exam 3 review
exam 3 review Econ 3303-001
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This 12 page Study Guide was uploaded by IHUOMA ECHENDU on Wednesday May 11, 2016. The Study Guide belongs to Econ 3303-001 at University of Texas at Arlington taught by kathy kelly in Winter 2016. Since its upload, it has received 26 views. For similar materials see money and banking in Economcs at University of Texas at Arlington.
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Date Created: 05/11/16
Review for Exam 3 (Final exam) The format will be the same as the previous exam. There will be 40 multiple choice questions worth 2.5 points each. You must bring your own scantron and sharpened number 2 pencil. Chapter 13 Federal Reserve Act 1913 created the Federal Reserve System. Structure of the Fed. Res. System Member banks Who must join? All national banks must join, its Optional for state banks. How join Banks become members of the Fed by purchasing stock in the Federal Reserve Bank in their district. Fixed dividends are paid on this stock All banks subject to res. req. whether a member or not. All banks can use the check clearing function of the Fed and can obtain discount loans from the Fed. 12 Fed. Res. Banks: The US is divided into 12 geographic regions with a Federal Reserve Bank in each region. Each bank may have several branches located throughout the region. They “establish” the discount rate, decide which banks will receive discount loans, and Select one commercial banker to serve on the Federal Advisory Council. Five of the twelve bank presidents vote on the FOMC Functions: Clear checks Issue new currency and withdraw damaged currency from circulation Make discount loans Evaluate proposed mergers and applications for banks to expand their activities Liaison between business community and the Fed System Examine bank holding companies and statechartered member banks Collect data on local business conditions Research topics related to monetary policy Board of Governors: Seven members each from a different geographic region in the US. Each member serves one nonrenewable 14year term and can also be appointed to complete a term for another member Number and terms: Terms expire every two years How become a member: Members are appointed by the President of the U.S. and confirmed by the U.S. Senate Chair: One of the seven members is appointed to serve a fouryear term as Chair. Can be reappointed to this position Duties of Board Vote on FOMC decisions Set the reserve requirements “Effectively” set the discount rate Represent the U.S. in economic matters Set margin requirements Set the salaries for Fed bank officers Approve bank mergers and specify permissible activities of bank holding companies Research topics related to monetary policy FOMC (Federal Open Market Committee): Who votes? Twelve voting members – seven Board of Governors plus five of the Fed bank presidents. The president of the New York Fed always votes and the remaining 4 voting members rotate amongst the other 11 regions. FOMC members meet about every 6 weeks and set monetary policy for the U.S. The chair of the Board of Governors is the chair of the FOMC Decisions of the FOMC are sent to the Open Market Desk at the New York Fed which carries out the necessary transactions Independence of the Fed Factors making the Fed independent • Members serve long terms • Fed is financially independent Factors making the Fed dependent • Fed was created by an act of Congress and can be changed by Congress • The President appoints the Board members and can influence legislation The Federal Reserve is overall quite independent Should the Fed be Independent? Yes, reasons for: • Can pursue longer run objectives • Avoids the political business cycle • Less likely that budget deficits will be inflationary No, concerns/ Reasons against: • Undemocratic • Hinders coordination of monetary and fiscal policy • Fed has not always done a good job 20. Why might eliminating the fed’s independence lead to a more pronounced political business cycle? If the Fed were not as independent, they might be coerced into pursuing an expansionary monetary policy that is politically popular, but might result in longterm inflationary tendencies. Chapter 14 Fed’s balance sheet Assets Securities – Fed ownership of Treasury securities and other types of securities that earn interest. This is the primary source of income for the Federal Reserve Loans to financial institutions – another source of interest income for the Federal Reserve Liabilities Currency in Circulation – currency held in the hands of the public (individuals and businesses) Reserves – vault cash plus deposits at the Federal Reserve Monetary Base: (highpowered money) – currency in circulation plus the total reserves in the banking system. MB = C + R. The primary method the Fed uses to change the monetary base is through open market operations. An open market purchase occurs when the Federal Reserve buys bonds on the open market (from dealers or banks). An open market sale occurs when the Federal Reserve sells bonds on the open market (to dealers or banks). Open market purchase: Open market sale (opposite of open market purchase) Shift from deposit to currency Shift from currency to deposit Loan to fin. Institution Repayment of loan from fin. Institution Other