Monetary Policy in The United States

Question 1

Monetary policy refers to how central banks use monetary instruments such as the discount rate, open operations, and _______ requirements to influence interest rates and monetary aggregates in order to achieve economic goals.

Answer 1

Reserve. As you recall, we described three main tools the FED uses to influence the economy–the discount rate (the interest rate they charge banks to borrow from the FED), open operations (selling and buying government securities to affect the total reserves), and reserve requirements (the proportion of reserves a bank is required to hold on to). The use of these three tools is known as monetary policy.

The aim is to attain economic goals such as low inflation, low unemployment, and strong real output. These are also known as policy determinants.

Question 2

The main goals of the FED include low inflation, low unemployment, strong real output, stable price levels, stable _________ markets and stable international financial conditions.

Answer 2

Financial. As the US trades with many other countries, it is important that international financial conditions are stable.

Question 3

Monetary strategy consists of policy determinants, targets, ___________ and control periods.

Answer 3

Constraints. These are the restricting values of other variables that concern the FED that are placed upon account managers at the FED. Therefore, for example, an account manager may be told to hit one target, but in doing so not to exceed a particular rate on another variable.

Question 4

A control period is a time period that applies to a range of targets, and a target is an economic ________ that the FED aims to achieve.

Answer 4

Variable. An example best illustrates this answer. An account manager at the FED may be told to maintain the growth of M2 to 5% over 2 months. Therefore, this control period is 2 months.

Question 5

An _________ target is a short-term target whereas an intermediate target is one that is achievable in the middle to longer term.

Answer 5

Operating. An example of an operating target is the federal funds rate. As you recall, the FED buys and sells securities on the open market to raise or lower total reserves, which in turn affects the federal funds rate (the interest rate at which banks borrow reserve funds from each other).

Question 6

The reason the FED would adopt intermediate targets is that it faces limitations on the availability of ___________ regarding its ultimate objectives, so it establishes intermediate targets on the way to meeting ultimate objectives. Also, different officials have different ideas on how monetary policy actions affect ultimate policy goals.

Answer 6

Information. Some economic variables, such as real output and employment rates can only be properly ascertained on a monthly basis. Therefore, information about the FED’s ultimate goals on inflation, employment, and real output are less readily available.

On the other hand, variables like interest rates and credit data are more readily available. Therefore, it makes more sense to use these variables as intermediate targets.

Question 7

Intermediate target variables should be regularly observable, predictable in impact, definable, measurable and ____________.

Answer 7

Controllable. This is a necessity. If the variable is susceptible to redefinition on a regular basis, then the FED would have difficulty measuring it.

Question 8

The potential intermediate target variables at the disposal of the FED include monetary aggregates, ______ aggregates, interest rates, nominal gross domestic product, and exchange rates.

Answer 8

Credit. Credit aggregates are a target measurable by the volume of lending. Types include aggregate credit, which is the total lending in the economy and another is total bank credit (or total lending and securities held by banks).

Question 9

Monetary aggregates, especially M1 and M2 have been used as an ____________ target, but they can be troublesome because in recent years the definition of M1 and M2 have been altered.

Answer 9

Intermediate. New forms of money-like assets are being introduced into the economy very quickly, especially with the pace of technological change we see today. Thus, these definitions have to be changed quite regularly.

Question 10

The most commonly used intermediate target by the FED is ______________.

Answer 10

Interest rates. Interest rates can be very regularly monitored and the effects of FED action on this can be quickly visible.

Question 11

The FED uses the federal funds rate as its _____ target for monetary policy, thereby anchoring the shortest maturity rates for yield curves of various financial instruments.

Answer 11

Daily. Changing the federal funds rate will result in a movement of this base for other interest rates. The use of this ‘anchor’ follows from the basic theory of risk and structure of interest rates.

Question 12

Since 1994 the FED has disclosed its _____ target for the federal funds rate and this has increased confidence in future daily interest rates.

Answer 12

Daily. This was a policy change and it has tightened the relationship between the market rates and federal funds rates.

Question 13

When targeting the ________ rate, the FED has to be mindful of the inflation rate.

Answer 13

Interest. The FED has to be careful not to lose anti-inflationary credibility. If it sets the rate too low in relation to expected inflation then, this will impact rational expectations.

The simplified idea is this–the lower the interest rates, the more money people will have to spend, which will reduce the value of the dollar. In other words, it will lead to reduced purchasing power–also known as inflation. A little inflation is normal, but too much inflation can be harmful to the economy.

Therefore, the FED can’t make the interest rates too low in relation to the current inflation rate.

Question 14

The selection of the sequence of monetary targets depends on the monetary ____________ process.

Answer 14

Transmission. The monetary transmission process is the process of reactions in financial, product and labor markets to monetary policy actions.

Question 15

In an open markets purchase, the monetary transmission process would eventually result in an ________ in aggregate demand.

Answer 15

Increase. Aggregate demand is the total amount of planned expenditures on goods and services.

The FED would purchase securities; this will increase bank reserves and money supply. As you recall, money demand (assumed to be equal to money supply) is negatively related to the returns on bonds, stocks, and goods. So when money supply is increased, this will reduce nominal and real rates of return on the money market and bond market instruments. This makes sense! As there’s more money available, it’s going to cost less to borrow it.

