Macro econ chapter 15
If the Fed believes the inflation rate is about to increase, it should
use a contractionary monetary policy to increase the interest rate and shift AD to the left.
If the Fed believes the economy is about to fall into recession, it should
use an expansionary monetary policy to lower the interest rate and shift AD to the right.
Which one of the following is not one of the monetary policy goals of the Fed?
Reduce income inequality.
Why was the Fed hoping for consumers to increase their spending in late 2010?
Since consumption spending is the largest component of GDP, an increase in consumption would have increased the growth rate of real GDP.
In a column in the Wall Street Journal, two economists at the Council on Foreign Relations argue: "Simply put, the Fed must choose between managing the level of reserves and managing rates. It cannot do both." Source: Benn Steil and Paul Swartz, "Bye-Bye to the Fed-Funds Rate,"Wall Street Journal, August 19, 2010. Do you agree?
No, because it is by managing reserves that the Fed manages interest rates.
What is a banking panic? Which of the following best explains how the Federal Reserve acts to help prevent banking panics?
A situation in which many banks experience runs at the same time. The Fed acts as a lender of last resort, making loans to banks so that they can pay off depositors.
Why is price stability one of the Fed's monetary policy LOADING... goals? Which of the following is not a problem of high inflation rates?
A. If inflation is low, the Fed will have flexibility to lessen the impact of recessions. B. By achieving price stability, the Fed also promotes economic growth. C. Rising prices erode the value of money as a medium of exchange and store of value. High inflation helps to stabilize financial markets.
These actions involve a number of risks, including the moral hazard problem. Which of the following best explains the moral hazard problem?
Firms may make riskier investments if they believe that the government will bail them out.
According to an article in the New York Times, an official at the Bank of Japan had the following explanation of why monetary policy LOADING... was not pulling the country out of recession: "Despite recent major increases in the money supply, he said, the money stays in banks." Source: James Brooke, "Critics Say Koizumi's Economic Medicine Is a Weak Tea," New York Times, February 27, 2002.
In the quote, when the official says "the money stays in banks," he is referring to an increase in the reserves in banks. But the real problem was that banks were not lending the reserves. The reason for this may have been a lack of borrowers .
John Maynard Keynes is said to have remarked that using an expansionary monetary policy to pull an economy out of a deep recession can be like "pushing on a string." What is Keynes likely to have meant?
Increasing reserves and lowering interest rates may not stimulate economic activity if banks don't lend and businesses don't borrow.
What is the Taylor rule?
It is a rule that links the Fed's target for the federal funds rate to the current inflation rate, real equilibrium federal funds rate, inflation gap and output gap.
Some economists argue that one cause of the financial problems resulting from the housing crisis was the fact that lenders who grant mortgages no longer typically hold the mortgages until they are paid off. Instead, lenders usually resell their mortgages in secondary markets. How might a lender intending to resell a mortgage act differently than a lender intending to hold a mortgage?
The lender might make more risky loans.
Former president Ronald Reagan once stated that inflation "has one cause and one cause alone: government spending more than government takes in." Source: Edward Nelson, "Budget Deficits and Interest Rates," Monetary Trends, Federal Reserve Bank of St. Louis, March 2004.
The statement is correct in that such expansionary fiscal policy is likely to stimulate aggregate demand , which can cause inflation.
An article in the New York Times in March 2002 reported that the housing market had been surprisingly strong during the previous year. According to the article, "In trying to explain the resilience of the housing market in the face of rising unemployment, shrinking stock portfolios and a soft economy, economists start with the Federal Reserve." Source: Daniel Altman, "Economy's Rock: Homes, Homes, Homes," New York Times, March 30, 2002. Economists normally expect that during a recession the housing market does badly because of rising unemployment and falling incomes. However, during 2001, the housing market did well despite the recession because
interest rates were low.
An article in a Federal Reserve publication observes that "20 or 30 years ago, local financial institutions were the only option for some borrowers. Today, borrowers have access to national (and even international) sources of mortgage finance." Source: Daniel J.McDonald and Daniel L. Thornton, "A Primer on the Mortgage Market and Mortgage Finance," Federal Reserve Bank of St. Louis Review, January/February 2008. What caused this change in the sources of mortgage finance? What would be the likely consequence of this change for the interest rates borrowers have to pay on mortgages? The primary reason for this change in the sources of mortgage finance was _____; the consequence of this change was also _____ in mortgage rates.
the development of a secondary mortgage market; a decrease
The federal funds rate is Additionally, the federal funds rate is
the interest rate that banks charge each other for overnight loans. very important for the Fed's monetary policy because the Fed uses the federal funds rate as a monetary policy target since it can control the rate through open market operations.
