MacroEconomics Final Study Set

The goldsmiths' fractional reserve system is similar to today's fractional reserve banking system, which has two significant characteristics _________________

1. Banks can create money in such a system 2. Banks are subject to "panics" or "runs," and thus need government regulation.

The Federal Reserve Banks use principal tools (techniques or instruments) to control the reserves of banks and the size of the money supply. There are __________

1. The Federal Reserve can buy or sell government securities through its open-market operations to change the excess reserves of banks and thus the lending ability of the banking system. 2. The Federal Reserve can raise or lower the reserve ratio 3. The Federal Reserve can raise or lower the discount rate. Raising the discount rate discourages banks from borrowing reserves from the Fed. Lowering the discount rate encourages banks to borrow from the Fed.

Transactions for creating a bank are ___________

Transaction 1: Creating a bank. A commercial bank is founded by selling shares of stock and obtaining cash in return. Stock is a liability and cash is an asset. Transaction 2: Acquiring property and equipment. A commercial bank needs property and equipment to carry on the banking business. They are assets of the bank. Transaction 3: Accepting deposits. When a bank accepts deposits of cash, the cash becomes an asset to the bank, and checkable deposit accounts that are created are a liability. Transaction 4: Depositing reserves in the Federal Reserve Bank. Transaction 5: Clearing a check drawn against the bank. The writing of a check on the bank and its deposit in a second bank results in a loss of reserves (assets) and checkable deposits (liabilities) for the first bank and a gain in reserves and deposits for the second bank.

The principal liabilities are Federal Reserve Notes (outstanding), the reserve deposits of commercial banks, and ____________

U.S. Treasury deposits.

The fundamental goal of monetary policy is to ______________

achieve and maintain price stability, full employment, and economic growth. The Federal Reserve can accomplish this goal by exercising control over the amount of excess reserves held by commercial banks, and thereby influencing the size of the money supply and the total level of spending in the economy.

An expansionary monetary policy can be implemented by ___________

actions of the Federal Reserve to buy government securities in open-market operations to lower the federal funds rate. This policy expands the money supply, putting downward pressure on other interest rates, and helps to stimulate aggregate demand. The prime interest rate is the benchmark rate that banks use to decide on the interest rate for loans to businesses and individuals; it rises and falls with the federal funds rate.

A contractionary monetary policy can be implemented by _____________

actions of the Federal Reserve to sell government securities in open-market operations that raises the federal funds rate. This policy contracts the money supply, putting upward pressure on other interest rates, and helps to reduce aggregate demand to maintain a stable price level.

The Troubled Asset Relief Program (TARP) was established by the federal government in late 2008 to make ____________

emergency loans to important U.S. financial institutions and businesses. A $700 billion "bailout" fund was used to support such firms as AIG, Citibank, and Bank of America, and also businesses such as General Motors and Chrysler. TARP, however, also created a moral hazard because it set a precedent for helping or rewarding some firms for taking larger risks than they otherwise would have without such government backing because the large firms were considered "too big to fail."

An expansionary policy may not work because _______________

even when the Federal Reserve makes more reserves available to banks, the economic conditions of recession or slow growth may make businesses hesitant to increase their borrowing and increase their investment spending. In addition, the Fed faces the problem of a liquidity trap in achieving its goal. Just adding liquidity in the form of excess reserves for the banking system may not be sufficient to get banks to increase their lending and add liquidity to the economy if the banks fear an uncertain economic future and are worried about whether their loans will be repaid.

Monetary policy is considered more important and valuable for _____________

stabilizing the national economy because of its several advantages over fiscal policy: it is quicker and more flexible; and it is more protected from political pressure.

The Board of Governors of the Fed exercises control over the __________

supply of money and the banking system. The U.S. president appoints the seven members of the Board of Governors, who serve for 14 years. He also selects the board chair and vice chair, who serve for 4-year terms.

The "big picture" of macroeconomics shows ______________

that the equilibrium levels of output, employment, income, and prices are determined by the interaction of aggregate supply and aggregate demand. There are three major components of aggregate supply: the prices of inputs or resources, factors affecting the productivity with which resources are used, and the legal and institutional environment. There are four major components of aggregate demand: consumption, investment, government spending, and net export spending. Fiscal, monetary, or other government policies may have an effect on the components of aggregate demand or supply, which in turn will affect the level of output, employment, income, and prices.

The monetary and financial sector of the economy is significantly influenced by ______________

the Federal Reserve System (the Fed) and the nation's banks and thrift institutions.

A single commercial bank in a multibank system can create money as the following two additional transactions show:

Transaction 6: Granting a loan. When a single commercial bank grants a loan to a borrower, its balance sheet changes. Checkable deposit liabilities are increased by the amount of the loan and the loan value is entered as an asset. In essence, the borrower gives an IOU (a promise to repay the loan) to the bank, and in return the bank creates money by giving the borrower checkable deposits. The bank has "monetized" the IOU and created money. When the borrower writes a check for the amount of the loan to pay for something and that check clears, then the checkable deposits are reduced by the amount of that check. A bank lends its funds only in an amount equal to its pre-loan excess reserves because it fears the loss of reserves to other commercial banks in the economy. Transaction 7: Buying government securities. When a bank buys government securities, it increases its own checkable deposit liabilities and therefore the supply of money by the amount of the securities purchase. The bank assets increase by the amount of the securities it now holds. The bank buys securities only in an amount equal to its excess reserves because it fears the loss of reserves to other commercial banks in the economy.