factors that impact MB Float Treasury deposits at the Fed Multiple Deposit Creation Remember! Each bank can lend out no more than the amount of excess reserves that bank holds. The banking system as a whole will be able to see an expansion of deposits. Simple Deposit Multiplier: reciprocal of the required reserve ratio. Can be used to determine the maximum deposit expansion when reserves are injected into the banking system. ∆D = 1/rr x ∆R Where ∆D = the maximum change in the checkable deposits rr = the required reserve ratio (in decimal format) ∆R = the initial change in reserves Criticisms of simple deposit multiplier: • Sometimes individuals and businesses choose to hold currency rather than putting the funds into the banking system • Sometimes banks choose to hold excess reserves rather than lending out all that they possibly could Factors that determine the money supply: MBn – nonborrowed monetary base Open Market Operations by the Federal Reserve; positive relationship BR – borrowed reserves Banks borrow funds from the Federal Reserve; positive relationship rr – required reserve ratio The minimum amount of checkable deposits that banks must keep in reserve. Set by the Federal Reserve; negative relationship c – Currency holdings The choice of depositors to hold cash vs. bank deposits; negative relationship e – Holdings of excess reserves The choice of banks to retain excess reserves rather than lend them out; negative relationship Money multiplier (m): The money multiplier shows how the money supply changes in response to a change in the monetary base. M = m (MB): M = m x MB where M = the M1 measure of the money supply m (the money multiplier) = (1 + c)/(rr + e + c) MB = the monetary base The monetary base can be written as two components. The borrowed reserves comes from the loans made to banks. The nonborrowed monetary base comes from the Fed open market operations. MB = MBn + BR 9. The Fed buys $100 million of bonds from the public and also lowers the required reserve ratio. What will happen to the money supply? The money supply will increase. The open market purchase causes the monetary base to increase. The lowered required reserve ratio causes the money multiplier to increase. Both of these actions cause the money supply to expand. 12. What effect might a financial panic have on the money multiplier and the money supply? Why? A financial panic would most likely cause banks to hold more excess reserves. This would cause the money multiplier to decrease and thus decrease the money supply if the Fed did not move the monetary base to offset the change in the money multiplier. 13. during the great depression years from 19301933, both the currency ratio and the excess reserve ratio rose dramatically. What effect did these factors have on the money multiplier? An increase in both the currency ratio and the excess reserves ratio resulted in a dramatic decrease of the money multiplier. Chapter 15 Market for reserves Federal funds rate Discount rate – ceiling Interest on reserves floor OMO shifts supply (vertical portion) Discount pol. shifts supply (horizontal) Change i or ft demand (horizontal) Reserve requirements shift demand (downwardsloping portion) Conventional Monetary Policy Tools—work on the shortterm interest rates Open Market Operations: Open market operations are used most often by the Fed to conduct monetary policy. They are fast, flexible, and completely controlled by the Fed. Dynamic – permanent to change target fed. Funds rate Outright purchase to lower target rate Outright sale to raise target rate Defensive – temporary to maintain target fed. Funds rate Repurchase agreement– Fed purchases securities with an agreement to resell at specific date Matchedsale purchase – Fed sells securities with an agreement to buy back at a specific date Discount Policy Types of loans • Primary credit – healthy banks overnight • Secondary credit – financially troubled banks pay a higher interest rate • Seasonal credit – limited to banks in vacation and agricultural areas Lender of last resort: Advantage of discount policy, Fed can perform lender of last resort function. Disadvantage of discount policy: Not completely controlled by the Fed Reserve Requirements: Can be set between 8% and 14% at the Fed’s discretion. Could be raised to 18% if needed. Advantage Impacts all banks Disadvantage Less effective today because of financial innovations Can cause liquidity problems for some banks Creates uncertainty and makes liquidity management more challenging Interest on Reserves: Can be used to change shortterm interest rates particularly if banks are holding large amounts of excess reserves Advantages of open market operations Nonconventional mon.pol. Tools: used during the most recent Financial Crisis Liquidity provision • Expansion of the discount window • Term auction facility • New lending programs Asset purchases • Purchases of mortgagebacked securities • Purchases of longterm Treasury securities Commitment to future policy actions: Try to impact interestrate expectations Conditional statement If this happens, we’ll have to take an action were going to keep interest rates low until the unemployment goes to 5% and inflation goes to 3% Unconditional statement 19. What is the main advantage and disadvantage of an unconditional policy commitment? The