How can investment banks be subject to liquidity problems? Investment banks can be subject to liquidity problems because
they often borrow short term, sometimes as short as overnight, and invest the funds in longer-term investments.
Support for a monetary rule of the kind advocated by Friedman declined since 1980 because
the Fed's performance since 1980 has been excellent even without a formal inflation target.
What is "Operation Twist"? "Operation Twist" refers to
the Fed's program to purchase $400 billion in long-term Treasury securities while selling an equal amount of shorter-term Treasury securities.
When Congress established the Federal Reserve in 1913, its main responsibility was Congress broadened the Fed's responsibility since
to make discount loans to banks suffering from large withdrawals by depositors. the 1930s as a result of the Great Depression.
When the Federal Reserve increases the required reserve ratioincreases the required reserve ratio as a part of a contractionary monetary policy, there is:
A decrease in the money supply and an increase in the interest rate.
When the Federal Reserve sells bondssells bonds as a part of a contractionary monetary policy, there is:
A decrease in the money supply and an increase in the interest rate.
Consider the following choices and determine the correct definition for the monetary rule.
A monetary rule is a plan for increasing the money supply at a constant rate regardless of the prevailing economic condition.
Martin Feldstein, an economist at Harvard University, has argued that QE2 led consumers to decrease saving and increase spending: "A likely reason for the fall in the saving rate and the resulting rise in consumer spending was the sharp increase in the stock market, which rose by 15% between August [2010] and the end of the year. That, of course, is what the Fed had been hoping for." Source: Martin Feldstein, "Quantitative Easing and America's Economic Rebound," www.project-syndicate.org, February 24, 2011. Why might QE2, which resulted in a decline in interest rates on long-term Treasury securities, have resulted in an increase in stock prices?
As interest rates fell, bond prices increased, asset holders started to buy more stocks instead of bonds, which in turn led to an increase in demand for stocks and stock prices increased.
Even though the core PCE is a better measure of the inflation rate than is the CPI, the CPI is still more widely used because the core PCE includes energy and food prices, which do not affect the cost of living of a typical consumer.
False
For more than 20 years, the Fed has used the federal funds rate as its monetary policy target. It has not targeted money supply at the same time because the
Fed cannot target both at the same time: It has to choose between targeting an interest rate and targeting the money supply.
Which of the following is NOT a monetary policy LOADING... goal of the Federal Reserve bank (the Fed)?
Low prices
In the graph of the money market shown on the right, what could cause the money supply curve to shift from MS11 to MS22? In the graph of the money market shown on the right, what could cause the money demand curve to shift from MD11 to MD22?
The Fed decreases the money supply by deciding to sell U.S. Treasury securities. A. An increase in real GDP. C. An increase in the price level
The Federal Reserve has multiple economic goals for monetary policy to achieve, However, it can be difficult to manage all of the goals at once. Which of the following is not true regarding the multiple goals of the Fed?
The goal of financial market stability means that the Fed tries to ensure that asset prices, such as stock prices, increase at a very high rate so investors can make more money.
Consider the following statement: "The Fed has an easy job. Say it wants to increase real GDP by $200 billion. All it has to do is increase the money supply by that amount."
The statement is incorrect because an increase in the money supply does not affect real GDP directly.
What is the purpose of the Taylor rule? The Taylor rule is used to
analyze and predict how the Fed targets the federal funds rate.
According to an article in the Economist magazine, in 2013 the Japanese economy was experiencing falling prices "on everything from chocolate bars to salad." Source: "Waging a New War," Economist, March 9, 2013. What is the term for a falling price level?
deflation
Milton Friedman would have liked the Fed to follow a monetary rule where the
money supply is increased every year by a percentage rate equal to the long-run growth rate of real GDP.
A former Federal Reserve official argued that at the Fed, "the objectives of price stability and low long-term interest rates are essentially the same objective." Source:William Poole, "Understanding the Fed," Federal Reserve Bank of St. Louis Review, Vol. 89,No. 1, January/February 2007, p. 4. This is true because
stable prices make it easier to plan for the future, so expectations can be stable, which makes it less costly to make loans.
As the interest rate increases,
consumption, investment, and net exports decrease; aggregate demand decreases.
