Chapter 15: Monetary Policy Flashcards
What is the organization responsible for conducting a nation’s monetary policy?
the central bank, which most nations have
US central bank is the Fed / the Federal Reserve
What is the US central bank?
The Fed / the Federal Reserve
Who runs the Federal Reserve?
7-member Board of Governors, appointed by President, confirmed by the Senate
Presidents of the 12 regional Federal Reserve banks, elected by commercial banks in each district
How long are appointment terms for Board of Governors of the Federal Reserve?
14 years, staggered to one term expires on January 31st of every other year. Limited to one term.
Do policy decisions of the Federal Reserve require congressional approval?
No
Can the President ask for the resignation of a Federal Reserve Governor?
No
Janet Yellen
First woman to chair the Board of Governors of the Federal Reserve, in 2014. She warned about a possible bubble in the housing market more than 2 years before the 2008 financial crisis.
Why does the Chair of the Board of Governors have more power and influence than other members?
The Chair controls the agenda and is the public voice of the Fed
What are the 3 functions of the Federal Reserve?
- Conduct monetary policy
- Promote stability of the financial system
- Provide banking services to commercial banks, other depository institutions, and the federal government
What does the Fed do to currency around Christmastime each year?
Increases the amount of currency available in banks. Then the Fed shrinks the amount again in January.
Purpose of bank regulation
To maintain the solvency of banks by avoiding excessive risk
Types of bank regulation
- Reserve requirements
- Capital requirements
- Restrictions on the types of investments banks may make
Bank Capital
Net worth of a bank - in order words, the difference between a bank’s assets and its liabilities
National Credit Union Administration (NCUA)
Supervises credit unions
Bank Holding Companies
Conglomerate firms that own banks and other businesses. Regulated by the Federal Reserve.
What is the practical issue with bank supervision?
It is not always straightforward to measure the value of a bank’s assets, because the value of loans depends on estimates regarding risk the loans will not be repaid
What is the political issue with bank supervision?
Bank supervisors can come under political pressure to keep quiet and back off decisions requiring a bank to close or change its financial investments
Bank Run
Situation where all depositors are racing to the bank to withdraw their deposits, triggered by rumors of a bank experiencing negative net worth. Even healthy banks do not keep enough cash on hand to fulfill all deposit liabilities.
Two strategies Congress put in place to protect against bank runs
- Deposit insurance
2. Lender of last resort
Deposit Insurance
Insurance system that makes sure depositors in a bank do not lose their money, even if the bank goes bankrupt. Banks pay an insurance premium to the FDIC.
Who is responsible for deposit insurance in the US?
The Federal Deposit Insurance Corporation (FDIC)
Lender of Last Resort
The Fed stands ready to lend to banks and other financial institutions when they cannot obtain funds from anywhere else. Protects solvent banks from failing when bank runs occur.
What are the 3 tools of a central bank to implement monetary policy?
- Open market operations (most commonly used)
- Changing reserve requirements
- Changing the discount rate
What is the relationship between commercial banks and the central bank?
The central bank is a “bank for banks”. Each private sector bank has its own account at the central bank.
Open Market Operations
Central bank sells or buys US Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates
Federal Funds Rate
Specific interest targeted in open market operations. Very short-term.
Who makes decisions regarding Open Market Operations?
Federal Open Market Committee (FOMC)
7 Board Members of the Federal Reserve + 5 voting members drawn from the regional Federal Reserve Banks (1 from NY + 4 rotating from other regions)
Discount Rate
Interest rate that banks pay the Federal Reserve for loans
If the central bank sells $500 in bonds to a bank that has issued $10,000 in loans and is exactly meeting the reserve requirement of 10%, what will happen to the amount of loans and to the money supply in general?
The bank has to hold $1,000 in reserves, so when it buys the $500 in bonds, it will have to reduce its loans by $500 to make up the difference. The money supply decreases by the same amount.
What would be the effect of increasing the reserve requirements of banks on the money supply?
An increase in reserve requirements would reduce the supply of money, since more money would be held in banks rather than circulating in the economy.
Expansionary Monetary Policy
Monetary policy that lowers interest rates and stimulates borrowing
Contractionary Monetary Policy
Monetary policy that raises interest rates and reduces borrowing
How do expansionary and contractionary monetary policies affect equilibrium graph?
Moves equilibrium up & left (contractionary) or down & right (expansionary) along the demand curve by affecting the supply of loanable funds
What does it actually mean when it is said the central bank has “raised interest rates” or “lowered interest rates”?
The central bank changes bank reserves in a way that affects the supply curve of loanable funds. This changes supply, and therefore the interest rate at equilibrium of supply and demand.
Why does contractionary monetary policy cause interest rates to rise?
