ECON 3303 Final Study Guide (Test 3)
ECON 3303 Final Study Guide (Test 3) Econ 3303-001
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This 19 page Study Guide was uploaded by Josh Radcliff on Wednesday December 9, 2015. The Study Guide belongs to Econ 3303-001 at University of Texas at Arlington taught by Kathy Kelly in Summer 2015. Since its upload, it has received 278 views. For similar materials see The Economics of Money and Banking in Economcs at University of Texas at Arlington.
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Josh Radclif Final Study Guide ECON 3303-001 MONEY AND BANKING Prof. Kathy Kelly Chapter 13 – Central Banks and the Federal Reserve System The Federal Reserve System was created in 1913 thanks to the Federal Reserve Act Structure of the Federal Reserve System (Know #s 1-4) o 1)Federal Reserve Banks – 12 of them in 12 diferent geographical districts across the US New York bank is the most important Certain privately owned banks buy stock for the Federal Reserve Bank in their district so they become part owners of that Federal Reserve Bank Total of 9 directors of each district bank, and they select a president Involvement in monetary policy 1) Establish the discount rate (interest rate banks pay the federal reserve banks on loans) 2) Decide which banks are allowed to receive discount loans from the Federal reserve banks 3) Select one person from each district to serve on the Federal Advisory Council 4) 5 of 12 bank presidents vote on the Federal Open Market Committee (FOMC) to decide open market operations 5) Clear checks 6) Issue new currency and takeout damaged currency from circulation. 7) Make discount loans to the banks in their district 8) Acts as the middleman between the people and the Federal Reserve System 9) Examine bank holding companies and state-chartered member banks to make sure they are healthy 10) Research topics related to monetary policy and collect data on business conditions o 2) Federal Open Market Committee (FOMC) AKA “The Fed” – 12 people that get together to decide on open market operations. 7 Board of Directors and 5 Federal Reserve bank presidents make up the FOMC (president of New York District always included) Only 5 Federal Reserve Bank Presidents vote Meets every six weeks (8 times per year) Makes open market operation decisions Sets the federal funds rate – the interest rate on overnight loans from one bank to another Chairman of FOMC also the Chairman of the Board of Directors Open market operations are the main way to control money supply Tighten monetary policy – A rise in the federal funds rate Easing Monetary Policy – A lowering of the federal funds rate o 3) Member Banks – A bank part of the Federal Reserve System All national banks are required to be member banks of the Federal Reserve System National banks are chartered (approved) by the Office of the Comptroller of the Currency, a federal institution Commercial banks chartered by the states are not required to be members. All member and nonmember banks have required reserve ratios that they must uphold, set by the Fed. o 4) Board of Governors of the Federal Reserve System 7 people appointed by the President and approved by the Senate All serve one 14 year term. It rotates where every 2 years, someone’s term ends Must come from 7 diferent districts so there’s no bias. One Chairman is selected by the Board themselves and serves a four year term that is renewable Board’s involvement in monetary policy (because all 7 are part of the Federal Open Market Committee (FOMC), which dictates monetary policy) 1) They vote on the conduct of open market operations 2) It sets the reserve requirements for all banks 3) Controls how much the discount rate is allowed to exceed the federal funds rate o i.e. how much the horizontal portion of the supply curve for open market operations can be above the federal funds rate equilibrium 4) The chair advises the president on economic policy Other duties besides monetary policy 1) Sets margin requirements, the dollar amount in cash banks must use to pay for securities in relation to the dollar amount the bank can take out in loans to pay for securities 2) Approves bank mergers, specifies what activities are allowed for bank holding companies, and keeps an eye on foreign banks in the US 3) Hires an economic staf to provide economic analysis and advice to help them How Independent is the Federal Reserve (AKA the Fed)? o Reasons why the Fed is independent? 