Week 19 - Money and Prices Pt2 Flashcards
What is the Federal Reserve System (the Fed)?
The Fed is the central bank of the U.S., responsible for monetary policy and regulation of financial markets.
What is monetary policy?
Monetary policy involves managing the money supply and interest rates to influence the economy.
Does the Fed directly control the money supply?
No, the Fed controls the money supply indirectly through monetary policy tools like open-market operations.
What happens when the Fed buys government bonds from the public (open-market purchase)?
Increases bank reserves
Increases the money supply
Encourages lending and investment
What happens when the Fed sells government bonds to the public (open-market sale)?
Decreases bank reserves
Reduces the money supply
Slows down lending and economic activity
Why does the Fed buy and sell government bonds?
To influence the money supply and control inflation, employment, and economic growth.
What are open-market operations (OMOs)?
Open-market operations are the buying and selling of government bonds by the Federal Reserve to influence the money supply.
What happens when the Fed purchases bonds from the public?
The Fed pays bondholders with new money.
The new money enters the economy.
The bond (which was not money) leaves the economy.
Deposits increase, leading to a multiple expansion of the money supply.
What happens when the Fed sells bonds to the public?
The bondholder pays with checking funds (which are money).
These checking funds leave the economy.
The bond (which is not money) enters the economy.
Bank reserves decrease, leading to a multiple contraction of the money supply.
How do open-market purchases and sales affect the economy?
Purchases: Increase money supply, boost lending, and stimulate economic activity.
Sales: Decrease money supply, reduce lending, and slow down the economy.
Why does an open-market purchase lead to a multiple expansion of the money supply?
New money increases bank reserves.
Banks use these reserves to make loans.
Loans get redeposited, leading to further money creation through the money multiplier effect.
How is the total money supply calculated?
Money supply = Currency held by public + Bank reserves/Reserve-Deposit ratio
Given 1,000 shekels in currency and 200 shekels in bank reserves, with a reserve-deposit ratio of 0.2, what is the initial money supply?
Money supply = 1,000 + 200/0.2
= 1,000 + 1,000
= 2,000 shekels
What happens when the central bank buys a bond for 100 shekels from the public?
The central bank injects 100 shekels into the economy.
If all 100 shekels are deposited into banks, reserves increase to 300 shekels.
The new money supply is:
Money supply = 1,000 + 300/0.2
= 1,000 +1,500
= 2,500 shekels
A 100-shekel increase in reserves leads to a 500-shekel increase in the money supply due to the money multiplier effect.
Why does a 100-shekel increase in reserves lead to a 500-shekel increase in the money supply?
The money multiplier is determined by the reserve-deposit ratio:
Money multiplier = 1/ Reserve-Deposit ratio
= 1/0.2 = 5
Every shekel added to reserves can create 5 shekels in total money supply.
100 × 5 = 500 shekels increase in money supply.
How does an open-market purchase by the central bank affect the money supply?
Buys bonds → Injects reserves → Expands money supply.
The effect is multiplied by the money multiplier, depending on the reserve-deposit ratio.
What does the money supply curve represent?
The money supply curve shows the total amount of money available in the economy, which is set by the central bank.
How does the central bank control the money supply?
The central bank sets the money supply at MS1 through tools like open-market operations (buying or selling government bonds).
What happens to the money supply curve when the central bank purchases government bonds?
An open-market purchase increases the money supply.
This shifts the money supply curve right from MS1 to MS2, reflecting the increase in the amount of money in circulation.
What happens to the money supply curve when the central bank sells government bonds?
An open-market sale decreases the money supply.
This shifts the money supply curve to the left as the amount of money in circulation decreases.
How do open-market operations affect the money supply curve?
Open-market purchases shift the money supply curve right (increase money supply).
Open-market sales shift the money supply curve left (decrease money supply).
What does equilibrium in the market for money mean?
Equilibrium occurs when the quantity of money the public wants to hold is equal to the money supply set by the central bank.
How does the interest rate affect the amount of money people want to hold?
As the interest rate rises, the opportunity cost of holding money increases, so people demand less money (they prefer to hold interest-bearing assets).
As the interest rate falls, people demand more money because the opportunity cost of holding money is lower.
How is the equilibrium interest rate determined?
The equilibrium interest rate is the rate at which the quantity of money the public wants to hold is equal to the money supply. At this rate, there is neither an excess nor a shortage of money in the economy.
What happens if the money supply is greater than the equilibrium demand for money?
There will be excess supply of money.
People will increase their spending or invest the excess money, causing the interest rate to fall until equilibrium is restored.
What happens if the money supply is less than the equilibrium demand for money?
There will be excess demand for money.
People will reduce spending or sell assets to increase their money holdings, causing the interest rate to rise until equilibrium is restored.