Unit 7 Flashcards
(22 cards)
What is quantitative easing?
A tool the central bank uses that incorporates buying long-term bonds
How is quantitative easing different from traditional Fed tools?
-Used when the Fed has cut rates to near zero but the economy still needs help
-The Fed purchasing longer term bonds off –most specifically long-term gov debt and mortgage-backed securities
-Differs from traditional approach of targeting short-term securities
How is quantitative easing expected to improve the economy?
Lower long-term rates to inc borrowing
What changes in the banking system are caused by quantitative easing?
-Mortgages are essentially bonds (a loan that is paid back over time w/ interest)
-When the Fed buys mortgage assets from banks it inc the demand for those securities
-The inc demand for these assets inc their price. When the price of a bond inc, the yield (interest rate) dec
How did the quantitative easing used to support the economy during the 2008 recession change the effectiveness of traditional fed policy tools?
The banking system is now flooded with reserves so now banks don’t need to trade overnight. Made buying/selling of short-term securities irrelevant
Which of the other Fed policy tools is also now irrelevant? Why?
The Discount rate and reserve requirements are also now irrelevant because reserves money was so abundant that banks could easily obtain money for required reserves.
The use of quantitative easing by the FED after 2008..
made reserves so abundant that small changes had no impact on interest rates –> Ample reserves framework (small mvmts in MS do not affect interest rates)
The New Monetary System – Ample Reserves Framework
-Since 2008, the U.S. has operated under an ample reserves system
-This means that changes in bank reserves and the money supply do not impact interest rates
-The FED now uses administrered rates to adjust interest rates
Administered Interest Rates
-Administered interest rates are interest rates that are determined by the Fed (not supply + demand)
-The two primary administered interest rates are: the DISCOUNT RATE and INTEREST ON RESERVES
-Interest on Reserves = the rate of interest the Fed pays on reserves banks hold at the Fed
The DISCOUNT RATE serves as a ceiling in the reserve market because…
No bank would be willing to borrow at a higher rate than the rate it can borrow from the Fed.
The INTEREST ON RESERVES RATE serves as a floor in the reserve market because…
no bank would be willing to lend at a lower rate than it can earn at the Fed.
As a first response to the 2008 recession, the Fed reduced…
its target interest rate to 0%. When this proved to be insufficient, the Fed used Quantitative Easing. As a result, the traditional Fed tools became useless. In their place, the Fed adopted administered rates.
In an ample reserves system, shifts in supply…
do NOT impact rates
Monetary Policy Tools in an Ample Reserves System
-Expansionary Policy: Decrease administered rates (Discount Rate and Interest on Reserves)
-Contractionary Policy: Increase administered rates
What if the Fed books losses because of its quantitative easing?
The Fed has assets that earn interest and liabilities. If the Fed’s assets pay a fixed interest rate, but it pays a variable rate on its liabilities, the Fed could bank losses if it raises administered rates. ***
The Philips Curve
-New Zealand-born economist Alban W.H. Phillips wrote a ground-breaking paper in 1958 that attempted to formalize the relationship between inflation and unemployment.
-Economists quickly began researching the relationship and were able to build models for most developed countries
AS and Phillips Curve
-The Phillips curve is very important to the FED b/c of its dual mandate to achieve price stability + full employment
-The AS and SRPC curves both show teh short-run tradeoff b/w inflation and unemployment
-The relationship b/w inflation and unemployment is inverse b/c firms raise wages at low unemployment, which inc inflation
Long Run Phillips Curve (LRPC)
-In the long run, there is no tradeoff b/w inflation nd unemployment
-The LRPC is drawn w/ a vertical line at natural unemployment rate / the Non-Accelerating Inflation rate of unemployment (NAIRU) (means that if the unemployment rate is at NAIRU the inflation rate will remain constant)
-The interesection of LRPC and SRPC shows the natural rate of unemployment and the expected inflation rate
Phillips Curve Rules!
- The economy will always be at a point on the SRPC
- When AD shifts, there is a mvmt along the SRPC
Phillips Curve and Stagflation
-During the 1960s, the relationship b/w inflation + unemployment predicted by the Phillips curve proved to be true
-In the 1970s, the U.S. economy experienced 2 severe oil shocks, or supply shocks, that caused both inflation and unemployment to rise
-This made economists question the validity of the Phillips Curve
-To the untrained eye, data for the next 20 years seemed to disprove the Phillips Curve….
-The SRPC will only apply when the economy’s expected inflation REMAINS CONSTANT
-Once the economy expects a new level of inflation to persist, the SRPC will shift!!!
Shifters of the SRPC
- Expectations of Inflation
-If inflation is expected to inc, SRPC shifts right
-If inflation is expected to dec, SRPC shifts left - Anytime the SRAS shifts the SRPC will shift in the opposite direction
The conditions of the 1970s created spiraling inflation, which undermined progress in fixing the recession. Chairman Paul Volcker then experimented with DISINFLATION…
-His contractionary monetary policy allowed wages to ultimately fall, shifting SRAS right and helping the economy bounce back
-Volcker held the economy in a recession for a long time to adjust inflation expectations.