1) The members serve 14 year terms so they can’t be ousted from office, and they’re less inclined to be corrupt and get on the president’s good side because they’re already going to be there longer than the president and their term isn’t renewable 2) It is financially independent because their holdings of securities and loans to banks makes them loads of money so they don’t need to borrow money from anyone o Overall, the Fed is quite independent Reasons why the Fed should be independent o 1) Can focus on long-run objectives and price level stability and are not restricted by the greedy needs of politicians who only want to focus on short term monetary policy so they can be elected o 2) Avoids the political business cycle (when politicians make policies to lower unemployment and interest rates during an election, they set up the economy for high inflation and high interest rates after the election in order to balance out the changes they had previously made to win the election. o 3) It’s less likely that the budget deficits will be inflationary because it keeps politicians from making decisions that will only benefit them as opposed to what’s best for the economy Reasons why the Fed should NOT be independent o 1) It is undemocratic because it leaves one group of people in charge of doing whatever they want can have serious consequences o 2) It hinders the coordination of monetary and fiscal policy. The two would be best coordinated if the same people that controlled fiscal policy also played a part in controlling monetary policy. o 3) The Fed doesn’t always do a good job, so why advocate independence when it already hasn’t always been successful with the independence that it does have? Question 20 on page 314: Why might eliminating the Fed’s independence lead to a more pronounced political business cycle? o When the Fed’s independence is eliminated, that means that other government officials and politicians have a say in what the Fed does. We know that many of these people only care about winning the election. So they would likely change monetary policy to lower unemployment and interest rates during an election period. The public would see these two things as very positive, thus electing that official. But the long-term efects of such drastic changes will be bad, so soon after elections, there would be lots of inflation and interest rates would need to go back up. o This results in a very pronounced political business cycle Chapter 14 – The Money Supply Process The Fed’s Balance Sheet o Assets 1) Securities – The Fed will buy securities from the banking system. In return, the banks will get reserves. When securities held by the Fed increases, the money supply increases 2) Loans to Financial Institutions (discount loans AKA borrowings from the Fed AKA borrowed reserves) – When the Fed loans out money, the discount rate is the interest rate they charge banks. Banks receive the loan, causing reserves and money supply to increase o Liabilities (an increase in liabilities leads to an increase in money supply) 1) Currency in Circulation (C) (AKA Federal reserve note) – The amount of money in the hands of the public 2) Reserves (R)– the deposited money the bank puts into the Fed plus vault cash Required reserves – the money the Fed requires banks to keep deposited at the Fed Excess reserves – Extra money within the Fed that banks aren’t required to keep there Required Reserve Ratio – For every dollar of deposits at the Fed, a bank must have $X in reserves Monetary Base (MB) = C + R Add both liabilities together to get the Monetary Base Money Supply (M) = money multiplier (m) * Monetary Base (MB) m= 1+c o rr+e+c o rr = required reserves o e = excess reserves o c = Currency in pocket ratio (AKA currency holdings raio) o When m increases, so does M o When MB increases, so does M o Factors that determine Money Supply The money supply is positively related to the non-borrowed monetary base, MB (iNe. open market sales and purchases) The money supply is positively related to the level of borrowed reserves, BR, from the Fed (i.e. loans to financial institutions) The money supply is negatively related to the required reserve ratio (because of the formula for the money multiplier given above) The money supply is negatively related to the amount of excess reserves (because of the formula for the money multiplier given above) Holding excess reserves constant, the money supply is negatively related to the currency holdings ratio (because of the formula for the money multiplier given above. Assume c is less than 1 when it changes) Control of the Monetary Base o Open Market Purchase – When the Fed buys securities from banks. Result is an increase in R, an Increase in MB, and an increase in M Bank’s T Account Decrease securities Increase reserves Both on the asset side Fed’s T Account Increase securities (asset) Increase reserves (liability) o Reserves increase even though the Fed is buying securities because the money appears out of nowhere into the Fed’s account because the Fed can create money o Open Market Sale – When the Fed sells securities to the banks Result is a decrease in R, a decrease in MB, and a decrease in M Bank’s T Account Increase in securities Decrease in reserves Both on the asset side Fed’s T Account Decrease in Securities (asset) Decrease in reserves (liability) o Reserves decrease because this is the bank’s money that the bank uses to pay for the securities. So this money just disappears. o Shifts from Deposits to Currency – When we the people take money out of our banks Result is an increase in C but a decrease in R, so no efect on MB. Also results in a decrease in the money multiplier (m) and decrease in the Money Supply (M) Nonbank Public T Account Decrease