Unit 5 Module 12 Monetary Policy in Theory and Practice

The recognition lag is __________. shorter for fiscal policy **about the same for monetary and fiscal policy shorter for monetary policy Correct! The time it takes for policymakers to recognize a problem with the economy is independent of the type of policy chosen to combat the problem.

The implementation lag is __________. **shorter for monetary policy about the same for monetary and fiscal policy shorter for fiscal policy Correct! The FOMC is able to make faster decisions than Congress.

In the classical view, monetary policy works directly to change the economy because when the Federal Reserve buys bonds in the open market, the money supply __________. **expands and spending increases expands, but spending decreases contracts, but spending increases contracts, and spending falls Correct! When the Fed increases the money supply, then at the current level of money income, money supply will exceed money demand. People attempt to spend their excess cash balances.

According to the quantity theory, when the central bank increases the money supply, individuals and private banks find that they are holding smaller money balances than they want. True **False Correct! Because individuals and private banks are holding larger money balances than they want, they will react by spending and making more loans.

To explain how people react when money balances increase, classical theory puts a strong emphasis on spending . The Keynesian model puts an equally strong emphasis on lending . Correct! In the Keynesian model, monetary policy is effective when banks lower interest rates and increase lending. Correct! In the classical view, the link between money and spending is direct.

Banks are more likely to hold a larger amount of excess reserves when the economy is __________. booming and the risk of borrowers defaulting is lower **in recession and the risk of borrowers defaulting is higher booming and the risk of borrowers defaulting is higher in recession and the risk of borrowers defaulting is lower Correct! Individuals are more likely to become unemployed and businesses are more likely to fail when the economy is in recession, so this increases the risk of default and motivates banks to extend fewer loans.

It is important for the Fed to pay attention to interest rates, because letting interest rates rise too high will likely __________. encourage too much investment and cause a recession encourage too much investment and cause inflation **discourage investment and cause a recession discourage investment and cause inflation Correct! High interest rates cause investment spending to fall and lower spending shifts aggregate demand left, which causes output, income, and employment to fall.

Correct! If the Fed sells bonds, bank reserves decrease. Correct! The Fed can sell bonds in the open market to decrease the money supply and raise interest rates. Correct! If the Fed buys bonds, bank reserves increase. Correct! The Fed can buy bonds in the open market to increase the money supply and lower interest rates.

An interest rate target requires the Fed to decrease the monetary base when the actual interest rate is higher than the target rate. True **False Correct! The Fed would need to increase the monetary base to cause the actual interest rate to fall in the direction of the target rate.

Correct! The initial effect of expansionary policy was a decrease in the interest rate, but inflationary expectations offset this change and cause interest rates to move in the other direction. Correct! The interest rate increases when prices are expected to increase because lenders must charge an inflation premium. Correct! Aggregate supply is vertical in the long run, so a rightward shift of aggregate demand leads to a higher equilibrium price level. Correct! Investment spending is expected to increase when interest rates fall, causing aggregate demand to shift to the right.

According to the monetarist view, the Fed should use monetary policy to stabilize money growth and keep the economy on a stable growth path. *True False Correct! Monetarists place less emphasis on interest rates and more on the direct effects of changes in the money supply on spending.

Correct! The monetarist view is that changes in the monetary base cause changes in the money supply, which directly affects spending. Correct! Keynesians emphasize the impact of changes in interest rates on investment spending, aggregate demand, and equilibrium output and employment.

According to the Keynesian model, contractionary monetary policy is more likely to be more effective than expansionary monetary policy because __________. businesses are more in favor of contractionary monetary policy banks have no choice but to increase loans when reserves increase, but they cannot maintain positive excess reserves households are more in favor of contractionary monetary policy **banks have no choice but to reduce loans when reserves fall, but they can maintain positive excess reserves Correct! If the Fed acts to reduce bank reserves, banks may borrow reserves from the Fed on a temporary basis, but will have to contract their loan portfolios to avoid negative excess reserves.

Effective monetary policy increases bank reserves, which results in __________. more lending and less investment spending less lending and less investment spending less lending and more investment spending **more lending and more investment spending Correct! If banks are willing to lend and businesses are willing to borrow, monetary policy has a significant impact on aggregate demand.

The Keynesian belief that banks are more likely to hold larger amounts of excess reserves during a recession was supported when excess reserves rose from $1.5 billion in September 2008 to above $900 billion in January 2009. **True False Correct! This increase happened when the economy entered recession.

If interest rates are low, the opportunity cost of holding money instead of interest-bearing assets is higher. True **False Correct! The opportunity cost of holding money is lower when interest rates are low.

