Monetary Policy

Question 1

What is Monetary Policy?

Answer 1

Monetary policy is actions of the Federal Reserve, by means of changes in the money supply and interest rates, that are intended to influence aggregate demand and change economic conditions

Question 2

What are the two types of Monetary Policy?

Answer 2

There are two types of monetary policy: expansionary monetary policy and contractionary monetary policy

Question 3

What is the goal of Expansionary Monetary Policy? What is it also known as?

Answer 3

The first type of monetary policy is expansionary monetary policy, also known as easy monetary policy. The goal of this policy is to increase the money supply and increase real GDP output

Question 4

What is the goal of Contractionary Monetary Policy? What is also known as?

Answer 4

The second type of monetary policy is contractionary monetary policy, also known as tight monetary policy. The goal of this policy is to decrease the money supply and decrease real GDP output. The Federal Reserve has four different possible tools they can use to either increase or decrease the money supply

Question 5

What are the tools the Federal Reserve can use for Monetary Policy?

Answer 5

There are several tools that the Federal Reserve can use to influence the money supply. These tools include the discount rate, reserve ratio, open market operations, and federal funds rate

Question 6

What is the Discount Rate tool?

Answer 6

Discount Rate: The discount rate is the interest rate that the Federal Reserve charges commercial banks to borrow money directly from the Treasury. When the discount rate changes, it makes borrowing money more or less expensive for commercial banks. When the discount rate is low, banks will borrow more, which injects more money into the economy, increasing the money supply. When the discount rate is high, banks will borrow less, which injects less money into the economy, decreasing the money supply.

Question 7

What is the Reserve Ratio tool?

Answer 7

Reserve Ratio: The reserve ratio, otherwise known as the reserve requirement, is the portion or percentage of all new demand deposits that banks must hold in reserve and cannot lend. If the Federal Reserve raises the reserve ratio, they decrease the money supply. This occurs because this allows less of a demand deposit to be put in excess reserves, and it cannot be loaned out. If the Federal Reserve decreases the reserve ratio, then they increase the money supply because this allows more of a demand deposit to be put in excess reserves, and it can be loaned out.

Question 8

What is the Open Market Operations tool?

Answer 8

Open Market Operations: Open-market operations is probably the most popular tool used by the Federal Reserve in either increasing or decreasing the money supply. Open-market operations involves the buying and selling of treasury bonds. When they buy bonds, it increases the money supply by handing over new money to investors to exchange for the bonds (assets). When they sell bonds, it decreases the money supply because the investors hand over their money to the FED in exchange for a bond.

Question 9

What is the Federal Funds Rate tool?

Answer 9

Federal Funds Rate: The federal funds rate is the interest rate at which commercial banks and depository institutions borrow money directly from each other. When the federal funds rate increases, it makes borrowing money more expensive. So, banks borrow less, which decreases the money supply and takes money out of the economy. When the federal funds rate decreases, it makes borrowing money less expensive. So, banks borrow more, which increases the money supply and puts money into the economy.

Question 10

Draw a graph showing the Money Supply decreasing? (IS-MP Model), What happens to the Discount Rate, Reserve Ratio, Federal Funds Rate? What effect does this have on Nominal Interest Rate, Investment Spending, Real GDP Output?

Answer 10

Draw a graph showing the Money Supply increasing? (IS-MP Model), What happens to the Discount Rate, Reserve Ratio, Federal Funds Rate? What effect does this have on Nominal Interest Rate, Investment Spending, Real GDP Output?

Question 11

What is the purpose of Monetary Policy? What effect does this have on recessionary and inflationary gaps, what does the FED do?

Answer 11

Monetary policy is the Federal Reserve’s way of correcting the economy. When the economy is either in a recessionary gap or an inflationary gap, the Federal Reserve can try and correct the economy by either increasing or decrease the money supply. They will practice expansionary monetary policy when the economy is in a recessionary gap in an effort to get the economy moving again and bring it back to equilibrium. They will practice contractionary monetary policy when the economy is in an inflationary gap in an effort to slow down the economy and bring it back to equilibrium.

Question 12

How does the Federal Reserve use Monetary Policy during a recessionary gap?How does this bring the economy back to equilibrium?

Answer 12

RECALL: Recessionary Gap to Full Equilibrium via Expansionary Monetary Policy

When the economy is a recessionary gap, the Federal Reserve will use monetary policy to increase the money supply in an effort to decrease the nominal interest rate. The lower nominal interest rate will lead to an increase in the quantity of investment demanded. As investment spending increases, aggregate demand will increase which brings the economy out of the recessionary gap and back to equilibrium

Question 13

Draw a Diagram showing: Recessionary Gap to Full Equilibrium via Expansionary Monetary Policy

Answer 13

First graph a recessionary gap, then show a graph of increase in money supply (IS-MP Model), show a graph of the movement along the demand curve as investment demand increases, then AD increases bringing it back to equilibrium

Question 14

How does the Federal Reserve use Monetary Policy during a inflationary gap? How does this bring the economy back to equilibrium?