Which of the following were important developments in the mortgage market that took place during the 1970s?
A. Fannie Mae and Freddie Mac began to act as intermediaries between investors and home buyers. B. Banks began to resell mortgages on the secondary market rather than holding them in their portfolios.
Why is price stability one of the Fed's monetary policy goals? Which of the following is not a problem of high inflation rates?
A. If inflation is low, the Fed will have flexibility to lessen the impact of recessions. B. Rising prices erode the value of money as a medium of exchange and store of value. C. By achieving price stability, the Fed also promotes economic growth. High inflation helps to stabilize financial markets.
If policymakers at the Fed are aware that GDP data are sometimes subject to large revisions, how might this affect their views about how best to conduct policy?
A. They would have gathered as much information as possible before designing a policy. B. They would have better understood the uncertainty of the outcome of a policy. C. They would have been more cautious about designing a policy.
Stock prices rose rapidly in 2005, as did housing prices in many parts of the country. By 2008, both stock prices and housing prices were declining sharply. Some economists have argued that rapid increases and decreases in the prices of assets such as shares of stock or houses can damage the economy. Currently, stabilizing asset prices is not one of the Federal Reserve's policy goals. In what ways would a goal of stabilizing asset prices be different from the four goals LOADING... listed in this chapter? Stabilizing asset prices should not be added to the list of the Fed's policy goals because they are more specific and deal mainly with individuals and firms. Each of these carry risk associated with them and the Fed should not be in the business of trying to make profit for individuals.
Asset prices deal with a specific type of wealth that carries risk associated with individual firms. True
Which of the following is a monetary policy target used by the Fed? The Fed uses policy targets of interest rate and/or money supply because
Interest rate. it can affect the interest rate and the money supply directly and these in turn can affect unemployment, GDP growth, and the price level.
The Federal Reserve cannot affect the price levelthe price level directly; therefore, the Fed typically uses the following as its policy target:
Interest rates.
At the beginning of 2005, Robert Toll, CEO of Toll Brothers, argued that the United States was not experiencing a housing bubble. Instead, he argued that higher house prices reflected restrictions imposed by local governments on building new houses. He argued that the restrictions resulted from "NIMBY"long dash—"Not in My Back Yard"long dash—politics. Many existing homeowners are reluctant to see nearby farms and undeveloped land turned into new housing developments. As a result, according to Toll, "Towns don't want anything built." Source: Shawn Tully, "Toll Brothers: The New King of the Real Estate Boom," Fortune, April 5, 2005. Why would the factors mentioned by Robert Toll cause housing prices to rise?
It would keep the supply of housing from increasing.
Recall that "securitization" is the process of turning a loan, such as a mortgage, into a bond that can be bought and sold in secondary markets. An article in the Economist notes: That securitization caused more subprime mortgages to be written is not in doubt. By offering access to a much deeper pool of capital, securitization helped to bring down the cost of mortgages and made home-ownership more affordable for borrowers with poor credit histories. Source: "Ruptured Credit," Economist, May 15, 2008. What is a "subprime mortgage," and would a subprime borrower be likely to pay a higher or a lower interest rate than a borrower with a better credit history?
Loans granted to borrowers with flawed credit histories; a higher interest rate.
Beginning in 2008, the Federal Reserve and the U.S. Treasury Department responded to the financial crisis by intervening in financial markets in unprecedented ways. Which of the following is one of the unprecedented actions of the Fed?
Making loans to primary dealers and holders of mortgage-backed securities.
Which of the following is not a correct comparison between a contractionary monetary policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?
None of the above are correct statements about the two models.
Why would securitization give mortgage borrowers access to a deeper pool of capital?
Since banks could resell mortgages to investors, they had access to more funds than just their own deposits.
Which of the following are reasons why the federal government uses the CPI when deciding how much to increase Social Security payments to retired workers to keep the purchasing power of the payments from declining?
The CPI continues to be the most widely used measure of inflation.
Explain whether you agree with this argument: If the Fed actually ever carried out a contractionary monetary policy, the price level would fall. Because the price level has not fallen in the United States over an entire year since the 1930s, we can conclude that the Fed has not carried out a contractionary policy since the 1930s.
The statement is false. A contractionary policy could result in a lower rate of inflation rather than a fall in the price level.