As the cost of borrowing is lower and relative rates of return on debt and equity instruments have dropped, investors will invest in real capital and consumer goods. This will therefore increase aggregate demand.

Take some time to try to understand the monetary transmission process we just described above, since it ties together a lot of relationships we’ve studied so far.

Question 16

Operating targets include federal funds rate, ___________ reserve targets, borrowed reserve targets and effective targets under narrow constraints.

Answer 16

Nonborrowed. Borrowed reserves are those reserves that the Federal Reserve lends to depositories through what is commonly referred to as the discount window.

Nonborrowed reserves are reserves that have not been borrowed from the FED. Banks can obtain nonborrowed reserves through open market operations. As you recall, we said that the FED can buy or sell securities through open market operations–this is how the FED controls the supply of nonborrowed reserves.

Question 17

Federal funds rate targets are successful when the FED knows what the money ______ is, but predictions on this are very difficult and may result in poor money stock control.

Answer 17

Demand. Nominal money demand can change with price levels, output levels, inflation expectations, and other factors. Therefore, it is very sensitive and difficult to predict. For theoretical purposes of understanding relationships between variables, we have been assuming that money demand is the same as money supply (which would indicate that we are at equilibrium where supply=demand).

Question 18

The main domestic goals of monetary policy are to limit inflation, prevent sharp swings in ______ and minimize and stabilize unemployment.

Answer 18

Output. Sharp movements in output (or gross domestic product) will destabilize the economy and employment levels.

Question 19

The initial monetary policy of the US between 1913 and 1929 focused on the application of the Real Bills doctrine, which states that as long as loans are made to support the production of goods and services, providing ________ to the banking system to make these loans will not be inflationary.

Answer 19

Reserves. One of the main ideas of the Real Bills Doctrine is that money created by loans to finance real production rather than speculation has no influence on prices (i.e. inflation).

Question 20

The real bills doctrine for monetary policy is not satisfactory because its impact is ___________.

Answer 20

Procyclical. By procyclical, we mean that it causes money supply to rise during economic expansion and fall during recession–which is the opposite of what we need.

When the economy is expanding, banks make ‘productive’ loans and therefore would have more assets to borrow from the FED. The FED would be discounting many real bills and this would expand the banking system and hence money supply.

However, when the economy is in recession, fewer loans would be made, there would be fewer real bills to discount, supply of credit and money is lower, thus causing a liquidity problem.

Question 21

The Great Depression was in part caused by the FED’s application of the __________ doctrine and failure to execute open market purchases to provide more bank reserves.

Answer 21

Real bills. As you recall, when the Fed makes open market purchases, it increases the total reserves. Open market purchases would have relieved the pressure on the financial market by increasing market supply and placing downward pressure on interest rates. The idea is that by increasing money supply, that increases aggregate demand and encourages economic growth.

Question 22

The loans given to __________ borrowers under the real bills theory were considered to be self-liquidating.

Answer 22

Commercial. The real bills theory proposed that banks should only lend money to commercial borrowers who would quickly repay the loan because they would use the money to fund production costs or shipping of goods for sale.

The idea was that commercial borrowers would be quickly paid when they sold the produced or shipped goods. Hence, banks would be repaid quickly. This theory is also known as the commercial loan theory.

The banks considered these loans as highly liquid because of the circumstances under which they were given, and hence under the real bills theory, these loans came to be called self-liquidating loans.

Question 23

Monetary policy in the US during the period 1940 to ____ was predominantly influenced by World War II.

Answer 23

1951. The FED’s policy was to keep interest rates low in order to support Treasury financing operations for the war effort.

Question 24

In 1951, the FED was worried that pegging interest rates to finance the war operations would result in _________.

Answer 24

Inflation. Fixing interest rates when aggregate demand is rising causes supplies of money to rise and this will bring on inflation. Remember, money supply increases when aggregate demand increases. if the money supply is increasing too fast, there will be too much money floating around for people to spend, which will reduce its purchasing power.

Question 25

As a result of the FED’s concern about pegging interest rates, an agreement called The Accord was signed to eliminate pegging, but the FED would not allow interest rates to ____________.

Answer 25

Rise rapidly. It would have been damaging to the economy to allow interest rates to shoot up. Therefore, it was agreed that the rates would be monitored until stability was achieved.

Question 26

After pegging of interest rates was removed, the FED initially followed the ____________ doctrine, which theorized that a small rise in interest rates was adequate to restrict aggregate demand, as a small rise in interest rates would be sufficient to reduce available credit offered by the banks.

Answer 26

Availability. Remember, as we learned earlier, when interest rates go down, investors spend more on private capital and consumption goods, raising the aggregate demand. Obviously, when interest rates go up, the opposite occurs–aggregate demand goes down.

It was called the availability doctrine because the Fed’s goal was to reduce available credit, which they hoped would keep aggregate demand in check. If aggregate demand is in check, then money supply is also in check, which should hopefully restrict inflation.

