Week 22 - Chapter 26: Monetary Policy + The Fed

Question 1

Fed watch

Answer 1

Analysts try and predict fed decisions on changes to the fed fund rate.

Question 2

Monetary policy as a stabilisation tool.

Answer 2

• Changing the money supply.
• It is quickly decided and implemented meaning it is more flexible and responsive than fiscal policy.

Question 3

Federal Open Market Committee (FOMC)

Answer 3

• Primary role is to control the money supply.
• Controlling the money supply allows the fed can control interest rates as the money supply and demand determine interest rate.

Question 4

Portfolio allocation decisions

Answer 4

Allocating wealth between different assets.

Question 5

Diversification

Answer 5

Owning a variety of assets to manage risk.

Question 6

Demand for money/ liquidity preference

Answer 6

The amount of wealth held in the form of money.
People will balance the cost (marginal cost is the lost interest) and benefit (ability to make transactions) when deciding how much of wealth to hold as money.

Question 7

What does the demand for money depend on

Answer 7

Nominal interest rate (i)
Real income/output (Y)
Price level (P)

Question 8

How does nominal interest (i) affect the demand for money

Answer 8

Higher interest rates means lower quantity of money demanded.

Question 9

How does real income/output (Y) affect the demand for money

Answer 9

Higher levels of income means a higher quantity of money demanded.

Question 10

How does price level (P) affect the demand for money

Answer 10

A higher price level means a higher quantity of money demanded.

Question 11

What does the money demand curve show

Answer 11

It shows the relationship between the aggregate quantity of money demanded (M) and the nominal interest rate (i).

Question 12

What causes changes in the money demand curve

Answer 12

• Shifts in the demand curve are caused by factors other than the nominal interest rate.
• Change in demand is caused by anything that affects the cost or benefit of holding money:
  – An increase in output
  – Higher price levels
  – Technological advances
  – Financial advances
  – Foreign demand for dollars

Question 13

Supply of money

Answer 13

The amount of money in the economy - the size of the money supply.

Question 14

How can the money supply be changed

Answer 14

The fed uses open market operations like buying/selling of bonds to increase/decrease the money supply:
- Increase money supply by buying bonds from the public increases demand for bonds, causing an increase in bond prices and a decreased interest rate.
- Selling bonds to the public increases supply of bonds, causing a decrease in bond prices and an increased interest rate.

Question 15

Money supply curve.

Answer 15

Shows the size of the money supply.
It is a straight vertical line as the supply is controlled by the fed so is not affected by interest rates.

Question 16

Equilibrium in the money market

Answer 16

The money supply and demand curves intersect at the equilibrium E with equilibrium interest rate i.

Question 17

How can the money supply be used to change interest rates

Answer 17

• By increasing the money supply, the money supply curve shifts left causing a new equilibrium and a decreased interest rate.
• By decreasing the money supply, the money supply curve shifts right causing a new equilibrium and an increased interest rate.

Question 18

How are bond price and interest rates related

Answer 18

Bond prices are inversely related to interest rates - as bond prices increase, interest rat decreases.

Question 19

Why does the fed announce policy in terms of interest rates.

Answer 19

• Public isn’t familiar with the size of the money supply.
• Main effects of monetary policy works through interest rates.
• Interest rates are easier to monitor than money supply.

Question 20

Federal Funds Rate (FFR)

Answer 20

The rate commercial banks charge on each other on short term (usually overnight) loans used to meet their reserve requirements.

Question 21

What is the federal funds rate used for

Answer 21

The fed usually expresses its policies in a target value for the FFR meaning the FFR is a very good indicator of the feds plans for future monetary policy.

Question 22

How does the fed change the FFR

Answer 22

Through open market purchases/ sales.
E.g.,
- The fed buys treasury securities through the open market which injects reserves into the banking system, lowering the FFR.
- Extra reserves can be loaned to other banks in the federal funds market.
- Loans between banks are incentivised to stop holding of idle reserves which puts downward pressure on interest rates.

