become the preferred monetary policy strategy in the future is uncertain b. the public's assessment of the central bank's success in target attainment is not easily accomplished c. the determination of the specific policy actions needed for any given inflation target is difficult to make

The basic Keynesian argument for discretionary monetary policy is that

aggregate demand is unstable and monetary policy can help to stabilize it.

Fractional reserve banking is the system that

allows banks to keep smaller reserves than their deposits.

In​ theory, the effect on the money supply would be _____________. ​But, in​ practice, the money supply ___________ as a result of the changes in the monetary base and multiplier.

ambiguous; fell

A liquidity trap occurs when

any additions to the monetary base are held as cash by people or reserves at banks.

A bank run is

a​ large-scale, panicky withdrawal of deposits from a bank.

The new monetary policy tool that the Fed began using in 2008 is

changing the interest rate paid on reserves

The degree to which the public believes the central bank's announcements about future policy is its

credibility

The degree to which the public believes the central​ bank's announcements about future policy is its

credibility.

The largest liability of the Fed from those on this list is

currency outstanding

Suppose there was a banking crisis. The money supply would shrink by the greatest amount if the public ________ their currency—deposit ratio and the banks ________ their reserve—deposit ratio.

increased; increased

When the central bank announces the inflation rate that it will achieve over the next one to four years, it is following a strategy known as

inflation targeting

Macroeconomic variables that the Fed cannot control directly but can influence fairly predictably, and which are related to the Fed's goals, are known as

intermediate targets

If the ​lender-of-last-resort mechanism works as​ designed, the severity of a financial crisis is _________ and the funds that banks borrowed during the panic are ___________ the central bank.

lessened; returned to

According to Walter​ Bagehot, an early advocate of the idea of a lender of last​ resort, most banks during a financial crisis are exposed to _____________ but not ____________

liquidity problems; bankruptcy

A properly constructed central​ bank-lending mechanism should have borrowing banks posting _____________ as collateral for the funds they receive.

marketable securities

Which of the following variables is likely to serve as an intermediate target for monetary policy?

money supply

Zero lower bound refers to the fact that

nominal interest rates cannot fall below zero.

When the Fed increases the quantity of assets it owns, it is said to be engaging in

quantitative easing

When the Fed increases the quantity of assets it​ owns, it is said to be engaging in

quantitative easing.

What are the variables that determine the recommended fed funds rate according to the Taylor​ rule?

recent​ inflation, the deviation of output from the level of​ full-employment output, and the deviation of recent inflation from its target of​ 2%

In the Keynesian​ model, suppose the Fed sets a target for the real interest rate. If the IS curve shifts down and to the​ left, and the Fed wants to keep output unchanged in the short run and the price level unchanged in the long​ run, it will

shift the LR curve down.

In the Keynesian model, suppose the Fed sets a target for the real interest rate. If the IS curve shifts up and to the right, and the Fed wants to keep output unchanged in the short run and the price level unchanged in the long run, it will

shift the LR curve up

History shows that the episodes of negative nominal interest rates that have occurred have been of relatively __________ duration on very ___________ securities.

short; short-term

The leadership of the Federal Reserve System is provided by

the board of Governors

The primary criticism by Keynesians of the credibility argument for rules is that

the cost of losing flexibility over policy choices may exceed the cost of gaining credibility.

What is the problem with setting the federal funds rate to follow the Taylor rule in this​ case?

the federal funds rate cannot be negative

In the Keynesian model, suppose the Fed wants to keep output unchanged. If the IS curve shifts to the left, and the Fed acts to keep output unchanged, then

the real interest rate will decrease

Banks hold some deposits on reserve at the Fed because

these deposits meet the reserve requirements of the Fed

Policymakers may be uncertain about the structure of the economy because

they don't know the predominant source of shocks to the economy.

During the Great​ Depression,

the​ currency-deposit ratio rose as a result of the loss of confidence in bank stability. Banks increased reserves to try and convince skeptical customers that they could meet their cash​ needs, which increased the​ reserve-deposit ratio as well. Increases in both of these ratios caused a decrease in the money multiplier.

During the 2008 financial​ crisis,

the​ currency-deposit ratio​ fell, in contrast to the Great Depression. But the marked increase in the​ reserve-deposit ratio meant that the money multiplier decreased overall.

According to the Taylor rule, if output is above its full employment level and inflation is less than 2%

what the Fed should do is ambiguous