Monetary Policy Flashcards
define interest rates
the cost of borrowing and the return on savings
what is the effect of increasing/decreasing interest rates on AD?
lower interest rates make borrowing cheaper, allowing C and I to spend/invest more, increasing AD
higher interest rates make borrowing more costly, causing C and I to save rather than spend, decreasing AD
define deflationary gap
a deflationary (also called recessionary) gap occurs when AD decreases, causing the average price level to fall
the ‘gap’ on the macroeconomic diagram is the difference between the full employment level of output and the current output
define demand-pull inflation
when AD persistently increases and reaches the near-vertical section (the neoclassical zone) of the SRAS curve
(the price level will increase with very little effect on RGDP)
define inflation, disinflation, and deflation
inflation: a sustained increase in the average price level of g&s over time
disinflation: a decrease in the rate of inflation (a decrease in the rate at which the average price level is rising)
deflation: when the average price level of g&s decreases over time
define money supply
money supply: how much money is circulating in the economy
what is the effect of increasing/decreasing the money supply on AD?
when the money supply increases, interest rates decrease, spending increases, AD increases
when the money supply decreases, interest rates increase, spending decreases, AD decreases
what are the roles of the central bank?
- banker to the government
- banker to commercial banks
- regulator of commercial banks
- controls the money supply/interest rates (3 tools)
- manipulates exchange rate policy
state the difference between nominal and real interest rates
nominal = today’s value
real = comparing the nominal to the base year to take inflation out of it
describe expansionary monetary policy
the central bank increases the money supply, interest rates decrease, C and I borrow/spend more and save less, AD shifts to the right, RGDP and PL increase, unemployment decreases
describe contractionary monetary policy
the central bank decreases the money supply, interest rates increase, C and I save more and borrow/spend less, AD shifts to the left, RGDP and PL decrease, unemployment increases
state the 3 tools that the central bank uses to change the money supply
- changes to the reserve requirement (rr)
- changes to the discount rate (DR)
- open market operations (OMO)
what is a reserve requirement (rr)?
rr = the amount of money that banks are required to hold “in reserve”
(they are not allowed to lend the rr money)
what is the effect of increasing/decreasing the reserve requirement on the money supply?
when the rr increases, the money supply decreases
when the rr decreases, the money supply increases
what is a discount rate (DR)?
DR = the rate central banks charge when they make loans to large commercial banks
(it is a type of interest rate that is unique for commercial banks)
*only commercial banks borrow money directly from the central bank
what is the effect of increasing/decreasing the discount rate on the money supply?
when the DR increases, the money supply decreases
when the DR decreases, the money supply increases
what are open market operations (OMO)?
OMO = the buying and selling of government bonds
what are government bonds?
when the government cannot cover its deficits it creates bonds so that it can continue to loan money
(bonds are essentially “iou” slips of paper that represent debt)
what is the effect of buying/selling bonds on the money supply?
buying bonds expands the money supply
selling bonds contracts the money supply
state the money multiplier formula
money multiplier = 1/rr
state the gobbledygook for OMO buying bonds
OMO-buying bonds, ↑MS, ↓int-rate, ↑AD-C&I, ↑PL, ↑RGDP, ↓unemp
state the gobbledygook for OMO selling bonds
OMO-sell bonds, ↓MS, ↑int-rate, ↓AD-C&I, ↓PL, ↓RGDP, ↑unemp
define yield
yield = the interest rate on a bond that is paid to the lender
define term
term = the time until a bond matures
long term bonds are riskier and therefore pay a higher rate
define junk bonds
bonds that get you a high yield in a short amount of time because the firm is about to close
define municipal bonds
state and local bonds (yields are not subject to federal income tax)
is the Sm curve perfectly elastic or inelastic?
the supply of money is perfectly inelastic (vertical line) therefore it is not responsive to changes in interest rates
why is the Dm curve downward-sloping?
there is an inverse relationship between NIR and Q
what is the effect of increasing Sm on Dm?
increasing Sm (shifting it to the right) causes Dm to decrease (expansion)
what is the effect of decreasing Sm on Dm?
decreasing Sm (shifting it to the left) causes Dm to increase (contraction)
draw the money supply diagram
define excess reserves
the amount of money banks have available to lend
define federal funds rate
the interest rate that banks charge each other for very short term (usually overnight) loans
how do you calculate the amount of money created/multiplied after a deposit is made?
- someone deposits money in the bank
- subtract the rr from the original deposit (everything else is the excess reserves)
- multiply the excess reserves by the money multiplier