advantage of an unconditional statement is the strength of the statement. This type of statement gives the impression that the Fed is committed to this policy and will not make a change easily. The disadvantage of an unconditional statement is the inflexibility. With an unconditional statement, if the economy changes the Fed cannot easily adjust policy to meet the changed circumstances. Chapter 16 Dual mandate: Achieve two coequal objectives – price stability and high employment (economic growth will follow) Other monetary policy goals Stability of financial markets Interestrate stability Stability in foreign exchange markets Conflict among goals Achieving price stability may worsen employment or interestrate stability in the short run. Hierarchical mandate: Put the goal of price stability first and then as long as it is achieved other goals can be pursued. Price stability should be the primary longrun objective, not necessarily primary for the shortrun if concerned about high unemployment. Nominal anchor: Nominal variable like the inflation rate or money supply which ties down the price level to help achieve price stability. Having a nominal anchor limits the timeinconsistency problem. Timeinconsistency problem: Think about the example of a whiny child. The idea that the central bank may announce one policy but do something different when circumstances change…bad in the long run. Inflation Targeting: Announcing specific numerical targets for the inflation rate. Advantages o Use all available information to determine monetary policy o Readily/easily understood by public; highly transparent o Increased accountability of central bank o Reduces likelihood of timeinconsistency problem Disadvantages o Delayed signaling – long lags for monetary policy o Too much rigidity: making it difficult to use monetary policy for recession type situations o Potential for increased output fluctuations o Potential for low economic growth Fed.Res. approach: The Federal Reserve’s Monetary Policy Strategy – “JustDoIt”, is forward looking and preemptive. Trying to decide where the monetary policy is going and acting in that direction. Advantages Uses all available information Demonstrated success Disadvantages Lack of transparency Low accountability Success depends on individuals in charge Today our central bank is moving to a “flexible form of inflation targeting.” Announce a specific numerical value for the inflation objective, but also make it clear that the Fed is pursuing maximum sustainable employment. We can get a feel for what actions they are going to take by whats happening in the labor market. Lessons for Monetary Policy from the Global Financial Crisis 1. Developments in the financial sector have a far greater impact on economic activity than was earlier realized. 2. The zero lower bound on interest rates can be a serious problem. 3. The cost of cleaning up after a financial crisis is very high. 4. Price and output stability do not ensure financial stability. Assetprice bubbles – pronounced increases in asset prices that depart from fundamental values. Types of assetprice bubbles: • Creditdriven bubbles: monetary policy can slow down this bubble and possibly stop it. There are dangers to this because monetary policy is very blunt. If it is in one specific market, a better option for a credit driven bubble is to tie up credit (hard to get). • Irrational exuberance bubbles Arguments against using monetary policy to end bubbles • Difficult to identify • Uncertainty that raising interest rates will change the bubble asset prices • Monetary policy will impact all asset prices not just the bubble asset prices • Potential harmful effects on the aggregate economy Macroprudential Policies Regulatory policy to impact what is happening in the credit markets in the aggregate. Choosing the Policy Instrument and intermediate target: Policy instrument – a variable that responds to the central bank’s tools and indicates the stance (easy or tight) of monetary policy. Two basic types • Reserve aggregates • Shortterm interest rates Intermediate target – stands between the policy instrument and the goal. Examples • Monetary aggregates • Longterm interest rates How is setting monetary policy like the sport of bowling or curling? Central bank must choose either to maintain aggregates or interest rates; cannot maintain both variables in a dynamic economy When targeting on nonborrowed reserves, interest rates will fluctuate. When targeting on interest rates, nonborrowed reserves will fluctuate. Aggregate vs. interest rate variable Criteria for choosing instruments and targets 1. Observable and measurable 2. Controllable by the central bank 3. Predictable effect on goals Policy instruments and intermediate targets must match, i.e. aggregates go with aggregates and interest rates go with interest rates Taylor Rule Method for setting the target nominal federal funds rate target when concerned about the dual mandate i.e. both price stability and high mployment (economic growth) Federal funds rate target = inflation + equil. real fed. funds rate + ½ inflation gap + ½ output gap Inflation = current inflation rate Equil. Real fed. Funds rate = the real fed. Funds rate that is consistent with full employment in the long run Inflation gap = actual inflation minus target inflation Output gap = actual real GDP minus potential GDP (GDP at full employment) 14. Why aren’t most central banks more proactive at trying to use monetary policy to eliminate assetprice bubbles? Monetary policy is too blunt. When the central bank changes interest rates, it impacts all asset markets not just the assetbubble market. 