Chapter 11

Question 1

How do banks increase the money supply?

Answer 1

They make loans with money in excess of the reserve requirements. Those loans will be deposited in other banks, who will make loans in excess of reserve requirements and so on.

Say that Steven is back at the Bank of Anytown to make a deposit. This time he puts $100,000 into his account. The bank’s required reserve ratio is 10%, which means that the bank must hold onto $10,000 of the deposit. This now leaves $90,000 to lend out to the next person who needs it. In walks Serena, who needs a $90,000 construction loan for various home improvements which the Bank of Anytown approves and issues. Serena now takes that to her bank and deposits the funds. Her bank’s required reserve ratio is also 10% so now they have $81,000 to lend to someone else after keeping $9,000 on reserve.

Question 2

How do banks earn money?

Answer 2

Interest on loans, Fees on accounts, Deposits from customers,
Investments in stocks, bonds, loans etc..

Question 3

Money multiplier. Problems?

Answer 3

Used to calculate increase in money supply as a result of banks making deposits and lending the excess of those deposits above the reserve requirements.

Ex: RR: 10%. Deposit of $500

$500*(1-10%)=$450 (Able to be lent)

$4501/10%=$45010=$4,500 increase in money supply

Question 4

Motives for having money

Answer 4

1. Being for transactions
2. For potential purchases (like when sales occur) or emergencies
3. To invest
4. To have some money as protection in case investments don’t do well

Question 5

Why is the money demand curve downward sloping?

Answer 5

When interest rates are higher, investments are more attractive, so people will exchange having money in checking accounts or in plain cash for investments like bonds.

https://study.com/cimages/multimages/16/demand-curve-for-money.jpg

Question 6

Shifters of money demand curve

Answer 6

Increases and decreases in real GDP

Higher price levels means more money demand

If a recession is expected, higher demand. If a boom, less.

Transfer Costs (Cost of converting investments into cash and checking accounts) (Less money demand if these costs are high)

Greater preference for risk means less money demand because they want to invest in more risky assets. Less means more.

Question 7

What shifts Money Supply?

Answer 7

Central Bank

Question 8

Federal Reserve structure

Answer 8

12 Central Bank offices around country with Presidents

Board of Governors

Open Market Operations Committee, which administer open market operations to influence federal funds rate and oversees balance sheet, discount rate and reserve requirements.

Question 9

Federal Reserve Functions

Answer 9

Monetary Policy
Set rules and regulations for banking system
Ensuring stability of financial system
Serves as a bank for other banks

Question 10

Why was the Fed created?

Answer 10

1907 Financial Crisis

Question 11

How did the Fed change over time?

Answer 11

1935: FOMC would be responsible for monetary policy

1977: Established price stability as a Fed goal.

1978: Congress made full employment a goal of the Fed.

Question 12

Open Market Operations

Answer 12

Fed buying and selling bonds to influence money supply.

Buying bonds will decrease federal funds rate. Selling will increase. The FFR is the rate charged by banks for borrowing with each other. It goes up, interest rates on loans go up and vice versa.

Question 13

Why do banks lend to each other?

Answer 13

Banks lend to each other to satisfy regulations like reserve requirements

Question 14

Discount rate

Answer 14

Rate at which Fed lends to other banks

Question 15

Permanent vs Temporary OMO

Answer 15

1. Permanent: Fed conducting usual business of selling and buying securities. Purchases are not temporary
2. Temporary: Fed buys and sell securities with understanding that those transactions will be reversed. Ex: A Fed bond purchase will be reversed by reselling it back to seller.

Question 16

Who sits on FOMC?

Answer 16

Board of Governors
NY Fed President
4 of 11 other Fed Presidents on rotating basis

Question 17

How do reserve requirements determine the impact of the FOMC?

Answer 17

The lower the reserve ratio, the greater the impact of a purchase of bonds

Let’s say Fed gives $1m from purchasing bonds to economy

10%: 1/0.11m=$10m
20%: 1/0.21m=$5m

Question 18

Why does the Fed lend to banks?

Answer 18

They lend to banks in case they are unable to obtain loans from other banks to meet reserve requirements.

Question 19

Types of discount rates

Answer 19

Primary: Interest rate received by banks in sound financial condition

Secondary: Interest rate received by banks in non-sound financial condition. Usually 0.5% above primary rate.

Seasonal: the Fed’s rate for non-emergency lending to banks that provide services to agricultural and other communities where credit demand is highly seasonal.

Question 20

Fourth tool of monetary policy

Answer 20

Fed paying interest on excess reverses held by banks.

Too high of interest earned can discourage banks from lending if federal funds rate is lower. Banks will see they can earn more by keeping money in the bank than lending to each other.

Question 21

Fisher effect problems

Answer 21

Nominal interest rate=inflation+real interest rate

Question 22

Real interest rate

Answer 22

Interest rate after accounting for inflation.
Used to assess if an interest-incurring investment is worth it.

If rate is negative, that means the interest being earned has not kept up with inflation and that you are losing your purchasing power. It’s like getting a raise, but your real income decreased.

Ex: If you are lending $100 at 3% interest, but inflation is 5% the next year. You need $105 to maintain that purchasing power, but you got $103 back. So, the purchasing power of that initial $100 is eroded.

If positive, that means the purchasing power of that interest is exceeding inflation, and that your ability to make purchases has increased. It’s like getting a raise and your real income increased.

Ex: If you are lending $100 at 8% interest, but inflation is 5% the next year. You need $105 to maintain that purchasing power, but you got $108 back. So, the purchasing power of that initial $100 actually increased beyond what was necessary to keep up with inflation.

Question 23

Hyperinflation

Answer 23

More than 50% inflation

Question 24

Policy lag

Answer 24

the lag between the time an economic problem arises, such as recession or inflation, and the effect of a policy (fiscal or monetary) intended to counteract it

Question 25

Recognition Lag

Answer 25

Time taken to recognize problem with macroeconomy

Question 26

Action Lag

Answer 26

Time taken to implement policy after decision lag

Question 27

Decision Lag

Answer 27

Time taken to pass a policy in response to economic problem after recognition lag

Question 28

Effectiveness Lag

Answer 28

the amount of time it takes for a fiscal or monetary policy’s effects to produce the desired result after action lag

Question 29

Determinants of loanable funds demand

Answer 29

Expectations of state of economy

Question 30

Determinants of loanable funds supply

Answer 30

1. Disposable income of people
2. Wealth of people

Question 31

How does government borrowing cause crowding out?

Answer 31

Increases demand in loanable funds market, leading to higher interest rates for business owners, making borrowing for investments unattractive and thus, hindering economic growth

Question 32

Supply-side economics

Answer 32

Focused on boosting aggregate supply through lower taxes, reduced regulation and privatization.

Question 33

Contractionary gap. Problems?

Answer 33

Potential output at full employment - actual output when economy is in recession.

Question 34

Expansionary gap. Problems?

Answer 34

actual output when economy is in boom and producing above potential output -Potential output at full employment actual output when economy is in recession.