checkable deposits Increase currency Both assets Bank’s T Account Decrease reserves (asset) Decrease checkable deposits (liability) Fed’s T Account Increase currency in circulation Decrease Reserves Both Liabilities o Shifts from Currency to Deposits – When we the people deposit money into our banks Result is a decrease in C but an increase in R, so no efect on MB Also results in an increase in the money multiplier (m) and decrease in the Money Supply (M) Nonbank Public T Account Increase in checkable deposits Decrease in currency Both assets Bank’s T Account Increase in reserves (asset) Increase in checkable deposits (liability) Fed’s T Account Decrease in currency in circulation Increase in Reserves Both liabilities o Loans to financial institutions – When the Fed makes a loan to a financial institution like a bank Result is an increase in R, an increase in MB, and an increase in M Bank’s T Account Increase in reserves (asset) Increase in Loans AKA borrowings form the Fed (liability) Fed’s T Account Increase in Loans (asset) Increase in Reserves (liability) o Repayment of loans to financial institutions – When a bank pays back the loan the Fed gave them Result is a decrease in R, a decrease in MB, and a decrease in M Bank’s T Account Decrease in reserves (asset) Decrease in Loans AKA borrowings from the Fed (liability) Fed’s T Account Decrease in Loans (asset) Decrease in Reserves (liability) o Other Factors that Afect the Monetary Base Float – When a bank cash’s a check with the Fed that was written to them by another bank, the bank will credit this check to the depositing bank before it debits the bank who wrote the check. This results in a very temporary overall increase in the total amount of reserves in the banking system. Temporary increase in MB ensues. Treasury Deposit at the Fed – When the treasury moves a deposit from a bank to the Fed, there is a deposit outflow so reserves in the bank decrease, leading to a decrease in the MB Multiple Deposit Creation – Simple Model o When the Fed supplies a bank with money, that bank can move the money around in its account to make it look like they simply created money out of nowhere. Kinda a confusing topic so hopefully I can explain it further to where it makes sense. Check Pages 323-326 if still confused. o When the Fed buys securities from a bank for $100, the bank will decrease its securities by $100 and increase its reserves by $100 o The bank will want to make this $100 grow, so they loan it out to a random guy. **The bank cannot lend out more than the amount of excess reserves that it holds o When the bank makes this loan, it will increase Loans (asset) by $100 and also increase checkable deposits (liability) by $100 because they created an account to put the $100 for this random guy so he could get access to it. o At this point in time, the bank’s T Account will look like this: Decrease securities by $100 (asset) Increase reserves by $100 (asset) Increase Loans by $100 (asset) Increase checkable deposits by $100 (liability) o For this short period of time before the random guy takes the money out of the newly created checkable deposit account, the bank “created money out of nowhere” because an increase in checkable deposits is an increase in the money supply o Once the random guy takes his money out, the bank will decrease reserves by $100 and also decrease checkable deposits by $100 so they both will become zero o The only remaining amounts in the T account are the decrease of securities by $100 and the increase in loans by $100. o This random guy will spend his money to get whatever he wanted the loan for, and that $100 will now be in the hands of another person. o This person will deposit the $100 in a diferent bank that has a required reserve ratio of 10%. o That bank will keep $10 in reserves but loan out the other $90 o This bank’s T account will look like this: Reserves: +$10 (Asset) Loans: +$90 (Asset Checkable Deposit: +$100 (liability) o When you repeat this process, the person who took the $90 loan spends it and the person who received that $90 deposits it in his bank. o This bank will keep $9 in reserves to meet the required 10% ratio, and it will loan out the other $81. The process will keep repeating like this. o The table on page 326 shows that if you continue this process, the $100 of reserves you started out with at the very first bank actually turns into a much larger increase in checkable deposits, inherently creating the money out of nowhere. Simple Deposit Multiplier - The increase in checkable deposits that results from an increase in reserves. It equals the reciprocal of the required reserve ratio o Problems/Critiques of the Multiple Deposit Creation / Simple Deposit Multiplier It assumes that the people will keep depositing the money they receive into the bank. This isn’t totally accurate because someone could decide to hold onto the money and not deposit it, causing the deposit creation process to stop. It also assumes that banks will loan out all of their excess reserves, which they don’t always do The Simple Model of the Multiple Deposit Creation