16

Question 1

What are the four main tools of monetary policy?

Answer 1

Open market operations

changes in borrowed reserves (discount lending)

changes in reserve requirements

changes in the interest paid on reserves.

Question 2

What do open market operations affect?

Answer 2

The quantity of reserves and the monetary base.

Question 3

What does discount lending (borrowed reserves) affect?

Answer 3

The monetary base.

Question 4

What do changes in reserve requirements affect?

Answer 4

The money multiplier.

Question 5

What does changing the interest paid on reserves influence?

Answer 5

The demand for reserves.

Question 6

What interest rate is primarily affected by central bank policy tools?

Answer 6

The interest rate on overnight interbank loans, often referred to as the federal funds rate (𝑖𝑓𝑓 in the U.S.).

Question 7

What is the equation for total reserves demanded (𝑅𝑑)?

Answer 7

𝑅𝑑 = Required Reserves (𝑅𝑅) + Excess Reserves (𝐸𝑅𝑑)

Question 8

What determines the level of required reserves?

Answer 8

They are imposed by the central bank.

Question 9

Why do banks hold excess reserves?

Answer 9

As insurance against deposit outflows.

Question 10

What is the opportunity cost of holding excess reserves?

Answer 10

The federal funds rate (𝑖𝑓𝑓) minus the interest on reserves (𝑖𝑜𝑟)

Question 11

What happens when 𝑖𝑓𝑓 > 𝑖𝑜𝑟?

Answer 11

The cost of holding excess reserves rises, and the demand for reserves (𝐸𝑅𝑑) falls.

Question 12

What is the shape of the reserve demand curve when 𝑖𝑓𝑓 > 𝑖𝑜𝑟?

Answer 12

Downward sloping.

Question 13

What happens when 𝑖𝑓𝑓 ≤ 𝑖𝑜𝑟?

Answer 13

Banks prefer to hold excess reserves; they don’t lend at lower rates, making the demand curve flat (perfectly elastic).

Question 14

What is the equation for total reserve supply (𝑅𝑠)?

Answer 14

𝑅𝑠 = Non-borrowed reserves (𝑁𝐵𝑅) + Borrowed reserves (𝐵𝑅)

Question 15

How are non-borrowed reserves (𝑁𝐵𝑅) provided?

Answer 15

Through central bank’s open market operations.

Question 16

What is the cost of borrowing reserves from the central bank?

Answer 16

The discount rate (𝑖𝑑).

Question 17

What happens when 𝑖𝑓𝑓 < 𝑖𝑑?

Answer 17

Banks do not borrow from the central bank; borrowed reserves (𝐵𝑅) = 0.

Question 18

What is the shape of the supply curve when 𝑖𝑓𝑓 < 𝑖𝑑?

Answer 18

Vertical

Question 19

What happens when 𝑖𝑓𝑓 ≥ 𝑖𝑑?

Answer 19

Banks borrow from the central bank and lend in the interbank market.

Question 20

What is the shape of the supply curve when 𝑖𝑓𝑓 ≥ 𝑖𝑑?

Answer 20

Horizontal (perfectly elastic) at the discount rate.

Question 21

What is the main objective of comparative statics in monetary policy?

Answer 21

To assess how changes in monetary policy tools affect the market for reserves and the interbank interest rate (𝑖𝑓𝑓).

Question 22

What are the four monetary policy tools used in comparative statics?

Answer 22

Open market operations, discount lending, reserve requirements, and interest on reserves.

Question 23

What is the Taylor Rule formula?

Answer 23

Target federal funds rate = inflation rate + equilibrium real fed funds rate + ½ (inflation gap) + ½ (output gap).

Question 24

What does the output gap indicate in the Taylor Rule?

Answer 24

Future inflation, as described by the Phillips Curve.

Question 25

What is NAIRU?

Answer 25

The rate of unemployment at which there is no tendency for inflation to change.

Question 26

How does an open market purchase (OMO) affect reserves and interest rate?

Answer 26

Increases non-borrowed reserves (𝑁𝐵𝑅 ↑) → Reserve supply ↑ → Federal funds rate (𝑖𝑓𝑓 ↓)

Question 27

How does an open market sale (OMO) affect reserves and interest rate?

