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Question 1

Three groups affect the money supply

Answer 1

1. The central bank is responsible for monetary policy
2. Depository institutions (banks) accept deposits and make loans
3. The public (people and firms) holds money as currency and coin or as bank deposits

Question 2

monetary base or high-powered money

Answer 2

The sum of reserve deposits and currency (held by the nonbank public and by banks).

This is because each unit of the base that is issued leads to the creation of more money

Question 3

i. Largest asset in the BS
ii. Two major liabilities of the Fed
iii. banks’ total reserves (RES)

Answer 3

i. holdings of Treasury securities
ii. currency outstanding & deposits by banks and other depository institutions
iii. Vault cash plus banks’ deposits

Question 4

100% reserve banking and fractional reserve banking

Answer 4

→When bank reserves are equal to deposits, the system is called 100% reserve banking.

→But banks lend out some of their deposits, as only a fraction of reserves are needed to meet the need for outflows.

→If the bank needs to keep only 25% of the amount of its deposits on reserve to meet the demand for funds, it can lend the other 75%.

→The reserve-deposit ratio would be 25%.

→When the reserve-deposit ratio is less than 100%, the system is called fractional reserve banking.

Question 5

The most direct and frequently used way of changing the money supply

Answer 5

by raising or lowering the monetary base through open-market operations.

Question 6

To increase the monetary base

Answer 6

the central bank prints money and uses it to buy assets in the market; this is an open-market purchase.

→Banks then find that their reserve-deposit ratio is higher than desired; this leads to a multiple expansion of loans and deposits.

→Banks then increase their loans until the reserve-deposit ratio returns to the desired level.

Question 7

If the central bank wants to decrease the monetary base,

Answer 7

it uses an open-market sale

Question 8

Taking the ratio of money supply and monetary base

Answer 8

M/BASE=(CU+DEP)/(CU+RES)

Question 9

the currency–deposit ratio (CU/DEP, or cu) is determined by the _____

The reserve–deposit ratio (RES/DEP, or res) is determined by ______.

money multiplier EQ

Answer 9

public ; banks

M=[(cu+1)/(cu+res)]∙BASE

Question 10

i. fractional reserve banking and money multiplier
ii. 100% reserve banking

Answer 10

i. The money multiplier is greater than 1 for res less than 1
ii. If cu = 0, the multiplier is 1/res, as when all money is held as deposits.

Question 11

bank run

Answer 11

§If people think a bank will not be able to give them their money, they may panic and rush to withdraw their money, causing a bank run.

§To prevent bank runs, the FDIC insures bank deposits, so that depositors know their funds are safe, and there will be no need to withdraw their money.

Question 12

The money multiplier during severe financial crises (i.e., the Great Depression).

Answer 12

→The money multiplier is usually fairly stable, but it fell sharply in the Great Depression.

→The decline in the multiplier was due to bank panics.

→People became mistrustful of banks and increased the currency-deposit ratio (Fig. 14.1).

→Banks held more reserves, in anticipation of bank runs, which raised the reserve-deposit ratio.

→Even though the monetary base grew 20% from March 1930 to March 1933, the money supply fell 35% (Figure 14.2a).

→As a result, the price level fell sharply (nearly one-third) and there was a decline in output.

Question 13

§Tools for Monetary control to meet policy objectives

Answer 13

→Open-market operations (primary)

→Reserve requirements

→Discount window lending

→Interest rate on reserves

Question 14

§Reserve requirements:

Answer 14

→The Fed forces banks to hold reserves of about 10% of the value of their transactions deposits (less for small banks)

→The Fed could change the money supply by changing reserve requirements but seldom does so because reserve requirements have a large impact on both the money supply and bank profits

Question 15

Discount window lending:

Answer 15

→Discount window lending is lending reserves to banks so they can meet depositors’ demands or reserve requirements

→The interest rate on such borrowing is called the discount rate

→The Fed was set up to halt financial panics by acting as a lender of last resort through the discount window

→A discount loan increases the monetary base

Question 16

§Interest rate on reserves:

Answer 16

→In the financial crisis that began in 2008, the Fed began paying interest to banks on their reserves held on deposit at the Fed

→The payment of interest on reserves gives banks the incentive not to spend resources avoiding holding reserves

→The interest rate paid on reserves is now a tool that the Fed can use to affect the amount of reserves that banks hold and the money supply

Question 17

federal funds rate or fed funds rate/cash rate

Answer 17

• The interest rate charged when banks borrow reserves from each other
• Generally, the fed funds rate/cash rate moves in line with other short-term interest rates …

Question 18

Central Banks _____ target both the money supply and short-term interest rates simultaneously.