therefore only predicts what would happen if there were full expansion (i.e. nobody held onto the money and the banks loaned all of it out) Question 9 page 338 o 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 Fed will be putting more money into the hands of the public, causing the currency in circulation (C) to increase. When the Fed lowers the required reserve ratio, the banks will decrease their reserves and put more money out into the hands of the public, also causing C to increase. When C increase, the Monetary Base increases, and that results in an increase in the money supply. Question 12 page 338 o What efect might a financial panic have on the money multiplier and the money supply? Why? A financial panic would cause people to hold onto their money more because they would be afraid to spend it or put it in the banks. This would increase the currency in holding ratio (c). When c increases, both the money multiplier and the money supply decrease because they are negatively related. Question 13 Page 338 o During the Great Depression years from 1930-1933, both the currency ratio and the excess reserves ratio rose dramatically. What efect did these factors have on the money multiplier? If both are increasing dramatically, that would cause the denominator to rise more than the numerator in the money multiplier equation. And when that happens, the money multiplier decreases. Both are negatively related to the money multiplier. Chapter 15 – Tools of Monetary Policy The Market for Reserves and the Federal Funds Rate o The market for reserves (i.e. the supply and demand of deserves) is what changes the federal funds rate o The federal funds rate is the interest rate on overnight loans (AKA non- borrowed reserves) between two banks o This is where we use the graphs we have studied over the past couple weeks Basic graph on page 342. The vertical portion of the supply curve is the supply of non- borrowed reserves Non-borrowed reserves are reserves acquired by banks through the open market operations discussed in the last chapter The horizontal portion of the supply curve is the supply of borrowed reserves that banks borrow from the fed The interest on these borrowed reserves from the Fed is called the discount rate. Non-borrowed reserves and borrowed reserves act as substitutes, which means that banks will choose to get their reserves either from open market operation OR borrow from the fed. Of course, the banks will choose to go with whichever has the lowest interest rate. Therefore, the discount rate acts as a ceiling for the federal funds rate because if the federal funds rate goes above the discount rate, then banks will stop the demand for non-borrowed reserves and will only want borrowed reserves from the Fed because that interest rate is lower The downward sloping portion of the demand curve is just a bank’s demand for both required reserves and excess reserves The demand curve flattens into a horizontal curve because banks do not lend in the overnight market when the federal funds rate drops below the interest rate paid on excess reserves. Therefore, the interest rate on reserves serves as the floor for the federal funds rate, meaning the federal funds rate won’t go below this interest rate on reserves o What shifts the supply curve? 1) Open Market Operations cause the vertical portion of the supply curve (non-borrowed reserves) to shift either left or right. An open market purchase causes the NBR curve to shift right o Result if the NBR curve intersects the downward sloping portion of the demand curve: federal funds rate to fall o Result if the NBR curve intersects the horizontal portion of the demand curve: No change in federal funds rate An open market sale causes the NBR curve to shift left o Result if the NBR curve interests the downward sloping portion of the demand curve: federal funds rate rises o Result if the NBR curve intersects the horizontal portion of the demand curve: No change in the federal funds rate 2) Changes in the discount rate cause the horizontal portion of the supply curve (borrowed reserves) to shift either up or down Increasing the discount rate causes the BR curve to shift up o Result if the BR curve intersects the downward sloping portion of the demand curve: federal funds rate rises o Result if the BR curve does not intersect the downward sloping portion of the demand curve: No change in the federal funds rate Decreasing the discount rate causes the BR curve to shift down o Result if the BR curve intersects the downward sloping portion of the demand curve: federal funds rate falls o Result if the BR curve does not intersect the downward sloping portion of the demand curve: No change in the federal funds rate o What shifts the demand curve? 