The Money Supply and Interest Rate

Question 1

what is the Monetary base (B)?

Answer 1

• Sum of currency in circulation and bank reserves (B 􏰀=C+R);
• the Federal Reserve’s liabilities to the private sector of the economy

Question 2

Definition of Open-market operations ?

Answer 2

• Purchases or sales of securities by a central bank
• Most open-market operations by the Federal Reserve are trades of U.S. Treasury bond
• Most recent financial crisis, the Fed also purchased bonds and prime mortgage-backed securities
• A central bank purchase of any type of securities (an expansionary open-market operation) raises the monetary base
• .A sale of securities (a contractionary open-market operation) reduces the base.

Question 3

the definition of Discount loan from The Fed (central bank)?

Answer 3

• Loan from the Federal Reserve to a bank made at the bank’s request
• The objective is to increase the monetary base.

Question 4

definition of Discount rate: (central bank)

Answer 4

• interest rate on discount loans

Question 5

THE FED’S BALANCE SHEET: (Assets and liabilities)

Answer 5

1. Assets
   * Securities
   * Loans to financial institutions
2. Liabilities
   * Currency in circulation
   * Bank reserves
   - Liabilities include deposits by the U.S. Treasury. (These are lia- bilities of the Fed to the government, not to the private sector, and so are not part of the monetary base).
   - Assets include reserves of foreign currency, which the Fed uses to intervene in foreign exchange markets.
   - Capital is provided by commercial banks, the formal owners of the Federal Reserve Banks.

Question 6

Definiton of Currency–deposit ratio (C/D):

Answer 6

• ratio of currency in circulation to checking deposits

Question 7

Definiton of Reserve–deposit ratio (R/D):

Answer 7

• ratio of bank reserves to checking deposits

Question 8

Money multiplier (m)

Answer 8

• ratio of the money supply to the monetary base (M =􏰀 mB)
• “M”is money supply
• “B” is base (monetary base)
• “m” is the the currency–deposit and reserve–deposit ratios
• “m” is usually greater than 1

Question 9

The FED monetary tools:

Answer 9

1. Open-market operations
2. Discount rate
3. Reserve requirements
4. Interest rate on reserves

Question 10

The Fed definition of “Reserve requirements”:

Answer 10

• regulations that set a minimum level for banks’ reserve–deposit ratios

Question 11

How the Fed can use open-market operations to change the money supply ?

Answer 11

• Buys and sells billions of dollars of securities; changing the monetary base (Mostly bonds from the gov) (stabilization)
• defensive open-market operation:
• to prevent the money supply from changing when the multiplier changes

Question 12

how the Fed affects the monetary base through discount loans? (on banks)

Answer 12

• the Fed can influence banks’ borrowing by changing the interest rate it charges, the discount rate.
• In practice, however, the Fed rarely uses the discount rate to manipulate the money supply.
• In recent years, it has kept the rate high enough so the level of discount loans is usually low.
• Most Fed lending occurs during financial crises and other emergencies when banks have trouble borrowing from their usual sources.

Question 13

How the Fed used the “reserve requirements” rule to influence the money supply ?

Answer 13

• by changing the required reserve ratio
• The Banking Act of 1933 gave them power to set reserve requirements
• The original purpose was to prevent liquidity crises, sometimes used reserve requirements to influence the money supply
• It is not use as a policy tool because the banks voluntarily choose to hold more than require.
• In economists’ language, reserve requirements are not “binding.”
  1. sweep programs move funds out of checking accounts temporarily
  2. ATMs is counted as vault cash, which is part of reserves.

Question 14

How the reserve requirements prolonged The Great Depression ?

Answer 14

• the high reserve–deposit ratios of the 1930s.
• Banks chose high levels of reserves to guard against bank runs
• Reserves greatly exceeded the minimum established by reserve requirements
• The Fed worried that this situation weakened its control of the money supply
• A sharp rise in the money supply could cause inflation.
• the Fed raised reserve requirements at three points in 1936 and 1937
• banks raised their actual reserves to maintain the gap (reserve and bank runs)
• This increase reduced the money multiplier, which in turn reduced the money supply and prolonged the depression.

Question 15

explain the fed monetary policy of Money targeting approach:

Answer 15

• Approach to monetary policy in which the central bank chooses a level for the money supply and adjusts it when economic conditions change

Question 16

Explain the fed monetary policy of Interest rate targeting:

Answer 16

• Approach to monetary policy in which the central bank chooses a level for the nominal interest rate and adjusts it when economic conditions change. The central bank sets the money supply at the level needed to hit the interest rate target

Question 17

Why the Fed prefer interest rate targeting?

Answer 17

• Economists believe the money-demand curve shifts frequently because of changes in transaction technologies. (ATM, credit card,etc.)
• Under money targeting, these shifts would cause interest rates to fluctuate over time (instability)
• The Fed prefers stability
• The Fed has tried money targeting in the past, most recently from 1979 to 1982. it was a failure.

Question 18

Explain the monetaristic experiment of the 80’s:

Answer 18

• The monetarist school of economics, led by Milton Friedman, advocated money targeting during the 1960s and 1970s
• Monetarists said the Fed should increase the money supply at a slow, steady rate, arguing that this policy would stabilize the economy.
• They pointed the 1930s when shifts in the money supply caused the prolongation of The Great Depression.
• Fed Chairman Paul Volcker began the Fed’s “monetarist experiment.”
• Instability in interest rates caused instability in economic growth
• Recessions occurred in the 80’s
• According to monetarists, the Fed under Volcker did not give their policy a fair chance.
• Volcker wanted to reduce inflation,he feared criticism and perhaps efforts in Congress to reduce the Fed’s independence.

Question 19

what is the Federal funds rate?

Answer 19

• interest rate that banks charge one another for one-day loans of reserves, or federal funds; also over- night interest rate

Question 20

what is the Federal Open Market Committee (FOMC) ?

Answer 20

• body that sets the Fed’s targets for the federal funds rate
• The FOMC has 12 members: the seven governors and the presidents of five of the banks.