Question 23

Can the fed control real interest rate

Answer 23

The fed has good control over nominal interest rate through changes to the money supply and because inflation changes slowly, this means that real interest rate changes by about the same amount as nominal interest rate in the short run.

Question 24

Money supply formula

Answer 24

MS = public currency + (bank reserves/ reserve-deposit ratio)
The fed can change the money supply not just by changing bank reserves but also by changing the amount of currency the public holds or the reserve deposit ratio.

Question 25

Discount window lending

Answer 25

* If a bank needs to borrow reserves it can do so from the fed. * Commercial banks can only borrow from the discount window if they meet certain criteria. * Lending increases reserves and ultimately increases the money supply.

Question 26

Discount rate

Answer 26

* The rate at which discount window lending is charged at. * It is usually higher than the FFR to encourage banks to lend and borrow from each other. * Changes in the discount rate signal tightening or loosening of the money supply.

Question 27

Reserve requirement

Answer 27

* The minimum values of the ratio of bank reserves to bank deposits that commercial banks are allowed to maintain. * Reducing/increasing the reserve requirement could increase/reduce the money supply. * Changing the reserve requirement may not always affect money supply as banks often have excess reserves.

Question 28

Excess reserves

Answer 28

Bank reserves in excess of the reserve requirements set by the central bank

Question 29

Zero lower bound

Answer 29

A level, close to zero, below which the central bank cannot further reduce short-term interest rates. At zero lower bound, people hold onto money rather than investing it resulting in low or no economic growth. At zero lower bound, traditional monetary policy tools are less effective at stimulating the economy.

Question 30

Liquidity trap

Answer 30

When interest is at the zero lower bound, agents are indifferent between holding bonds and money.

Question 31

What tools does the fed use when at zero lower bound

Answer 31

Quantitative easing, forward guidance and interest on excess reserves.

Question 32

Quantitative easing

Answer 32

* The central bank buys financial assets, lowering the yield or return of those assets while injecting liquidity. * By purchasing longer maturity assets, the fed increases their price and lowers long-term interest rate which incentivises spending/investment and therefore causes growth.

Question 33

Forward guidance

Answer 33

The fed gives indications of its future policies so that markets will react.

Question 34

Interest rates on excess reserves

Answer 34

Even when interest rates are at 0, the fed can still offer interest rates on its reserves to give banks a reason to keep money at the Fed.

Question 35

How can the fed fight inflation

Answer 35

Inflation rises/falls in expansionary/recessionary gaps respectively so the fed can fight inflation by trying to close output gaps. It does this through the federal funds rate as this affects many other interest rates. If there is an expansionary gap, the fed can use monetary policy and increase the FFR to discourage spending, reducing output and closing the gap, therefore reducing inflation. In a recessionary gap the fed does the opposite by decreasing the FFR.

Question 36

Why does news of inflation hurt stock prices

Answer 36

When inflation is expected to increase, it is expected that the fed will increase interest. This hurts stocks in 2 ways: - Higher interest slows down economic activity, reducing profits of companies with shares in the stock market which likely will reduce the dividends firms pay shareholders. - Higher interest reducing stocks values through increased required return. Higher interest also means that interest bearing alternatives like new government bonds will be more attractive which reduces stock demand and therefore price.

Question 37

What is the fed's policy reaction function

Answer 37

A function which describes how the action of a policymaker takes depends on the sate of the economy. Can be seen as the relation between inflation and real interest rate. E.g., increasing interest in recessionary gaps and decreasing interest in expansionary gaps.

Question 38

What is Taylors Rule

Answer 38

An attempt to describe the Fed’s behaviour in terms of a quantitative policy reaction function.

Question 39

Taylors Rule reaction function

Answer 39

r = 0.01 + 0.5(Y-Y* / Y*) + 0.5π r: real interest rate set by fed Y-Y*: output gap Y-Y* / Y*: output gap relative to potential output π: inflation rate as a decimal