Midterm Part B

Question 1

What is the first Interest Rate Policy Tool?

Answer 1

1) Open market operations (OMO): the Fed buys or sells Treasury securities in the open market (also known as the secondary market for Treasury securities)

Question 2

What is the second Interest Rate Policy Tool?

Answer 2

2) The discount rate is the interest rate the Federal Reserve charges banks for short-term loans through the discount window.

• ⬆️ A higher discount rate makes borrowing more expensive for banks, leading to higher interest rates on consumer loans like mortgages and credit cards.
• ⬇️ A lower rate reduces borrowing costs, making loans more affordable and encouraging spending.

Question 3

What is the third Interest Rate Policy Tool?

Answer 3

3) Bank reserve requirements (or required reserve ratio)
are the percentage of deposits that banks must retain (not loan out).
This ensures they have enough money to cover withdrawals and other obligations.

Question 4

What is the fourth Interest Rate Policy Tool?

Answer 4

4) Verbal persuasion to influence banks’ willingness to tighten or loosen their lending

Question 5

what is pure expectations theory (PET)

Answer 5

Pure Expectations Theory (PET) states that long-term interest rates are based on expected future short-term interest rates.

• The return on a 2-year bond should be about the same as investing in a 1-year bond now and another 1-year bond next year.
• If investors expect short-term interest rates to rise (e.g., due to inflation), longer-term bond rates will also increase.
• The market adjusts long-term rates so that neither option (holding a long-term bond or rolling over short-term bonds) has a clear advantage.