Answer 14

When the economy is in an inflationary gap, the Federal Reserve will use monetary policy to decrease the money supply in an effort to increase the nominal interest rate. The higher nominal interest rate will lead to a decrease in the quantity of investment demanded. As investment spending decreases, aggregate demand decreases, which brings the economy out of an inflationary gap and back to equilibrium.

Question 15

Draw a Diagram showing: Inflationary Gap to Full Equilibrium via Expansionary Monetary Policy

Answer 15

First draw a inflationary gap, then show a graph of money supply decreasing (IS-MP model), show a graph of the movement along the investment demand curve as investment decreases, AD then decreases bringing it back to equilibrium

Question 16

What does the central bank include?

Answer 16

Bank of Canada and the Federal Reserve System

Question 17

What is the Bank of Canada Responsible for?

Answer 17

Responsible for price stability

Controls and regulates financial insitutions and markets
- Bank to the commercial banks
- Bank to the federal government

Organizes market for reserves

Monetary Policy

Question 18

What does the Bank of Canada set?

Answer 18

Bank of Canada sets:

Reserve requirements

Target overnight rate: rate at which banks lend each other money for overnight loans

Bank rate

Deposit rate

Question 19

What is the Central Banks Policy Goals?

Answer 19

The Federal Reserve and the Bank of Canada have inflation targets. Price stability helps achieve stable inflation, they do this by targeting around 2%. The idea is that low and stable inflation will promote full employment. When inflation is at target, unemployment is at a natural rate. By targeting inflation, the central bank also achieves stability in the labor market (interdependence principle), a little inflation helps the labor market adjust with 2% inflation nominal wages increase, with 0% inflation, measured inflation is high and creates deflation lowering nominal wages.

Question 20

What happens if they set inflation rate below 0?

Answer 20

Zero lower bound: nominal interest cannot be less than 0%

Question 21

How does the Central Bank set interest rates? List the steps.

Answer 21

Look at the current economy: try to predict inflation
Start with a neutral long run real interest rate
Where is inflation relative to target?
Look at the output gap?
Policy rate= inflation+neutral real interest rate+½(inflation - 2%)+ output gap
Once they have the policy rate (interest rate) they can set the real interest rate in the IS-MP model
They do this by taking the nominal interest rate subtracting inflation and adding risk premium
i= nominal interest rate
Real interest rate, subtract inflation: r= i- inflation
Add risk premium: r= r+risk premium
In reality the real interest rate is interest rate-expected inflation
The central bank can now affect the market interest rate threw Monetary Policy

Question 22

Banking and the Expansion of Money Supply? What do banks do? What system do they have?

Answer 22

Banks are financial institutions that accept deposits and make loans. They also serve as intermediary bodies that help the Federal Reserve control the money supply. In our banks, we use a system known as fractional reserve banking.

Question 23

What is Fractional Reserve Banking? What terms do they use?

Answer 23

Fractional Reserve Banking is the practice by which a bank accepts deposits and is required to hold only a fraction of its deposits in cash reserves. The amount that the bank has to keep as cash reserves is determined by the reserve ratio (i.e. reserve requirement) that is set by the Federal Reserve. This allows the bank to loan out the remainder of the deposit to borrowers. By loaning out this money the bank creates “new” money in the economy. There are several terms involved in the process of fractional reserve banking.

Demand Deposits: A deposit of new money left in the bank that can be withdrawn without prior notice by the account owner

Excess Reserves: The remainder of every demand deposit after required reserves are held that banks made available to others as new loans

Required Reserves: The portion of every demand deposit that banks must hold in cash reserves and are not allowed to lend out. This is determined by the reserve ratio set by the federal reserve.

Question 24

What is the money multiplier?

Answer 24

When demand deposits are made, the banks have a portion of excess reserves that are created by the fractional reserve banking system. These excess reserves become new loans and set off a chain reaction of money creation throughout the entire economy.

Money multiplier is the amount of money that banks generate with each dollar of excess reserves

Question 25

What are Bank Balance Sheets?

Answer 25

Bank balance sheets (i.e. T-accounts) are a visual record of the fractional reserve banking within a bank. These ledgers show the assets and liabilities within a bank.

Question 26

What are Assets in Bank Balance Sheets?

Answer 26

Assets include both required and excess reserves, outstanding loans, and securities

Question 27

What are liabilities in bank balance sheets?

Answer 27

Liabilities include demand deposits, account investments, and equity.

Question 28

What is the Reserve Ratio formula?

Answer 28

Demand Deposits/ Required Reserves