Answer 27

Decreases non-borrowed reserves (𝑁𝐵𝑅 ↓) → Reserve supply ↓ → Federal funds rate (𝑖𝑓𝑓 ↑)

Question 28

When might an OMO have no effect on the interbank rate?

Answer 28

If reserve supply intersects demand at its flat (perfectly elastic) portion.

Question 29

What happens when the demand for reserves increases?

Answer 29

Equilibrium shifts up; 𝑖𝑓𝑓 tends to rise unless offset by increased supply through OMO.

Question 30

How can a central bank keep 𝑖𝑓𝑓 constant during a demand increase?

Answer 30

By purchasing bonds to increase the supply of reserves

Question 31

What is the CB's daily tactic for targeting 𝑖𝑓𝑓?

Answer 31

Estimate reserve demand each morning and supply reserves accordingly.

Question 32

What happens when the discount rate (𝑖𝑑) is lowered but remains above 𝑖𝑓𝑓?

Answer 32

No effect on the interbank rate; banks don’t borrow from the CB.

Question 33

What happens when the discount rate (𝑖𝑑) is lowered to equal 𝑖𝑓𝑓?

Answer 33

Borrowing from CB increases → Reserve supply ↑ → 𝑖𝑓𝑓 ↓

Question 34

What is the effect of increasing the reserve requirement?

Answer 34

Increases reserve demand → 𝑖𝑓𝑓 ↑ → Contractionary policy.

Question 35

What is the effect of decreasing the reserve requirement?

Answer 35

Decreases reserve demand → 𝑖𝑓𝑓 ↓ → Expansionary policy.

Question 36

What happens if 𝑖𝑓𝑓 > 𝑖𝑜𝑟 and 𝑖𝑜𝑟 increases but remains below 𝑖𝑓𝑓?

Answer 36

No effect on the interbank rate (𝑖𝑓𝑓).

Question 36

What happens if 𝑖𝑓𝑓 = 𝑖𝑜𝑟 and 𝑖𝑜𝑟 increases?

Answer 36

𝑖𝑓𝑓 also increases; both move together.

Question 37

How can a central bank control the range of 𝑖𝑓𝑓?

Answer 37

By setting the interest on reserves (𝑖𝑜𝑟) and the discount rate (𝑖𝑑): 𝑖𝑜𝑟 ≤ 𝑖𝑓𝑓 ≤ 𝑖𝑑

Question 37

What are dynamic OMOs?

Answer 37

Operations aimed at changing the level of reserves and the monetary base.

Question 38

What are defensive OMOs?

Answer 38

Temporary operations to offset other movements affecting reserves and the monetary base.

Question 39

What is a repurchase agreement (repo)?

Answer 39

The CB buys securities with an agreement to resell them in 1–15 days.

Question 40

What is a matched sale-purchase agreement (reverse repo)?

Answer 40

The CB sells securities with an agreement to buy them back in 1–15 days.

Question 41

three advantages of OMOs.

Answer 41

Complete control, flexibility & precision, easily reversed and quickly implemented.

Question 42

What is the discount window?

Answer 42

A facility where banks can borrow reserves from the central bank.

Question 43

What are the three types of discount loans?

Answer 43

Primary credit – For healthy banks; rarely used. Secondary credit – For troubled banks (rate is 𝑖𝑑 + 0.5%). Seasonal credit – For banks in agriculture or tourism (phasing out).

Question 44

What are the main roles of discount policy?

Answer 44

Alter reserves and money supply Act as lender of last resort Prevent financial panics Introduce moral hazard

Question 45

What is a downside of discount lending as a monetary tool?

Answer 45

The CB cannot control the volume—banks decide whether to borrow.

Question 46

What are reserve requirements?

Answer 46

A fraction of deposits banks must hold with the CB or as vault cash.

Question 47

What is a key disadvantage of reserve requirements?

Answer 47

They can cause liquidity problems for banks due to fluctuations.

Question 48

What is the purpose of paying interest on reserves (𝑖𝑜𝑟)?

Answer 48

To provide a floor for the interbank rate (𝑖𝑓𝑓).

Question 49

Why is increasing 𝑖𝑜𝑟 effective after a financial crisis?

Answer 49

It’s more efficient than massive OMOs when banks hold excess reserves.