Money and Banking (Ch. 15 and 16)

-these 2 types of mandates are not very different if? -however, a substantial difference between these two mandates might exist because the public and politicians may believe that

-if maximum employment is defined as natural rate of employment - a hierarchical mandate puts too much emphasis on inflation control and not enough on stabilizing output.

-Secondary credit is given to banks that are: -interest set at?

-in financial trouble and are experiencing severe liquidity problems. -50 basis points (0.5 percentage point) above the discount rate.

skepticism about the merits of quantitative easing:

-in past most of the increase in the monetary base just flowed into holdings of excess reserves. - because the federal funds rate had already fallen to the zero lower bound, the expansion of the balance sheet and the monetary base could not lower short-term interest rates any further and thereby stimulate the economy -an increase in the monetary base does not mean that banks will increase lending, because they can just add to their holdings of excess reserves instead of making loans

What is the effect on demand? -Federal funds rate decreases, the opportunity costs of holding excess reserves falls:

-increases

-choosing an aggregate target involves losing control of the

-interest rate

-define frictional unemployment: -structural unemployment: -the point at which the demand for labor equals the supply of labor.

-involves searches by workers and firms to find suitable matchups, is beneficial to the economy -a mismatch between job requirements and the skills or availability of local workers -natural rate of unemployment

Should Central Banks Try to Stop Asset-Price Bubbles?: -Describe arguments for: "lean against" -what policies would be most effective in restraining it?

-leaning against credit booms instead, leaning against credit driven bubbles but not against asset-price bubbles driven by irrational exuberance (easier to identify credit booms -macroprudential policy and Monetary policy

Interest on Reserves affect on federal funds rate: -when AD and AS intersect at sloping S: (initial federal funds rate is greater than interest rate paid on reserves) -when ADand AS intersect as flat AS: (initial federal funds rate = interest paid on reserves)

-leaves federal funds rate unchanged -raises federal funds rate

-in most circumstances the amount of discount lending under the primary credit facility is very small. If the amount is so small, why does the Fed have this facility?

-the facility is intended to be a backup source of liquidity for sound banks so that the federal funds rate never rises too far above the federal funds target set by the FOMC

5 potential goals of economic policy: 5. Stability in Foreign Exchange Markets:

-the increasing importance of international trade to the U.S. economy, the value of the dollar relative to other currencies has become a major consideration for the Fed.

-NAIRU, the nonaccelerating inflation rate of unemployment

-the theory states that when the unemployment rate is above NAIRU, with output below potential, inflation will fall, but when it is below NAIRU, with output above potential, inflation will rise

policy instrument: -what is this? -also called?

-variable that responds to the central bank's tools and indicates the stance (easy or tight) of monetary policy. -whether its easy or tight -operating instrument

-describe time inconsistency problem: (Think NY diet resolution) -are expansionary policies "good" or bad" in long run

-we find ourselves unable to consistently follow a good plan over time; the good plan is said to be time-inconsistent and will soon be abandoned. -A central bank will have better inflation performance in the long run if it does not try to surprise people with an unexpectedly expansionary policy, but instead keeps inflation under control.

-supply-side economics policies: -A rise in the value of the dollar makes American industries ______ competitive with those abroad, and a drop in the value of the dollar stimulates inflation in the United State

-which are intended to spur economic growth by providing tax incentives for businesses to invest in facilities and equipment and for taxpayers to save more. -less

There are two situations in which the other tools have advantages over open market operations. 1 .when the Fed wants to raise interest rates after banks have accumulated large amounts of excess reserves. 2. when discount policy can be used by the Fed to perform its role as lender of last resort

1. In this case, the federal funds rate can be raised by increasing the interest on reserves, which eliminates the need to conduct massive open market operations to raise the federal funds rate by reducing reserves. 2.

-with federal funds rate below id (discount loan) firms will take loans through ____ rater than federal reserve bc it's cheaper -here the supply curve is?