1) Changing the Reserve Requirements causes the downward sloping portion of the demand curve to shift either left or right An increase in the required reserves causes a shift to the right in the downward sloping demand curve o Result if the NBR curve interests the downward sloping portion of the demand curve: federal funds rate rises o Result if the NBR curve interests the horizontal portion of the demand curve: No change in the federal funds rate A decrease in the required reserves causes a shift to the left in the downward sloping demand curve o Result if the NBR curve interests the downward sloping portion of the demand curve: federal funds rate falls o Result if the NBR curve interests the horizontal portion of the demand curve: No change in the federal funds rate 2) Changing the interest rate on reserves causes the horizontal portion of the demand curve to shift either up or down An increase in the interest rate on reserves causes an upward shift in the horizontal portion of the demand curve o Result if the NBR curve interests the downward sloping portion of the demand curve: no change in the federal funds rate UNLESS the horizontal portion of the curve moves up above the equilibrium. If this is the case, the federal funds rate will rise to match the floor (horizontal portion of demand curve) o Result if the NBR curve intersects the horizontal portion of the demand curve: Federal funds rate rises A decrease in the interest rate on reserves causes a downward shift in the horizontal portion of the demand curve o Result if the NBR curve interests the downward sloping portion of the demand curve: No change in the federal funds rate o Result if the NBR curve interests the horizontal portion of the demand curve: federal funds rate falls o Types of Open Market Operations 1) Dynamic – permanently change the level of reserves and the monetary base Changing the level of reserves is what they do when they want to change the target federal funds rate 2) Defensive – Two temporary types which are intended to ofset movements in other factors that afect reserves and the monetary base, such as changes in Treasury deposits with the Fed or changes in the float 1) Reverse Repurchase Agreement (reverse repo) – The Fed purchases securities with an agreement that the seller will repurchase between 1 and 15 days from the original date of purchase. It is a temporary open market purchase 2) Matched sale-purchase transaction (repo) – The Fed sells securities and the buyer agrees to sell them back to the Fed in the near future o Discount Policy – The banks borrow reserves (discount loans) from the Federal Reserve at the discount window. Types of loans 1) Primary credit (AKA standing lending facility) – banks are allowed to borrow all they want at very short maturities (usually overnight) from The Fed o Discount rate typically set at 1% higher than the federal funds rate o Don’t do often just because the federal funds interest rate to borrow from other banks is typically lower than the discount rate to borrow from The Fed. 2) Secondary credit – Given to banks that are in financial trouble and are experiencing severe liquidity problems o Typically set at 0.5% higher than the discount rate to act as a penalty for the banks not doing well 3) Seasonal credit – Given to meet the needs of a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits. o Interest rate is the average of the federal funds rate and the certificate of deposit rate Lender of Last Resort – The Fed prevents bank failures to struggling banks by providing reserves to banks when no one else would, thereby preventing financial and bank panics. o Reserve Requirements – a quick review When reserve requirements increase Money supply decreases Federal funds rate increases When reserve requirements decrease Money supply increases Federal funds rate decreases All depository institutions must have the same reserve requirements o Interest on Reserves – Fed only started paying interest on reserves in 2008. Since we started paying interest on reserves, the federal funds rate has never gotten down to the floor, so we have never had to use interest rate on reserves as a monetary tool. o Advantages of Open Market Operations – The most important conventional tool of monetary policy 1) Fed has complete control over the open market operations. It’s controlled and initiated by the Fed only 2) Open market operations are flexible and precise. The Fed can use it to the exact extent desired 3) All open market operations are easily and immediately reversed if needed 4) Can be implemented quickly without any administrative delays o Nonconventional (unconditional) Monetary Policy Tools used only in the crisis of 2007 1) Liquidity Provision – has 3 components; new loans the Fed gives other than discount loans a) Discount Window Expansion - Lower the discount rate by an unprecedented amount, down to only 0.25% higher than the federal funds rate (as opposed to the typical 1%) b) Term Auction Facility – Fed made loans at a rate determined through an auction, so the loan could be made to a failing bank at below the discount rate as opposed to above the discount rate like we discussed with secondary credit, above. c) New Lending Programs – The Fed lends to institutions other than banks such as J.P. Morgan and AIG 2) Large-Scale Asset Purchases – The Fed bought long-term assets to broaden the types of assets they had; three purchases in addition to the normal open market purchase of