Monetary Policy

Question 1

define interest rates

Answer 1

the cost of borrowing and the return on savings

Question 2

what is the effect of increasing/decreasing interest rates on AD?

Answer 2

lower interest rates make borrowing cheaper, allowing C and I to spend/invest more, increasing AD

higher interest rates make borrowing more costly, causing C and I to save rather than spend, decreasing AD

Question 3

define deflationary gap

Answer 3

a deflationary (also called recessionary) gap occurs when AD decreases, causing the average price level to fall

the ‘gap’ on the macroeconomic diagram is the difference between the full employment level of output and the current output

Question 4

define demand-pull inflation

Answer 4

when AD persistently increases and reaches the near-vertical section (the neoclassical zone) of the SRAS curve

(the price level will increase with very little effect on RGDP)

Question 5

define inflation, disinflation, and deflation

Answer 5

inflation: a sustained increase in the average price level of g&s over time
disinflation: a decrease in the rate of inflation (a decrease in the rate at which the average price level is rising)
deflation: when the average price level of g&s decreases over time

Question 6

define money supply

Answer 6

money supply: how much money is circulating in the economy

Question 7

what is the effect of increasing/decreasing the money supply on AD?

Answer 7

when the money supply increases, interest rates decrease, spending increases, AD increases

when the money supply decreases, interest rates increase, spending decreases, AD decreases

Question 8

what are the roles of the central bank?

Answer 8

1. banker to the government
2. banker to commercial banks
3. regulator of commercial banks
4. controls the money supply/interest rates (3 tools)
5. manipulates exchange rate policy

Question 9

state the difference between nominal and real interest rates

Answer 9

nominal = today’s value

real = comparing the nominal to the base year to take inflation out of it

Question 10

describe expansionary monetary policy

Answer 10

the central bank increases the money supply, interest rates decrease, C and I borrow/spend more and save less, AD shifts to the right, RGDP and PL increase, unemployment decreases

Question 11

describe contractionary monetary policy

Answer 11

the central bank decreases the money supply, interest rates increase, C and I save more and borrow/spend less, AD shifts to the left, RGDP and PL decrease, unemployment increases

Question 12

state the 3 tools that the central bank uses to change the money supply

Answer 12

1. changes to the reserve requirement (rr)
2. changes to the discount rate (DR)
3. open market operations (OMO)

Question 13

what is a reserve requirement (rr)?

Answer 13

rr = the amount of money that banks are required to hold “in reserve”

(they are not allowed to lend the rr money)

Question 14

what is the effect of increasing/decreasing the reserve requirement on the money supply?

Answer 14

when the rr increases, the money supply decreases

when the rr decreases, the money supply increases

Question 15

what is a discount rate (DR)?

Answer 15

DR = the rate central banks charge when they make loans to large commercial banks

(it is a type of interest rate that is unique for commercial banks)

*only commercial banks borrow money directly from the central bank

Question 16

what is the effect of increasing/decreasing the discount rate on the money supply?

Answer 16

when the DR increases, the money supply decreases

when the DR decreases, the money supply increases

Question 17

what are open market operations (OMO)?

Answer 17

OMO = the buying and selling of government bonds

Question 18

what are government bonds?

Answer 18

when the government cannot cover its deficits it creates bonds so that it can continue to loan money

(bonds are essentially “iou” slips of paper that represent debt)

Question 19

what is the effect of buying/selling bonds on the money supply?

Answer 19

buying bonds expands the money supply

selling bonds contracts the money supply

Question 20

state the money multiplier formula

Answer 20

money multiplier = 1/rr

Question 21

state the gobbledygook for OMO buying bonds

Answer 21

OMO-buying bonds, ↑MS, ↓int-rate, ↑AD-C&I, ↑PL, ↑RGDP, ↓unemp

Question 22

state the gobbledygook for OMO selling bonds

Answer 22

OMO-sell bonds, ↓MS, ↑int-rate, ↓AD-C&I, ↓PL, ↓RGDP, ↑unemp

Question 23

define yield

Answer 23

yield = the interest rate on a bond that is paid to the lender

Question 24

define term

Answer 24

term = the time until a bond matures

long term bonds are riskier and therefore pay a higher rate

Question 25

define junk bonds

Answer 25

bonds that get you a high yield in a short amount of time because the firm is about to close

Question 26

define municipal bonds

Answer 26

state and local bonds (yields are not subject to federal income tax)

Question 27

is the Sm curve perfectly elastic or inelastic?

Answer 27

the supply of money is perfectly inelastic (vertical line) therefore it is not responsive to changes in interest rates

Question 28

why is the Dm curve downward-sloping?

Answer 28

there is an inverse relationship between NIR and Q

Question 29

what is the effect of increasing Sm on Dm?

Answer 29

increasing Sm (shifting it to the right) causes Dm to decrease (expansion)

Question 30

what is the effect of decreasing Sm on Dm?

Answer 30

decreasing Sm (shifting it to the left) causes Dm to increase (contraction)

Question 31

draw the money supply diagram

Answer 31

Question 32

define excess reserves

Answer 32

the amount of money banks have available to lend

Question 33

define federal funds rate

Answer 33

the interest rate that banks charge each other for very short term (usually overnight) loans

Question 34

how do you calculate the amount of money created/multiplied after a deposit is made?

Answer 34

1. someone deposits money in the bank
2. subtract the rr from the original deposit (everything else is the excess reserves)
3. multiply the excess reserves by the money multiplier