Week 4: The Federal Reserve and Monetary Policy Flashcards
What is monetary policy?
Changes in the money supply to contract or expand the economy.
What are the three kinds of money?
Commodity money (gold, silver,…); Bank money (checkbooks and bank drafts); Fiat or Paper money
What are the three functions of money?
A medium of exchange; A standard of volume; A store of value;
What is the price of money?
Amount of interest paid per unit of time expressed as a percentage of the amount borrowed.
Name three reasons why interests rates differ.
Term; Risk; Liquidity (the more liquid the loan, the lower the interest rates)
Name and describe the two sources of money demand.
- Transactions demand for money: Needed by consumers & businesses as a medium of exchange (basic determinant of the amount of money demanded for transactions is the level of nominal GDB)
- Asset demand for money (speculative motive): store of value (look out for inflation)
What three characteristics of the modern banking system were also characteristics of the early goldsmiths?
Fractional reserve (e.g. 10% of deposit).
Suppose the reserve requirement is 20%. What is the money multiplier?
MM = 1/RR (rr = reserve requirement).
so if you deposit 100$, there will be 500$ of new money in circulation. => the smaller reserve requirement, the bigger the money multiplier.
Why is the Federal Reserve considered the “lender of last resort?”
When banks fail, they go to the federal reserve to borrow money.
What are the three instruments of monetary policy? Which is the most important?
1) Setting the reserve requirement. The central bank can increase M by lowering RR. (rarely used)
2) The discount rate (the interest rate the central bank charges to banks when they borrow money). Lowering the discount rate makes it cheaper for banks to borrow money and increases M.
3) Open market operations (most important): Buying and selling of government securities to expand or extract M. The Central bank buys government bonds from banks to increase M.
Suppose the Federal Reserve sells bonds. Is this contractionary or expansionary monetary policy?
Contractionary, it takes money out of the banks.
Describe the monetary transmission mechanism.
eg to close an inflationary gap: RR down => M down => interest rates up => C, I, X down => AD down => real GDP and inflation go down.
Which is more precise: monetary policy or fiscal policy? Why?
Fiscal Policy. Because link between money supply and shifts in the AE curve is much more complex.
What is the Keynesian view of monetary policy?
They support an activist role for monetary policy. Keyn belive that monetary policy is a “fine-tuning” tool most effective when the economy is near full employement. Here investment and AE respond swiftly to changes in the interest rate caused by changes in the money supply. In a recession or depression, monetary policy is innefective, investment does not respond as forcefully to easier money and lower interest rates in a severe downturn. => here they believe expansionary fiscal policy is more appropriate.
What is the Monetarist view of monetary policy?
They do not believe in an active fiscal and monetarist role. The problems of inflation happen when the government prints too much money, recession when they print too little.