-federal funds market -vertical

-The decision making authority for open market operations is the? what do they do?

-federal open market committee; -sets target federal funds rate

-once the federal funds rate hits the discount rate the supply curve becomes? -with excess supply of reserves, the federal funds rate?

-flat -falls

-The most extreme example of unstable prices is.. -how can inflation strain a country's social fabric

-hyperinflation -Conflict might result, because each group in the society may compete with other groups to make sure that its income keeps up with the rising level of prices

-central banks typically have an inflation target around the __ % level -The benefits of a higher inflation target accrue only when?

-2 -zero lower bound problem occurs

The Tayor Rule: -Formula: -define

-Federal Funds target rate= Inflation Rate + equilibrium real fed funds rate + (1/2)(inflation gap) + (1/2)(output gap) -The principle that the monetary authorities should raise nominal interest rates by more than the increase in the inflation rate

Advantages of Fed's Just do it approach:

-Forward-looking behavior and stress on price stability -help to discourage overly expansionary monetary policy, thereby ameliorating the time-inconsistency problem

Does skepticism about the merits of quantitative easing mean that the Fed's nonconventional monetary policy actions during the financial crisis were ineffective in stimulating the economy?

-The Fed Chair at the time, Ben Bernanke, argued that the answer is no, because the Fed's policies were directed not at expanding the Fed's balance sheet but rather at credit easing

-Define discount window: -The Fed's discount loans to banks are of three types: - is the discount lending that plays the most important role in monetary policy

-The facility at which banks can borrow reserves from the Federal Reserve 1. primary credit 2.secondary credit 3. seasonal credit - primary credit

-define nominal anchor: - A more subtle reason for a nominal anchor's importance is that it can limit the time-inconsistency problem... what is this? -a nominal anchor is said to be like a? (think little kid/ parenting ex)

-a nominal variable, such as the inflation rate or the money supply, that ties down the price level to achieve price stability (central element in succesful monetary policy) -in which monetary policy conducted on a discretionary, day-by-day basis leads to poor long-term outcomes -behavior rule

-what is natural rate of output? -what is this also called? -policy can try to?

-a particular level of output is produced at the natural rate of unemployment, -potential output -they should try to stabilize the level of output around its natural rate

-Macroprudential regulation definition: -Prudential supervision is subject to more _________ pressure than monetary policy because it affects the bottom line of financial institutions more directly

-aims to mitigate risk to the financial system as a whole -political

-define credit easing: -functions to?

-altering the composition of the Fed's balance sheet in order to improve the functioning of particular segments of the credit markets - increase flow of credit and lending

Open Market Operations affect on Federal funds rate: - AD and AS initially intersect at downward soping Demand curve will ______ federal funds rate -- AD and AS initially intersect at flat Demand curve will ______ federal funds rate

-an open market purchase causes the federal funds rate to fall (increase supply) , whereas an open market sale causes the federal funds rate to rise. -fall -not affect; bc federal funds rate cannot fall below thew interest paid on reserves

-intermediate target:

-any number of variables (ex: monetary aggregate or interest rates) that have a direct effect on unemployment and the price level and that the Fed seeks to influence -stand between the policy instrument and the goals of monetary policy(ex price stability and output growth)

-define price stability: -why is this desireable?

-central bankers define as low and stable inflation, is increasingly viewed as the most important goal of monetary policy -a rising price level (inflation) creates uncertainty in the economy, and that uncertainty might hamper economic growth

-Difference between dynamic and defensive open market operations

-dynamic:are intended to change the level of reserves and the monetary base -defensive: intended to offset movements in other factors that affect reserves and the monetary base, such as changes in Treasury deposits with the Fed or changes in float.

-when the Federal Reserve was created, its most important role was to act as? -what problems are associated with this?