Charles Calomiris, an economist at Columbia University, was quoted as saying the following of the initiatives of the Treasury and Fed during the financial crisis of 2007minus−2009: "It has been a really headspinning range of unprecedented and bold actions... That is exactly as it should be. But I'm not saying that it's without some cost and without some risk." Source: Steven R.Weisman, "With Bold Steps, Fed Chief Quiets Some Criticism," New York Times, May 28, 2008. What was unprecedented about the Treasury and Fed's actions?
They involved an unusual degree of government involvement in financial markets, including partial ownership of firms.
In the fall of 2011, investors began to fear that some European governments, particularly Greece and Italy, might default on the bonds they had issued, making the prices of the bonds fall sharply. Many European banks owned these bonds, and some investors worried that these banks might also be in financial trouble. An article in the Economist magazine referred to the "prospect of another Lehman moment." The article noted that, "Governments are once again having to step in to support their banks." Source: "Here We Go Again," Economist, October 8, 2011. What did the article mean by a "Lehman moment"? A "Lehman moment" meant
a deepening of the financial crisis brought about by bankruptcy of a major bank.
If the Federal Reserve purchases $170170 million worth of U.S. Treasury bills from the public, the money supply will
increase
If the Federal Reserve purchases $180180 million worth of U.S. Treasury bills from the public, the money supply will
increase
Why is the Fed sometimes said to have a "dual mandate"? The Fed is said to have a" dual mandate" because
maintaining price stability and high employment are the two most important goals of the Fed that are explicitly mentioned in the Employment Act of 1946.
An increase in interest rates affects aggregate demand by
shifting the aggregate demand curve to the left, reducing real GDP and lowering the price level.
In addition, budget deficits can cause inflation if
the central bank buys the bonds used to finance the deficits.
If many unemployed people have been out of work for a long time, why might policies that increase their ability to find jobs be more effective in reducing unemployment than a policy of monetary stimulus?
Long-term unemployment is due to the mis-match between the skills that are in demand and the skills that unemployed workers have. Policies such as additional training can mitigate such unemployment by making workers better skilled.
What is "quantitative easing"? Quantitative easing involved the Fed's
buying longer term Treasury securities that are not usually involved in open market operations.
While serving as the president of the Federal Reserve Bank of St. Louis, William Poole stated, "Although my own preference is for zero inflation properly managed, I believe that a central bank consensus on some other numerical goal of reasonably low inflation is more important than the exact number." Source: William Poole,"Understanding the Fed," Federal Reserve Bank of St. Louis Review, Vol. 89, No. 1, January/February 2007, p. 4. Which of the following are benefits that the economy might gain from an explicit inflation target LOADING... even if the target chosen is not a zero rate of inflation?
A. Improved accountability for the Fed B. More accurate expectations of future inflation C. Better communication between the Fed and the public
Which of the following is not a correct comparison between an expansionary monetary policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?
A. In the dynamic model, expansionary policy would be used when demand does not grow sufficiently; in the basic model, expansionary policy would be used when demand falls. B. The dynamic model assumes that potential GDP is constantly growing while the basic model assumes that it is static. C. If the economy is below full employment, expansionary monetary policy will cause an increase in the price level in both models.
Which of the following was the Fed's objective in using "quantitative easing" and "Operation Twist"?
A. To keep interest rates on 10-year Treasury notes low. .B. To increase aggregate demand. C. To keep interest rates on mortgages low.
When the Fed conducts monetary policy, it uses several policy targets to indicate how effectively policy decisions are working. Which of the following makes it less likely an economic variable would be a good policy target?
An economic variable that is one of the Federal Reserve goals such as the unemployment rate or real GDP.
An article by three economists at the Federal Reserve Bank of Richmond notes that by the fall of 2011, many unemployed people in the United States had been out of work for more than six months. The economists argue that: "After a long period of unemployment, affected workers may become effectively unemployable." They conclude that: "Policy options [such as providing additional training] that increase the ability of unemployed workers to find work " may be more effective at reducing unemployment than additional monetary stimulus." Source: Andreas Hornstein, Thomas A. Lubik, and Jessie Romero,"Potential Causes and Implications of the Rise in Long-Term Unemployment," Federal Reserve Bank of Richmond, Economic Brief, September 2011. What is a policy of monetary stimulus?
It is an expansionary monetary policy which lowers interest rates.
What do economists mean by the demand for money? What is the advantage of holding money? What is the disadvantage of holding money?
It is the amount of money—currency and checking account deposits—that individuals hold. Money can be used to buy goods, services, or financial assets. Money, in the form of currency or checking account deposits, earns either no interest or a very low rate of interest.