short-term securities that lowered interest rates for particular types of credit; again, also occurred in the crisis of 2007 A) QE1 - The Fed purchased $1.25 trillion of mortgage- backed securities from Fannie Mae and Freddie Mac B) QE2 – The Fed purchased $600 billion of long-term Treasury assets. C) QE3 – More purchases of mortgage-backed securities and long-term Treasury assets with an open-ended 3) Commitment to future policy actions – Actions with intent of making interest rates fall in the long-term; Goal is also to influence peoples’ expectations of the market and influence the types of assets we purchase A) Conditional commitment – The commitment to keep the federal funds rate at zero for an extended period of time. The decision was predicated on a weak economy going forward, and it indicates that the commitment would be abandoned if things got better B) Unconditional commitment – The same exact thing as a conditional statement except the Fed doesn’t indicate that it will abandon the zero federal funds rate if things got better o Problem: If something happens and the market doesn’t respond in the right way, it will take a long time to change back to the way it was because the market doesn’t respond immediately to these changes Question 19 Page 364 o What is the main advantage and the main disadvantage of an unconditional policy instrument? 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 – The Conduct of Monetary Policy: Strategy and Tactics Dual Mandate – The two main goals the Fed attempts to achieve at the same time through monetary policy o 1) Price stability – the most important goal of monetary policy o 2) High employment – stable job environment Hierarchical Mandate – Prioritizing the goals of the Fed in order of importance. So Price stability #1, high employment #2, etc. Can’t have a dual mandate and hierarchical mandate. Must be one or the other. Other monetary policy goals o Steady economic growth so people trust in the market o Stable financial markets so economy doesn’t contract o Interest-rate stability so people don’t become uncertain with fluctuating rates o Stable foreign-exchange markets so our dollar doesn’t become too strong or weak o TREND = STABILITY in everything! Nominal Anchor – A variable that ties down the price level to achieve price stability o Examples are inflation rate or money supply. Keeping these variables in place directly promote low and stable inflation expectations, which results in price stability o Advantage: A nominal anchor also limit the time-inconsistency problem o Time-Inconsistency Problem – Using monetary policy day-to-day to make big changes which are good now, but they lead to poor long-term outcomes When a nominal anchor is announced, the banks are less tempted to make surprise expansionary policies to help short- term interest rates that are good for now but bad for later Inflation Targeting – Setting a target for inflation in order to make monetary policy decisions to keep inflation within the target range o 1) The Fed announces to the public a medium-term numerical objective (AKA target) for inflation o 2) The Fed commits to price stability being the primary, long-run goal of monetary policy and commits to achieving the inflation goal o 3) The Fed uses many variables in making decisions about monetary policy o 4) The Fed is transparent about their plans and objectives of monetary policy o 5) The central bank has increased accountability for attaining its inflation objectives o Advantages of Inflation Targeting Reduces Time-inconsistency problem because a target is set and the Fed won’t make a crazy adjustment to help short-term interest rates that would hurt us long-term Increased Transparency and accountability described above It’s more consistent with Democratic Principles Results have proven this works at reducing rates of inflation and inflation expectations o Disadvantages of Inflation Targeting Delayed signaling – Long lags in the efects of monetary policy reveal inflation out-comes after a substantial lag Too Much rigidity – Some people believe it handcufs monetary policymakers so they don’t have as much freedom to respond to unforeseen circumstances Potential for Increased Output Fluctuations – Some say that when inflation is above the target, monetary policy may get too tight and result in larger output fluctuations Low Economic Growth – Some fear that inflationary targeting will lead to low growth in output and employment o Federal Reserve Approach to Monetary Policy They took a “just do it” approach to changing monetary policy. They did whatever they thought would be best to control long- run inflation. No targets were set Advantage: The Fed actually had a lot of success in the past with this method Disadvantage: There was not much transparency, so people didn’t trust the Fed as much, which would lead people to being more hesitant when it came to their decisions in the market o Asset-Price bubbles – Pronounced increases in asset prices that depart from fundamental values and eventually burst and plummet back downward Types of bubbles Credit-Driven Bubbles – When a credit boom begins, it becomes easier for people to get credit to purchase certain assets (such as houses), which leads to a higher value of those assets. That higher value entices even more lending to consumers because the asset that now has higher value can act as more collateral. Irrational Exuberance – bubbles that form solely by overly optimistic expectations o Ex: Tech-stock bubble and burst in the 90s because people were expecting this incredible stuf to come out and be so popular and it didn’t quite catch on as much as everyone had hoped Monetary policy isn’t great to use to fix bubbles because it afects the entire market and not just the specific asset that is starting to bubble o 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 2 types: o 1) reserve aggregate variable – setting a target for quantity demanded of non-borrowed reserves o 2) Interest rate variable – setting a target for the federal funds rate Can target one or the other but not both because they are incompatible When one shifts, the other changes as well (if they intersect at the sloped portion of the demand curve), making it impossible to target both at the same time. Intermediate target – stands between the policy instrument and the goals of monetary policy (i.e. price stability); not directly afected by monetary policy, but linked to the goals of monetary policy Criteria for choosing instruments and targets The instrument must be observable and measureable; it must be controllable by the central bank; and it must have a predictable efect on the goals o The Taylor Rule The Federal funds rate = the inflation rate + an “equilibrium” real federal funds rate + ½(inflation gap) + ½(output gap)… Don’t need to memorize It’s the method for choosing a nominal target when you have a dual mandate Question 14 on page 395 o Why aren’t most central banks more proactive in trying to use monetary policy to eliminate asset-price bubbles? Monetary policy is too blunt. When the central bank changes interest rates, it impacts all asset markets not just the asset- bubble market. Question 24 on page 396 o If the Fed has an 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 If demand for reserves shifts to the right, it will cause an increase in the interest-rate (federal funds rate), which we don’t want because we already set a target at the initial rate. So to combat that, we must shift supply to the right. The Fed does this by increasing reserves through open market purchases, which increases the monetary base, which increases the money supply. Chapter 25 – Transmission Mechanisms of Monetary Policy Transmission mechanisms are ways in which monetary policy afects aggregate demand in the economy – Check out page 605 as a good table to study o NOTE: All of the following mechanisms deal with a change in the REAL interest rate The only exception is “cash flow,” which afects the NOMINAL interest rate (described below) o Reminder: Aggregate Demand = Consumer Expenditures + Investments + Government expenditures + Net Exports OR: AD = C + I + G + NE Transmission mechanisms will focus on how C, I, and NE change, therefore how AD is afected o Traditional Interest-Rate Channel – targets Investment spending (I) Easing monetary policy leads to a fall in real interest rates, thus decreasing AD ↓r ↑I ↑AD Other Asset Price Channels o 1) Exchange Rate Efects on Net Exports – Targets net exports (duh) When the domestic real interest rate falls, the dollar depreciates, and things that we sell become cheaper for people outside the US because their money is stronger compared to ours. This will cause them to buy more of our stuf, and we will export more ↓r ↓value of the dollar ↑NE ↑AD o 2) Tobin’s Q Theory – Q is a variable Evaluates the value of a corporation vs. the cost of replacing the equipment within that corporation; so if the value of the corporation is much higher than replacement costs of equipment, companies can issue more stock at a price higher than the cost of its equipment. When stock prices go up, the company wealth will go up, and they will invest more with that wealth. Vice versa holds true if the value of the corporation is less than the cost of replacing the equipment But how can changing monetary policy play a role in this stock price change? Lowering real interest rates on bonds means that the expected return on stock falls. This makes stocks more attractive than bonds, so the demand for them increases, which raises their price o ↓r ↑stock prices ↑Q ↑I ↑AD o 3) Wealth Efects – Modigliani came up with it and focuses on Consumption through nondurable goods and stock prices When a consumer’s lifetime resources increase, they will spend more on nondurable goods today, such as a vacation. Monetary easing of the real interest rate will lead to a rise in stock prices, and when stock prices rise, a consumer’s wealth will increase, which increases lifetime resources and thus also increases Consumption spending on nondurable goods ↓r ↑ stock prices ↑ Wealth ↑ lifetime resources ↑ C ↑AD Credit View - Transmission mechanisms operating through asymmetric information efects on