-lendor of last resort -The Federal Reserve's role as lender of last resort is, if anything, more important today than ever because of the high number of bank failures experienced in the 1980s and early 1990s and during the global financial crisis from 2007 to 2009. -Prob: banks are willing to risk more bc they know the federal reserve will bail them out if need be (moral hazard problem)

-In the ______ run, no inconsistency exists between the price stability goal and the other goals mentioned earlier. -define hierarchical mandates: -define dual mandates:

-long run -which put the goal of price stability first and then state that other goals can be pursued as long as price stability is achieved -to achieve two coequal objectives: price stability and maximum employment (output stability).

Forward Guidance: -aka? -what is this?

-management of expectations -committing to the future policy action of keeping the federal funds rate at zero for an extended period, the Fed could lower the market's expectations of future short-term interest rates, thereby causing the long-term interest rate to fall.

-Seasonal Credit is given to: -how's the interest rate?

-meet the needs of a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits. -interest rate charged on seasonal credit is tied to the average of the federal funds rate and certificate of deposit rates.

Discount lending affect on federal funds rate: -lowering the discount rate shifts the supply curve down, what affect does this have on federal funds rate? (when D and S intersect at sloping supply) (no lending; BR=0) -lowering discount rate shifts supply curve down,what affect does this have on federal funds rate? (when they intersect at flat S) (some lending; BR> 0

-no affect -fall in federal funds rate

-what are nonconventional monetary policy tools -what are the 4 forms?

-non interest rate tools 1. liquidity provision 2. asset purchases 3. forward guidance 4. negative interest rates on bank deposits at a central bank

-what are asset price bubbles? -what are the 2 types: 1. Credit driven bubbles: 2. Bubbles Driven Solely by Irrational Exuberance

-pronounced increases in asset prices, or "bubbles," that depart from fundamental values and that eventually burst resoundingly. 1. occur when 'changes in financial markets stimulate the availability of credit, thereby increasing the demand for and prices of some assets'. 2. Bubbles that are driven solely by overly optimistic expectations, but that are not associated with a credit boom, pose much less risk to the financial system

-liquidity provisions and large scale asset purchases led to an unprecedented ________ of Federal Reserve's Balance sheet -This expansion of the balance sheet is referred to as? This led to?

-quadrupling -quantitative easing; a huge increase in the monetary base.

Reserve requirements affect on federal funds rate: -when the Fed raises reserve requirements, the federal funds rate _______ -When the Fed decreases reserve requirements, the federal funds rate ______

-rises -falls

In recent years, most central banks have concluded that the link between interest rates and goals such as stable inflation is stronger than the link between aggregates and inflation. For this reason, central banks throughout the world now generally use

-short-term interest rates as their policy instrument

-lean vs. clean debate: -which type of bubble is more costly?

-should policy lean against bubble or clean up after bubble burst? -credit driven

-Healthy banks are allowed to borrow all they want at very short maturities (usually overnight) from the primary credit facility, and it is therefore referred to as a? -the discount rate is set at?

-standing lending facility -higher than federal funds rate target (because the Fed prefers that banks borrow from each other in the federal funds market so that they continually monitor each other for credit risk)

-phillips curve theory:

-states that changes in inflation are influenced by the state of the economy relative to its productive capacity, as well as by other factors

-describe zero- lower-bound- problem:

-the central bank is unable to lower its policy interest rate (the federal funds rate for the Fed) further because it has hit a floor of zero -financial institutions are unwilling to earn a lower return by lending in the federal funds market than they could earn by holding cash, with its zero rate of return

-when federal funds rate falls below interest rate paid on reserves, banks will no longer lend in the federal funds market bc the can hold more in excess reserves so they hold more in excess reserves indefinitely. what is the result?

