Monetary Policy in The United States Flashcards
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.
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.
The main goals of the FED include low inflation, low unemployment, strong real output, stable price levels, stable _________ markets and stable international financial conditions.
Financial. As the US trades with many other countries, it is important that international financial conditions are stable.
Monetary strategy consists of policy determinants, targets, ___________ and control periods.
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.
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.
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.
An _________ target is a short-term target whereas an intermediate target is one that is achievable in the middle to longer term.
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).
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.
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.
Intermediate target variables should be regularly observable, predictable in impact, definable, measurable and ____________.
Controllable. This is a necessity. If the variable is susceptible to redefinition on a regular basis, then the FED would have difficulty measuring it.
The potential intermediate target variables at the disposal of the FED include monetary aggregates, ______ aggregates, interest rates, nominal gross domestic product, and exchange rates.
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).
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.
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.
The most commonly used intermediate target by the FED is ______________.
Interest rates. Interest rates can be very regularly monitored and the effects of FED action on this can be quickly visible.
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.
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.
Since 1994 the FED has disclosed its _____ target for the federal funds rate and this has increased confidence in future daily interest rates.
Daily. This was a policy change and it has tightened the relationship between the market rates and federal funds rates.
When targeting the ________ rate, the FED has to be mindful of the inflation rate.
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.
The selection of the sequence of monetary targets depends on the monetary ____________ process.
Transmission. The monetary transmission process is the process of reactions in financial, product and labor markets to monetary policy actions.
In an open markets purchase, the monetary transmission process would eventually result in an ________ in aggregate demand.
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.
Operating targets include federal funds rate, ___________ reserve targets, borrowed reserve targets and effective targets under narrow constraints.
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.
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.
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).
The main domestic goals of monetary policy are to limit inflation, prevent sharp swings in ______ and minimize and stabilize unemployment.
Output. Sharp movements in output (or gross domestic product) will destabilize the economy and employment levels.
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.
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).
The real bills doctrine for monetary policy is not satisfactory because its impact is ___________.
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.
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.
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.
The loans given to __________ borrowers under the real bills theory were considered to be self-liquidating.
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.
Monetary policy in the US during the period 1940 to ____ was predominantly influenced by World War II.
- The FED’s policy was to keep interest rates low in order to support Treasury financing operations for the war effort.
In 1951, the FED was worried that pegging interest rates to finance the war operations would result in _________.
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.