Answer 18

cannot

Question 19

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Question 20

Targeting the interest rate through OPO

Answer 20

• Works well if the main shocks to the economy are to the LM curve (shocks to money supply or money demand)
• Stabilizes output, the real interest rate, and the price level, as it offsets shocks to the LM curve completely
• But if other shocks to the economy (such as IS shocks) are more important than nominal shocks, targeting an interest rate may be destabilizing, unless the Fed changes the target for the fed funds rate.

Question 21

§Suppose a shock shifts the IS curve to the right …

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Answer 21

§If the Fed were to maintain the real interest rate, it would increase the money supply, thus making output rise even more, which would be destabilizing.

§Instead, the Fed needs to raise the real interest rate to stabilize output.

§Research suggests that the optimal fed funds rate varies substantially over time.

§But there is substantial uncertainty about what the level of the optimal fed funds rate is on any given date.

Question 22

Optimal interest rate target LR CURVE

Answer 22

• The advantage to targeting a real interest rate is that shocks to money demand or money supply are offset automatically.
• The Fed uses open-market operations to hit its target for the real interest rate; it allows the money supply to be whatever is necessary to hit that target.
• So, the key to good policymaking is finding the optimal target for the real interest rate in response to shocks to the IS curve.
• But there is substantial uncertainty about the optimal interest rate target!

§Research suggests that the optimal fed funds rate varies substantially over time.

Question 23

Lags in the effects of monetary policy

Answer 23

→It takes a fairly long time for changes in monetary policy to have an impact on the economy.

→Interest rates change quickly, but output and inflation barely respond in the first four months after the change in money growth (Fig. 14.11)

→Because of the lags, policy must be made based on forecasts of the future, but forecasts are often inaccurate

Question 24

Describe the main sources of uncertainty that affect monetary policymakers and give an example of each.

Answer 24

1. Uncertainty about the current state of the economy

▻ E.g., the fact that different economic variables often give conflicting signals about the current strength of the economy and the fact that data are often revised, and the initial releases of the data are much less accurate than later releases of the data

2. Incompleteness of their models of the economy

▻ E.g., the fact that no one is certain whether a classical model or the Keynesian model is the best description of the economy, our lack of knowledge about the slopes and locations of each of the curves in each model, and uncertainty about the levels of full-employment output and the natural rate of unemployment.

▻ In addition, there is uncertainty about the predominant source of shocks to the economy.

3. Uncertainty about how the expectations of the public will be affected by economic shocks and policy actions.

▻ E.g., the idea that the public is not sure of the central bank’s motives, which might affect their expectations.

Question 25

incomplete models of the economy

Answer 25

oNo one knows the best model that describes the economy (classical vs. Keynesian, slopes and locations of curves, levels of full-employment output and natural rate of unemployment)

oSome research suggests policymakers should respond less because model is not known

oRecent research suggests stronger action is needed to prevent a bad outcome

oUncertainty about predominant source of shocks suggests using a rule (i.e., such as the Taylor rule)

Question 26

Uncertainty about how expectations of public will be affected by shocks and policy actions

Answer 26

oCentral bank may need to anchor inflation expectations and inform people of its plans

oThe Fed under Chairman Bernanke has increased the information it provides

Question 27

Monetary policy in the Great Recession ZLB

Answer 27

• The housing crisis, which began in 2007, led to losses at financial institutions, but no one thought it would lead to a major financial crisis,
• However, the Fed faced a major obstacle … the Zero Lower Bound (ZLB) on interest rates:

→The Fed cut interest rates to near zero by the end of 2008, hitting the zero lower bound

→In such a liquidity trap, increases in the money supply are held by banks or the public, and have no effect on spending