The Fed did not cause the Depression, but perhaps a more aggressive expansionary monetary policy would have made it shorter and milder. **True False Correct! Monetarists, led by Milton Friedman, have demonstrated that the Fed's lack of action may have caused such a prolonged and severe downturn.

If the Fed attempts to maintain a target interest rate and a recession causes interest rates to fall, the Fed would need to pursue __________. expansionary monetary policy to raise interest rates, and this would help to cure the recession expansionary monetary policy to raise interest rates, but this would likely worsen the recession contractionary monetary policy to raise interest rates, and this would help to cure the recession **contractionary monetary policy to raise interest rates, but this would likely worsen the recession Correct! This is an argument against using an interest rate target.

In recent years, the link between the money supply and GDP has __________. strengthened, leading the Fed to focus more on money supply targets strengthened, leading the Fed to focus more on interest rate targets weakened, leading the Fed to focus more on money supply targets **weakened, leading the Fed to focus more on interest rate targets Correct! This link has weakened, leading the Fed to focus more on interest rate targets.

If the Fed is committed to a money supply target and interest rates increase because of a housing boom, the Fed would need to __________. **allow interest rates to increase, even though investment spending could suffer as a result take action to reduce interest rates, since this will not impact the money supply allow interest rates to increase, even though investment spending will grow too quickly as a result change the money supply target to allow for slower money growth Correct! High interest rates have a negative impact on investment spending.

In the classical tradition, an increase in the money supply creates excess money balances. As these balances are spent, __________. aggregate demand shifts to the right, decreasing equilibrium prices and output aggregate demand shifts to the left, increasing equilibrium prices and output aggregate demand shifts to the left, decreasing equilibrium prices and output **aggregate demand shifts to the right, increasing equilibrium prices and output Correct! With higher spending, aggregate demand shifts right and equilibrium price and output both increase.

In the Keynesian view, an increase in the money supply causes aggregate demand to shift to the right. That means that if there is an increase in bank reserves, this leads to __________. **lower interest rates, which causes investment spending to increase higher interest rates, which causes investment spending to increase higher interest rates, which causes investment spending to decrease lower interest rates, which causes investment spending to decrease Correct! An increase in the money supply reduces interest rates because more funds will be available for banks to lend. The lower interest rates will stimulate investment demand.

According to the Keynesian view of the monetary process, higher investment spending causes output and national income to __________. fall and employment fall **rise and employment rise rise and employment to fall fall and employment rise Correct! Increased spending causes aggregate demand to increase, so equilibrium output increases, resulting in more employment.

In the Keynesian view, financial markets are linked to aggregate supply and aggregate demand primarily through changes in planned investment. Additionally, planned investment is the most stable component of aggregate demand. True **False Correct! Planned investment changes when interest rates change, along with other factors.

In discussions of monetary policy, the inside lag is the __________. implementation lag only recognition lag only recognition, implementation, and impact lags combined **recognition and implementation lags combined Correct! Both of these lags are called the inside lag, and the outside lag refers to the time from action to impact.

It is estimated that it takes about 18 to 24 months for the full effect of monetary policy to be felt due to inside and outside lags. **True False Correct! It takes this much time to recognize a problem, implement policy, and wait for policy to have effect.

For monetary policy, the outside lag may be long because __________. **it takes time for banks to increase or decrease their lending or for individuals to adjust their spending policymakers must meet and agree on the type of policy needed to steer the economy in the right direction it takes time for policymakers to recognize that the inflation rate is too high it takes time for policymakers to recognize that the unemployment rate is too high Correct! The outside lag refers to the time from action to impact. Once monetary policymakers take action, they must wait for banks to extend loans and borrowers to take out loans, then they must wait for borrowers to spend and for the additional spending to work it's way through the economy.

Monetary policy is affected by the same kinds of lags as fiscal policy: recognition, implementation, and impact. **True False Correct! These are often called inside and outside lags, but they are essentially the same.

Monetary policy is less effective in a global economy because if policymakers expand the money supply and cause spending to increase, __________. none of the increased spending is used to purchase foreign-produced goods and services **some of the increased spending is used to purchase foreign-produced goods and services more of the increase in spending will lead to higher prices rather than higher output less of the increase in spending will lead to higher prices rather than higher output Correct! Some of the extra money is, in effect, exported, increasing demand in the rest of the world as well as at home.

Regardless of whether monetary policy works the way Keynesians believe or the way monetarists believe, it is more effective in an open economy than in a closed economy. True **False Correct! Monetary policy is less effective in an open economy.