Question 27

Up to ____, the FED followed the money market strategy which aimed for financial stability and low inflation and commonly used free reserves as a policy tool but the targets were not quantified.

Answer 27

1970. Instead of specifying specific numerical goals, words such as “tone” and “feel” of the market were often used, thereby creating little accountability for managers implementing the open market operations.

Question 28

_____________ are defined as excess reserves minus borrowed reserves.

Answer 28

Free reserves. Borrowed reserves are funds borrowed by member banks from federal reserve banks to meet required reserve ratios.

Question 29

The consequence of the _____________ strategy was that the economy grew slowly.

Answer 29

Money markets. This strategy produced slow economic growth because money supply expanded very slowly and inflation was also low.

Question 30

The US had to rapidly escalate fiscal expansion because of the war effort from the mid 1960s. The sudden ______ in the money supply contributed to a period of inflation that lasted into the 1970s.

Answer 30

Growth. The FED tried to hold on to interest rate targets for too long during the expansion and this meant that the FED provided too much monetary base, which resulted in inflation.

As we just covered a couple of questions ago, when the aggregate demand rises (due to wartime production), but the interest rate stays the same, money supply is going to increase too quickly and cause inflation. Increasing the interest rate would have the effect of keeping the money supply in check.

Question 31

After ____, the FED started to use intermediate targeting of money supply measures, which were then utilized as policy.

Answer 31

1970. An intermediate target is an economic variable that the FED has decided is worth controlling in order to meet its ultimate monetary policy objectives. So in other words, the Fed’s monetary policy became to control money supply, which is known as the Quantity Theory approach (versus Real Bills doctrine, availability doctrine, etc.)

Question 32

The quantity theory approach is a complete turnaround from the Real Bills doctrine. The quantity theory approach believes that price level and real output could and should be stabilized through ___________ control.

Answer 32

Money stock. That’s what the Quantity Theory approach is all about–controlling the money supply to control the economy. The goal of controlling the money stock is to ultimately control price levels and output. In the real bills doctrine, it’s the other way around–output is what determines money stock.

Question 33

In 1973, the US experienced a period of ___________ when output was stagnant and inflation was rising.

Answer 33

Stagflation. Stagflation is a term used to describe a period of characteristic high inflation combined with economic stagnation, unemployment, or economic recession. Usually the two don’t go together–high inflation and low economic growth. When they do, it can be a tough decision for the Fed.

First, the bank can choose to pursue a loose money policy to stimulate the economy and create jobs by increasing the money supply (by lowering interest rates) and exacerbate the inflation problem further.

Or second, it can pursue a tight money policy (by increasing interest rates) to try and reign in inflation at the cost of perhaps increasing unemployment further.

Question 34

From the late 1970s to the early 1980s, the FED raised the discount rate, placed a marginal reserve ratio on managed ___________ and started targeting nonborrowed reserves.

Answer 34

Liabilities. Nonborrowed reserves are those which have not been borrowed from the FED by banks. Nonborrowed reserves are increased or decreased by open market purchases or sales, respectively.

Question 35

______ policy is the tax and spending programs of the government, whereas monetary policy is the policies that the FED and government pursue to meet their economic aims.

Answer 35

Fiscal.

Question 36

When the government reduces government spending and increases taxes, then these policies are called ______________ fiscal policies.

Answer 36

Contractionary. It’s called contractionary because it can cause the economy to contract. Reduced government spending and increasing taxes is going to reduce the money supply, which is going to reduce aggregate demand (and consequently GNP).

Question 37

Government policies that increase government spending and ________ taxes are called Expansionary fiscal policies.

Answer 37

Decrease. Expansionary fiscal policy is obviously the opposite of contractionary policy; it’s designed to increase money supply and aggregate demand, and consequently result in economic expansion (GNP goes up).

Question 38

Monetary policy that increases the money supply is called expansionary or loose, and those that reduce the money supply are contractionary or tight, and changes such as these can only be measured in their effect if we know their _________.

Answer 38

Magnitude. For example, we need to know how much the interest rate has been reduced or increased by in order to calculate its effect on the economy.

Question 39

The policy __________ problem is the problem of deciding whether monetary or fiscal policymakers should target internal goals such as real income or go for external targets such as balanced trade.

Answer 39

Assignment. This is a problem because errors of this nature can cause goals to move farther away from reach.

Question 40

Monetary policy _________ are time periods between the need for countercyclical policy action and the actual effects of that action on an economic variable. As these lags can be quite time-consuming, the need to develop policy rules to specify policy strategies is necessary.

Answer 40

Time lags. Setting rules that lay out the ultimate aims and the path to getting there greatly reduce policy time lags.

Question 41

The three types of policy time lag are the ___________ lag, response lag and transmission lag.

Answer 41

Recognition. The transmission lag is the time period that passes between the implementation of the intended countercyclical policy and its eventual effects on an economic variable.

Question 42

The recognition lag is the time lag between the time for the ____ of a countercyclical policy and the recognition of the need by the policymaker.

Answer 42

Need. It’s pretty intuitive. The response lag is the time lag between recognizing the need for countercyclical policy and the actual implementation of that policy.