-the demand curve becomes flat (infinitely elastic)

Criteria for choosing the policy instrument: 1. Controllability: 2. Predictable Effect on goals:

1. A central bank must be able to exercise effective control over a variable if the variable is to function as a useful policy instrument. If the central bank cannot control the policy instrument, knowing that it is off track does little good because the central bank has no way of getting it back on track. 2. most important characteristic of a policy instrument is that it must have a predictable effect on a goal such as high employment or price stability;

Should Central Banks Try to Stop Asset-Price Bubbles?: -Describe arguments Against: "clean up"

1. Asset-price bubbles are nearly impossible to identify. 2. raising interest rates may be very ineffective in restraining bubbles because market participants expect such high rates of return from buying bubble-driven assets. 3. Many different asset prices exist, and at any one time a bubble may be present in only a fraction of asset markets. 4. Monetary policy actions to prick bubbles can have harmful effects on the aggregate economy; can affect employment, inflation, etc. 5. As long as policymakers respond in a timely fashion, by easing monetary policy aggressively after an asset bubble bursts, the harmful effects of a bursting bubble can be kept at a manageable leve

Open Market operations four basic advantages over the other tools:

1. Open market operations occur at the initiative of the Fed, which has complete control over their volume. 2. Open market operations are flexible and precise; they can be used to the exact extent desired 3. Open market operations are easily reversed 4. Open market operations can be implemented quickly; they involve no administrative delays.

Advantages of inflation targeting: (5)

1. Reduction of the Time-Inconsistency Problem 2. increased transparency 3. increased accountability of central bank 4. Consistency with Democratic Principles 5. improved performance

Situations in which conventional monetary policy won't work:

1. The financial system seizes up to such an extent that it becomes unable to allocate capital to productive uses, and so investment spending and the economy collapse 2. the negative shock to the economy can lead to the zero-lower-bound problem

Problem with this idea? -Setting negative interest rates on banks' deposits is supposed to work to stimulate the economy by encouraging banks to lend out the deposits they were keeping at the central bank, thereby encouraging households and businesses to spend more

1. banks might not lend out their deposits at the central bank, but instead move them into cash 2. charging banks interest on their deposits might be very costly to banks if they still have to pay positive interest rates to their depositors. In this case, bank profitability would fall

Liquidity Provision: 1. Discount window expansion 2. Term auction facility 3. New lending provisions

1. borrowing from the discount window has a "stigma" attached to it (because such borrowing suggests that the borrowing bank is desperate for funds and thus in trouble), use of the discount window was limited during the crisis. 2. To encourage additional borrowing, in December 2007 the Fed set up a temporary Term Auction Facility (TAF), in which it made loans at a rate determined through competitive auctions 3. The Fed broadened its provision of liquidity to the financial system well beyond its traditional lending to banking institutions. These actions included lending to investment banks as well as lending to promote purchases of commercial paper, mortgage-backed securities, and other asset-backed securities.

5 potential goals of economic policy: 3.Stability of financial markets: 4.Interest rate stability

3. financial crises can interfere with the ability of financial markets to channel funds to people with productive investment opportunities and can lead to a sharp contraction in economic activity. 4. Interest-rate stability is desirable because fluctuations in interest rates can create uncertainty in the economy and make it harder to plan for the future.

Forward guidance cont: -There are two types of commitments to future policy actions 1. Conditonal 2. Unconditional -which is stronger and why?

1. commitment to keep the federal funds rate at zero for an extended period starting in 2008 was conditional because it stated that the decision was predicted on a weak economy going forward 2. just stating that it would keep the federal funds rate at zero for an extended period, without indicating that this decision might change depending on the state of the economy. -An unconditional commitment is stronger than a conditional commitment because it does not suggest that the commitment will be abandoned and so is likely to have a larger effect on long-term interest rates.

The four lessons learned from the global financial crisis, what does this mean for inflation targeting? 1. Developments in the financial sector have a far greater impact on economic activity than was earlier realized 2. The zero lower bound on interest rates can be a serious problem.

1. global financial crisis made it abundantly clear that the adverse effects of financial disruptions on economic activity could be far worse than originally anticipated. 2. Fed's have to use unconventional tools; they are more complicated to use than conventional tools and their impact on the economy is more uncertain, so they may be harder to use effectively.