• To escape the problems caused by the ZLB, the Fed took unusual policy measures from 2009 to 2014.
• It affected interest-rate expectations by using forward guidance:

→The Fed signalled how long it expected interest rates to remain low

→It hoped to reduce long-term interest rates to stimulate spending

→The Fed implemented forward guidance first in 2009 and for many years following

• The Fed also expanded the amount of assets it held, engaging in quantitative easing which increased the monetary base and reducing long term IR by buying long-term Treasury securities (and debt and mortgage-backed securities).
• this prevented deflation from happening by increasing the inflation rate

Question 28

Monetarists and classical macroeconomists advocate the use of rules:

Answer 28

→Rules make monetary policy automatic, as they require the central bank to set policy based on a set of simple, pre-specified, and publicly announced rules

→The rule should specify something under the Fed’s control, like growth of the monetary base, not something like fixing the unemployment rate at 4%, over which the Fed has little control

→The rule may also permit the Fed to respond to the state of the economy

Examples of rules:

oIncrease the monetary base by 1% each quarter

oMaintain the price of gold at a fixed level

Most Keynesian economists support discretion

→Discretion means the central bank looks at all the information about the economy and uses its judgment as to the best course of policy

→Discretion gives the central bank the freedom to stimulate or contract the economy when needed; it is thus called activist

in favour of rules: central bank credibility

• Even if the central bank has a lot of information and forms policy wisely, rules give credibility by building a reputation for following through on its promises, even if it is costly in the short run

to achieve ^:

1. increase the CB’s reputation as an inflation fighter.

This can be done by establishing inflation goals and meeting them and appointing someone who has a well known reputation in fighting tough inflation further increases credibility.

2. Increasing central bank independence.

Government can’t interfere with the central bank, people are more likely to believe that the central bank is committed to keeping inflation low and will not cause a political business cycle)

Empirical evidence: the more independent the central bank, the lower the inflation rate

however, there is a tradeoff between credibility and flexibility because:

• to be credible, rules must be nearly impossible to change,
• so during a crisis situation if a rule is based on economic relationships then the lack of flexbilility may be very costly
• rules creates unacceptable risks

Question 29

Describe the Taylor rule.

Answer 29

The Taylor rule (after John Taylor) sets the fed funds rate target depending on recent inflation, the deviation of output from the level of full-employment output, and the deviation of recent inflation from its target of 2%.

i = 𝝅 + 0.02 + 0.5y + 0.5(𝝅 – 0.02)

i = the nominal fed funds rate (the Fed’s intermediate target);

𝝅 = the rate of inflation over the previous four quarters;

y = (𝒀 -𝒀̅)/𝒀̅ = the percentage deviation of output from full-employment output.

Hence, the Taylor rule requires that the real fed funds rate, i - 𝝅, respond to

1. the difference between output and full-employment output, and
2. the difference between inflation and its target, here taken to be 2%, or 0.02.

y or π increase, the real fed funds rate is increased, causing monetary policy to tighten

Question 30

Inflation targeting

Answer 30

Inflation targeting → The central bank announces targets for inflation over the next 1 to 4 years!

Does not qualify as a policy rule, in the strict sense:

1. It targets a goal variable (inflation) rather than a policy variable (interest rate or a monetary aggregate)
2. There is room for discretion in the short run, as long as the inflation target is met in the longer run

Disadvantages

→Inflation responds to policy actions with a long lag, so it’s hard to judge what policy actions are needed to hit the inflation target

→Hard for the public to tell if the central bank is doing the right thing, so central banks may miss their targets badly, losing credibility

Question 31

What is the reserve–deposit ratio and how does it affect bank runs?

Answer 31

Because banks lend out some of their deposits, the reserves held by a bank equal only a fraction of its outstanding deposits.

In a crisis, a large number of depositors may withdraw their deposits simultaneously, exhausting the bank’s reserves and forcing it to close. This panicky withdrawal is called a bank run

Question 32

The currency-deposit ratio

Answer 32

refers to the relationship between the amount of cash a person holds and the amount of money she maintains in readily accessible bank accounts, such as checking accounts.