In 1993, Federal Reserve Board of Governors Chair Alan Greenspan announced that the policy of the Fed would emphasize __________. the M2 money supply as a policy target the M1 money supply as a policy target *real (inflation-adjusted) interest rates as a policy target nominal interest rates as a policy target Correct! Greenspan's goal was to slow the growth of bank reserves and put the brakes on bank lending so that the expansion would continue, but not at a pace that would result in accelerating inflation.

Since 1982, the Fed has been committed to a money supply target and has allowed the money supply to grow at a fixed rate each year. True *False Correct! Money supply growth has not been stable during this time period.

The monetary base is equal to deposits made by the public in their bank accounts. True *False Correct! Deposits are larger than the monetary base in a fractional reserve system because of bank loans.

The Fed has the most direct control over __________. excess reserves the money supply *the monetary base bank lending Correct! The Fed controls the monetary base, which consists of currency in the hands of the public plus reserves held by banks.

In the Keynesian view, money demand ishighly sensitive to interest rates. When money demand is highly sensitive to interest rates, the money demand curve is flatter than when money demand is insensitive to interest rates. A given expansion of the money supply will bring about a smaller decline in interest rates, causing monetary policy to be less effective. Correct! Because a given expansion of the money supply has little effect on the interest rate, it has a smaller impact on spending, output, and employment. Correct! When money demand is highly sensitive to interest rates, a given expansion of the money supply will bring about a smaller decline in interest rates. Correct! The more sensitive money demand is to the interest rate, the flatter the money demand curve. Correct! The quantity of money demanded is very sensitive to interest rates in the Keynesian view.

The Federal Open Market Committee (FOMC) meets regularly and makes decisions about changes in the money supply. Because of the Fed's independence from Congress and the executive branch, it can move quickly without asking anyone's permission.

The Taylor rule stipulates that for each 1% increase in inflation, the Fed should __________. decrease the nominal interest rate by less than 1% (*increase the nominal interest rate by more than 1% decrease the nominal interest rate by more than 1% increase the nominal interest rate by less than 1% Correct! The benefit of such a rule is to reduce uncertainty about how the Fed would choose to respond to inflation, thereby promoting price stability.

The benefit of inflation targeting is to reduce uncertainty and reassure the public regarding how the Fed intends to respond when inflation threatens to escalate. *True False Correct! The Taylor rule is one example of inflation targeting.

If the Fed follows a money supply target, interest rates will ___________. fluctuate with the ups and downs of the business cycle, causing more stable investment spending remain stable over time, causing more stable investment spending remain stable over time, causing more volatile investment spending **fluctuate with the ups and downs of the business cycle, causing more volatile investment spending Correct! Interest rates are sensitive to the business cycle because the demand for investment funds is stronger when the economy is stronger, and vice versa.

The federal funds rate is the interest rate __________. the Fed charges banks on reserve loans *banks charge each other on reserve loans banks charge the Fed on reserve loans banks charge their best corporate customers Correct! If a bank is not meeting the reserve requirement, it can borrow reserves from another bank in the federal funds market.

The Fed cannot pursue both an interest rate target and a money supply target at the same time. *True False Correct! When the Fed chooses one target, it loses control of the other.

The monetary base consists of __________. reserves held by banks currency in the hands of the public currency deposited in banks *currency in the hands of the public plus reserves held by banks Correct! The Fed determines the size of the monetary base, the public determines the division between cash and bank deposits.

In the Keynesian view, several things could go wrong in translating changes in the money supply into changes in output. Which of the following is not one of these things? **Consumers may not respond to lower taxes. Borrowers may not respond to lower interest rates. Banks may not lend. Interest rates may not fall. Correct! This is a potential problem with fiscal policy rather than with monetary policy.

When banks are holding excess reserves, __________. required reserves exceed actual reserves, and they are maximizing loans and profit potential actual reserves exceed required reserves, and they are maximizing loans and profit potential **actual reserves exceed required reserves, and they are not maximizing loans and profit potential required reserves exceed actual reserves, and they are not maximizing loans and profit potential Correct! Banks are allowed to continue making loans until excess reserves equal zero, when actual reserves are equal to required reserves.

Modern macroeconomists in the classical tradition who focus their attention on monetary policy are called monetarists. Milton Friedman was the founder of monetarism. This group of economists feels that monetary policy is very important in affecting the level of employment, output, and prices—especially prices. Most monetarists regard recessions and depressions, as well as inflation, as results of bad monetary policy rather than some sort of normal, regular fluctuations in a market economy.

When the Fed bought government bonds during World War II to help finance the war effort, the money supply __________. fell, pushing the economy into a recession **rose, creating inflationary pressures fell, creating inflationary pressures rose, pushing the economy into a recession Correct! The Fed was buying bonds, causing the money supply to increase and creating inflationary pressures.