24. If the fed has interest rate target, why will an increase in the demand for reserves lead to a rise in the money supply? Use a graph of the market for reserves to explain. An increase in the demand for reserves will cause the interest rate to increase. If the central bank has an interestrate target, they do not want this to occur. In order to prevent this, the central bank must conduct an open market purchase and expand the monetary base. The increase in the monetary base will result in an expansion of the money supply as long as the money multiplier remains constant. Chapter 25 Transmission Mechanisms Examine ways in which monetary policy impacts the economy Traditional Interestrate channel • Using monetary policy to change the real interest rate. • Changes in the real interest rate impact business investment spending decisions, and consumer spending on residential housing and consumer durable goods. • Monetary policy can be effective even if nominal rates are zero – it is the real interest rate that is important variable. Other Asset price channels Variables other than the interest rate. Exchange Rate Effects on Net Exports • Monetary policy changes impact the real interest rate. • Lowering the real interest rate changes make domestic assets less desirable relative to foreign assets. • Currency depreciates. • Domestic goods are now cheaper relative to foreign goods. • Net exports increase. Tobin’s q Theory • A lower real interest rate makes stock more attractive than the alternative bonds. • Stock prices increase as demand for stock increases. • q equals the market value of firms divided by the replacement cost of capital. • Higher stock prices leads to a higher q. • A higher q leads to more spending on new investment goods. Wealth Effects • Consumption spending by consumers on nondurable goods and services. • Consumption spending is determined by lifetime resources of consumers. • Higher stock prices lead to an increase in the value of financial wealth increasing lifetime resources of consumers and consumption spending increases. Consumption spending Credit View – Based on the concept of asymmetric information Bank Lending Channel • Certain borrowers will not have access to the credit markets unless they borrow from banks. • An increase in bank reserves increases the quantity of loans that banks can make. • More loans leads to more investment spending and consumer spending. • Larger impact on spending by smaller firms since they are more dependent on bank loans. Balance Sheet Channel • Stock prices increases results in net worth of firms increasing. • Higher net worth of firms leads to increased ability to obtain financing for investment spending. Cash Flow Channel • Cash flow is the difference between firms’ cash receipts and cash expenditures. • Nominal interest rates impact a firm’s cash flow. • Interest payments on shortterm debt have the greatest impact on cash flow. • When interest rates are low, riskprone borrowers make up a smaller fraction of those demanding loans. Unanticipated price Level Channel • An unanticipated increase in the price level lowers the value of firms’ liabilities in real terms (decreases the burden of the debt). • Real value of the assets will not fall. • Real net worth increases. Household Liquidity Effects • Looks at the impact on consumers’ desire to spend rather than on lenders’ desire to lend. • When consumers have a large amount of financial assets relative to debt, their estimate of the probability of financial distress is low. • More willing to purchase consumer durables or housing. Reasons credit channels are important Monetary transmission mechanisms. 1. Financial frictions do affect firms’ employment and spending decisions. 2. Small firms are hurt more by tight monetary policy than large firms. 3. Asymmetric information has been shown to explain many other important economic phenomena. Lessons for Monetary Policy 1. It is dangerous to consistently associate an easing or tightening of monetary policy with a fall or rise in shortterm nominal interest rates. 2. Other asset prices besides those on shortterm debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms. 3. Monetary policy can be effective in reviving a weak economy even if shortterm interest rates are already near zero. 4. Avoiding unanticipated fluctuations in the price level is an important objective of monetary policy, thus providing a rational for price stability as the primary longrun goal of monetary policy. 8. “The cost of financing investment are related only to interest rates; therefore, the only way that monetary policy can affect investment spending is through its effects on interest rates.” Is this statement true, false, or uncertain? Explain your answer. False. Monetary policy can affect stock prices, which affect Tobin’s q, thus affecting investment spending. In addition, monetary policy can affect loan availability, which may also influence investment spending.
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