Why might European governments have felt the need to support their banks in order to avoid another Lehman moment?
The European governments wanted to avoid wider economic repercussions resulting from bank failures that could undermine the financial positions of other firms and lead to a further reduction in prices of financial assets.
In 2013, one article in the Wall Street Journal noted that: "The Fed's Board of Governors kept the discount rate unchanged at 0.75%," while another article predicted that: "The Fed can be expected to state again that the target rate won't change until mid-2015." Sources: Michael J. Casey, "Let's Get This Over and Done With, Fed," Wall Street Journal, June 19, 2013; and Sarah Portlock and Eric Morath, "Some Fed Officials See 'Diminished' Downside Risks," Wall Street Journal, February 26, 2013. What is the name of the "target interest rate" mentioned in this article? Who borrows money and who lends money at this "target interest rate"? What is the discount rate?
The federal funds rate. Banks borrow and banks lend. The discount rate is the rate at which the Fed lends to banks.
In response to problems in financial markets and a slowing economy, the Federal Open Market Committee (FOMC) began lowering its target for the federal funds rate from 5.25 percent in September 2007. Over the next year, the FOMC cut its federal funds rate target in a series of steps. Writing in the New York Times, economist Steven Levitt observed, "The Fed has been pouring more money into the banking system by cutting the target federal funds rate to 0 to 0.25 percent in December 2008." Source: Steven D. Levitt, "The Financial Meltdown Now and Then," New York Times, May 12, 2009. What is the relationship between the federal funds rate falling and the money supply increasing? How does lowering the target for the federal funds rate "pour money" into the banking system?
To decrease the federal funds rate, the Fed must increase the money supply. To increase the money supply, the Fed buys bonds on the open market, which increases bank reserves.
Central banks try to maintain price stability. This is typically assumed to refer to inflation. However, if prices are falling, this is undesirable as well because deflation also impacts price stability.
True
It would be possible to decide whether these factors or a bubble was the cause of rising housing prices by looking at the number of new home units sold. If the number of new home units sold rose noticeably over time, then the evidence supports the bubble argument.
True
William McChesney Martin, who was Federal Reserve chairman from 1951 to 1970, was once quoted as saying, "The role of the Federal Reserve is to remove the punchbowl just as the party gets going."
When he said "to remove the punchbowl," he meant to engage in contractionary policy. In terms of the economy, "just as the party gets going" refers to a situation in which real GDP is greater than potential GDP, which will result in an increase in the inflation rate.
According to an article in the Economist: Calculations by David Mackie, of J.P. Morgan, show that virtually throughout the past six years, interest rates in the euro area have been lower than a Taylor rule would have prescribed, refuting the popular wisdom that the [European Central Bank] cares less about growth than does the Fed. Source: "The European Central Bank: Haughty Indifference, or Masterly Inactivity?" Economist, July 14, 2005. Why would keeping interest rates "lower than a Taylor rule would have prescribed" be an indication that the European Central Bank cared more about growth than popular wisdom held?
When interest rates are relatively low, it tends to increase the money supply and raise aggregate demand, which pushes up short-run economic growth.
The article also stated that Japanese Prime Minister Shinzo Abe was pressuring the Bank of Japan, the Japanese central bank, to take steps to hit an inflation target of 2 percent. Why would the Bank of Japan, the Japanese central bank, be reluctant to raise its target for short-term interest rates if the price level is falling?
When the target rate increases, money growth slows down, and inflation should decrease.
The following appears in a Federal Reserve publication: "In practice, monetary policymakers do not have up-to-the-minute, reliable information about the state of the economy and prices. Information is limited because of lags in the publication of data. Also, policymakers have less-than-perfect understanding of the way the economy works, including the knowledge of when and to what extent policy actions will affect aggregate demand. The operation of the economy changes over time, and with it the response of the economy to policy measures. These limitations add to uncertainties in the policy process and make determining the appropriate setting of monetary policy...more difficult." Source: Board of Governors of the Federal Reserve System, The Federal Reserve System: Purposes and Functions, Washington, DC, 1994. If the Fed itself admits that there are many obstacles in the way of effective monetary policy, why does it still engage in active monetary policy rather than use a monetary growth rule, as suggested by Milton Friedman and his followers? Policymakers at the Fed believe that
although it is not perfect, active monetary policy is still a stabilizing force in the economy.