Disadvantages of Fed's just dot it approach:

1. lack of tranparency 2. the opacity of the Fed's policymaking made it hard for Congress and the general public to hold the Federal Reserve accountable:

-5 elements of target inflation:

1. public announcement of medium-term numerical objectives (targets) for inflation; 2. an institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieving the inflation goal 3. an information-inclusive approach in which many variables (not just monetary aggregates) are used in making decisions about monetary policy 4. increased transparency of the monetary policy strategy through communication with the public and the markets about the plans and objectives of monetary policymakers 5. increased accountability of the central bank for attaining its inflation objectives

-Defensive open market operations are of two basic types: 1. repurchase agreements (repos) 2. a matched sale-purchase transaction (a reverse repo)

1. the Fed purchases securities with an agreement that the seller will repurchase them in a short period of time, anywhere from one to fifteen days from the original date of purchase (this is temporary) 2. which the Fed sells securities and the buyer agrees to sell them back to the Fed in the near future. (temp sale)

-The supply of reserves can be broken into 2 components

1. the amount of reserves that are supplied by the Fed's open market operations, called nonborrowed reserves (NBR) 2. the amount of reserves borrowed from the Fed, called borrowed reserves (BR).

Open market operations: 1. Open market operations are the most important conventional monetary policy tool because... 2. Open market purchases expand reserves and the monetary base..leading to? 3. Open market sales shrink reserves and the monetary base...leading to?

1. they are the primary determinants of changes in interest rates and the monetary base, the main source of fluctuations in the money supply 2. increase in money supply and lowering short term interest rates 3. decreasing the money supply and raising short-term interest rates.

Disadvantages of inflation targeting:

1. too much rigidity (limits their ability to respond to unforeseen circumstances) 2. Potential for Increased Output Fluctuations 3. low economic growth

-A central bank like the Fed has at its disposal two basic types of policy instruments 1. Reserve aggregates: 2. Interest rates:

1. total reserves, nonborrowed reserves, the monetary base, and the nonborrowed base 2. the federal funds rate and other short-term interest rates

-Altering the composition of the Fed's balance sheet can stimulate the economy in several ways:

1. when the Fed provides liquidity to a particular segment of the credit markets that has seized up, such liquidity can help unfreeze the market and thereby enable it to allocate capital to productive uses, consequently stimulating the economy. 2. even if short-term interest rates have hit a floor of zero, asset purchases can lower interest rates for borrowers in particular credit markets and thereby stimulate spending

5 potential goals of economic policy: 1.High Employment and Output Stability: 2. Economic Growth:

1. worthy for 2 main reasons the alternative situation—high unemployment—causes much human misery and when unemployment is high, the economy has both idle workers and idle resources (closed factories and unused equipment), resulting in a loss of output (lower GDP). 2. policies can be aimed specifically at promoting economic growth by directly encouraging firms to invest or by encouraging people to save, which provides more funds for firms to invest

The four lessons learned from the global financial crisis, what does this mean for inflation targeting? 3. The cost of cleaning up after a financial crisis is very high 4. Price and output stability do not ensure financial stability

3. recoveries from financial crisis is very slow; government indebtedness almost always sharply increases and can lead to defaults on government debt 4. The low volatility of both inflation and output fluctuations may have lulled market participants into thinking less risk was present in the economic system than was really the case, leading them to take excessive risks, which in turn helped to fuel the global financial crisis.

During normal times the federal reserve uses 3 tools of monetary policy open market operations, discount lending, and reserve requirements, these are referred to as?

Conventional monetary policy tools

Large Scale Asset purchases:

The Fed's open market operations normally involve only the purchase of government securities, particularly those that are short-term. However, during the crisis, the Fed started two new, large-scale asset purchase programs (often referred to as LSAPs) to lower interest rates for particular types of credit.