The principal assets of the Federal Reserve Banks are ___________

U.S. government securities and loans to commercial banks.

The ability of a banking system composed of many individual commercial banks to lend and create money is _____________

a multiple (greater than 1) of its excess reserves and is equal to the excess reserves of the banking system multiplied by the checkable-deposit (or monetary) multiplier.

. The balance sheet of a single commercial bank is a statement of the _____________

assets, liabilities, and net worth (stock shares) of the bank at a specific time; and in the balance sheet, the bank's assets equal its liabilities plus its net worth. This balance sheet changes with various transactions.

Since 2000 U.S. monetary policy has been both expansionary and restrictive in response to ______________

concerns about recession and inflation. After the Great Recession, the Federal Reserve established several innovative policies to stimulate economic growth and increase employment: To keep short-term interest rates at their lowest levels, it adopted a zero interest rate policy (ZIRP). Nominal interest rates could not go below zero without hurting the economy, so the Federal Reserve faced a zero lower bound problem. To overcome this problem, it established a policy of quantitative easing (QE) in which it bought bonds or securities to increase bank reserves. The Federal Reserve has gone through three rounds of quantitative easing.

The excess reserves are ________________

equal to the actual reserves less the required reserves.

The policy response to the financial crisis involved the use of both __________

fiscal and monetary policy

The banking system remains centralized and regulated by government because ___________

historical problems in the U.S. economy led to different kinds of money and the mismanagement of the money supply. The U.S. Congress passed the Federal Reserve Act of 1913 to establish the Fed as the nation's central bank to be responsible for issuing currency and controlling the nation's money supply.

The history of the early goldsmiths illustrates ___________

how paper money came into use in the economy and how banks create money. The goldsmiths accepted gold as deposits and began making loans and issuing money in excess of their gold holdings

The actual reserves of a commercial bank are ___________

its deposits at the Federal Reserve Bank

An individual commercial bank balances its desire for profits with _________

its desire for liquidity or safety (which it achieves by having excess reserves or vault cash). The federal funds market allows banks with excess reserves to lend funds overnight to banks that are short of required reserves. The interest rate paid on the overnight loans is the federal funds rate.

There are limitations and real-world complications with monetary policy in spite of ___________________

its successes over the years

Federal Funds Rate (FFR)

the interest rate that a bank must pay on an overnight loan from another bank

The reserve ratio is ______________

the ratio of required reserves to a bank's own checkable deposit liabilities. The Fed has the authority to establish and change the ratio within limits set by Congress.

The required reserves, which a bank must maintain at its Federal Reserve Bank, equal ___________

the reserve ratio multiplied by the checkable deposit liabilities of the commercial bank.

Monetary Policy is subject to a recognition lag between ______________

the time the need for the policy is recognized and also an operations lag that occurs between the time the policy is implemented and it begins to influence economic activity.

By examining the consolidated balance sheet and the principal assets and liabilities of the Federal Reserve Banks, an understanding of _____________

the ways the Federal Reserve can control and influence the reserves of commercial banks and the money supply can be obtained.

Monetary policy affects the equilibrium GDP in many ways. Some are __________

1. The cause-effect chain goes from the money market to investment spending to equilibrium GDP. 2. If recession or slow economic growth is a major problem, the Federal Reserve can institute an expansionary monetary policy that increases the money supply, causing the interest rate to fall and investment spending to increase, thereby increasing aggregate demand and increasing real GDP by a multiple of the increase in investment. 3. If inflation is the problem, the Federal Reserve can adopt a restrictive monetary policy that decreases the money supply, causing the interest rate to rise and investment spending to decrease, thereby reducing aggregate demand and controlling inflation.

The 12 Federal Reserve Banks of the Fed have three main functions.

1. They serve as the nation's central bank to implement the policies set by the Board of Governors. 2. They are quasi-public banks that blend private ownership of each Federal Reserve Bank with public control of each bank through the Board of Governors. 3. They are "bankers' banks" that perform banking services for the member banks in their regions.

The Federal Reserve serves as the lender of last resort. During the financial crisis it established many innovative facilities that were ________

designed to keep money and credit available and flowing to financial institutions and businesses. It did so by loaning more funds and purchasing hard-to-sell securities from banks and other institutions. It also paid banks interest on the deposits they were required to keep at the Federal Reserve or that they held in their bank vaults.

The monetary multiplier is equal to the _______________

reciprocal of the required reserve ratio for checkable deposits. The maximum expansion of checkable deposits is equal to the initial excess reserves in the banking system times the monetary multiplier. To illustrate, if the required reserve ratio were 20 percent, then the monetary multiplier would be 5 (or 1 divided by 0.20). If excess reserves in the banking system were $80 million, then a maximum of $400 million in money could be created (or 5 times $80 million).

The United States has a fractional reserve banking system. This term means ___________

that banks keep only a part or a fraction of their checkable deposits backed by cash reserves.