credit markets; in other words, they help with the moral hazard and adverse selection problems o 1) Back Lending channel – Expansionary monetary policy increases bank reserves and bank deposits leads to a rise in the quantity of loans and more investment by consumers who receive these loans ↑bank reserves and deposits ↑money to loan out to consumers ↑I ↑AD o 2) Balance Sheet Channel – Focuses on decreasing adverse selection and moral hazard to increase Investments When a bank has low net worth, moral hazard and adverse selection increases because owners may be tempted to engage in riskier business to bring the company back up, and banks won’t want to lend to a company with low net worth. So to fix this, easing monetary policy will cause a rise in the stock prices, so a firm’s net worth will increase, thus decreasing adverse selection and moral hazard, and increasing lending and investments ↓r ↑stock prices ↑Net worth ↓adverse selection and moral hazard ↑lending ↑ I ↑ AD o 3) Cash Flow Channel – ONLY one that focuses on nominal interest rates; based on the willingness of lenders to lend Easing monetary interest rates will lower the nominal interest rates which will result in less cash expenses, meaning cash flow will increase. When cash flow increases, the liquidity of the firm increases, making it easier for lenders to know whether the firm will be able to pay its bills, therefore decreasing adverse selection and moral hazard. And of course, lending increase along with Investment ↓nominal interest rates ↑cash flow ↓adverse selection and moral hazard ↑lending ↑ I ↑ AD o 4) Unanticipated Price Level Channel - Changes investment through price level Since an easing of monetary policy raises inflation, it will lead to an unanticipated rise in the price level. And an unanticipated rise in the price level will lower the value of the firm’s liabilities (AKA value of their debt decreases) while keeping the value of their assets the same. Therefore, the firm’s net worth will increase, lowering adverse selection and moral hazard, increasing lending, and increasing investments ↓ r unanticipated ↑ Price level ↑net worth ↓adverse selection and moral hazard ↑lending ↑ I ↑ AD o 5) Household Liquidity Efect – Focuses on durable goods; based on the willingness of consumers to spend Easing monetary interest rates causes the real interest rate to decrease, which results in increased price level. The increased price level results in an increased value of the consumer’s household assets, therefore making them less stressed about their finances. If they are less stressed, they will choose to consume more durable goods (C), thus increasing aggregate demand ↓r ↑stock prices ↑value of household assets ↓stress about their finances ↑C on durable goods ↑AD Reasons Credit Channels are Important o 1) There is evidence proving that the behaviors listed above are accurate o 2) Small firms are credit-constrained, meaning they don’t have very easy access to lots of credit like a big firm may have. That means they can be hurt severely by a tight monetary policy, so easing monetary interest rates will have a positive efect on small firms o 3) These credit channels are based on changing the asymmetric information of moral hazard and adverse selection. Asymmetric information has been proven to explain many other economic phenomena, so we can assume that if it is credible and if it is the basis for credit channels, then credit channels are very important Lessons for Monetary Policy o 1) It is dangerous to consistently associate an easing or tightening of monetary policy with a fall or rise in short-term NOMINAL interest rate o 2) Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms o 3) Monetary policy can be efective in reviving a weak economy even if short-term interest rates are already near zero o 4) Avoiding unanticipated fluctuations in the price level is an important objective of monetary policy, thus providing a rationale for price stability as the primary long-run goal of monetary policy Side note she made in class on the final review day e o The formula to calculate the real interest rate is r=i−π o Wheee i is the nominal interest rate o π is the expected inflation o So in all the scenarios above, we have a decreasing real interest rate, and besides the cash flow, we don’t touch the nominal interest rate. So in order for the real interest rate to decrease, we must have a little inflation. If we had deflation, we would be subtracting a negative number, which we know turns into addition, resulting in an increased real interest rate Question #8 on page 615 o The costs of financing investment are related only to interest rates; therefore, the only way that monetary policy can afect investment spending is through its efects on interest rates.” Is this statement true, false, or uncertain? Explain your answer. False. Monetary policy can afect stock prices, which afect Tobin’s q, thus afecting investment spending. In addition, monetary policy can afect loan availability, which may also influence investment spending.
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