Contractionary policy reduces the amount of loanable funds in the economy. As with all goods, greater scarcity leads a greater price, so the interest rate, or the price of borrowing money, rises.
Why does expansionary monetary policy causes interest rates to drop?
An increase in the amount of available loanable funds means that there are more people who want to lend. They, therefore, bid the price of borrowing (the interest rate) down.
How does contractionary monetary policy affect aggregate demand?
Higher interest rates result in
- Reduced business investment
- Reduced consumer borrowing and spending
How does expansionary monetary policy affect aggregate demand?
Lower interest rates result in
- Increased business investment
- Increased consumer borrowing and spending
When would a contractionary monetary policy be beneficial?
If an economy is producing at a quantity of output above its potential GPD and inflation is too high. Contractionary policy would raise interest rates, discouraging borrowing and spending, and lowering inflation.
How should monetary policy operate?
Be “countercyclical”, acting to counterbalance the business cycles of economic downturns and upswings
Who is the single person with the greatest power to influence the US economy?
Chairperson of the Federal Reserve
Quantitative Easing
Nontraditional policy adopted by the Fed in late 2008 when interest rates were already near zero. Government purchased long-term government (Treasury bonds) and (risky) private mortgage-backed securities from banks > made credit available > stimulated aggregate demand
What is the general time lag of monetary policy effects?
1-3 years
When may expansionary monetary policy not work well?
When banks are choosing to hold excess reserves and businesses/consumers are reluctant to borrow and spend - due to fear about the economy
Velocity
How quickly money circulates through the economy
Velocity = (Nominal GDP) / (Money Supply)
What does a higher velocity mean?
That the average dollar circulates more quickly/more times per year in an economy
When deflation occurs, does money have more or less purchasing power?
More
But it effectively raises interest rates
If the nominal interest rate is 7% and the rate of inflation is 3%, what is the effective real interest rate?
4%
If the nominal interest rate is 7% and there is deflation of 2%, what is the effective real interest rate?
9%
What is the “double whammy” effect of deflation?
In addition to causing a recession, deflation makes it difficult for monetary policy to be effective
Nominal GDP equation
Nominal GDP = Price Level (or GDP deflator) x Real GDP
Basic Quantity Equation of Money
Money Supply x Velocity = Price Level x Real GDP
What is the most common definition of the money supply?
M1
What was Milton Friedman’s view of monetary policy in the 1970s?
Central bank should increase money supply at a constant growth rate, and should not be given too much discretion to conduct policy (argued that it would become source of economic stability and uncertainty)
Why might banks want to hold excess reserves in time of recession?
In times of economic uncertainty, banks may worry that borrowers will lose the ability to repay their loans. They may also fear that a panic is more likely and they will need the excess reserves to meet their obligations.
Why might the velocity of money change unexpectedly?
If consumer optimism changes, spending can speed up or slow down. This could also happen in a case where consumers need to buy a large number of items quickly, such as in a situation of national emergency.
What do most central bankers around the world believe is the primary task of monetary policy?
Fighting inflation
In the neoclassical model of the economy, where is the aggregate supply curve drawn?
As a vertical line at the level of potential GDP
In neoclassical economics, if an expansionary monetary policy shifts aggregate demand, what does it affect?
Inflation increases
GDP and unemployment are unaltered
Does the US Federal Reserve practice inflation-targeting?
No, it takes both inflation AND unemployment into account
Inflation Targeting
Central bank is legally required to focus on primarily keeping inflation low
Dow Jones Industrial Index
Measures the US stock market. Dow Jones includes 30 very large companies from across the U.S. economy
Nasdaq Index
includes many smaller technology companies
housing bubble
a run-up in housing prices fueled by demand, speculation, and exuberant spending to the point of collapse. … At some point, demand decreases or stagnates at the same time supply increases, resulting in a sharp drop in prices—and the bubble bursts
“leverage” as used by financial economists
means borrowing
Leverage Cycle
When economic times are good, banks and the financial sector are eager to lend, and people and firms are eager to borrow. This surge of lending exaggerates the episode of economic growth. It can even be part of what lead prices of certain assets—like stock prices or housing prices—to rise at unsustainably high annual rates.
At some point, when economic times turn bad, banks and the financial sector become much less willing to lend, and credit becomes expensive or unavailable to many potential borrowers. The sharp reduction in credit, perhaps combined with the deflating prices of a dot-com stock price bubble or a housing bubble, makes the economic downturn worse than it would otherwise be.
Argument against the central bank keeping an eye on asset prices and leverage cycles
Neither the Federal Reserve nor any other central banks want to take the responsibility of deciding when stock prices and housing prices are too high, too low, or just right. This would outrage people and political representatives.
