Download Chapter 28: Monetary Policy and the Debate about Macro Policy

Chapter 28: Monetary Policy
Chapter 28: Monetary Policy
Questions for Thought and Review
2.
Contractionary monetary policy shifts the aggregate demand curve to the left. In the short
run, this will reduce output and reduce the price level. The long-run effect depends on
where the economy is relative to potential output. In the graph on the right, the
contractionary monetary policy brings the economy back to its potential.
4.
It is neither completely private nor completely public. The Fed is a semi-autonomous
agency of the federal government. Although it is owned by member banks, its officials
are appointed by government. It is a creation of Congress, but has much more
independence than do most public agencies.
6.
Six explicit functions of the Fed are: 1) conducting monetary policy; 2) supervising
financial institutions; 3) serving as a lender of last resort; 4) providing banking services to
the U.S. government; 5) issuing coin and currency; and 6) providing financial services to
commercial banks.
8.
The money multiplier is (1+c)/(r+c). If the Fed eliminated the reserve requirement, the
money multiplier would increase and, without other Fed action, the supply of money
would also increase.
10.
When the Fed buys bonds the price of bonds rises and the interest rate falls.
12.
If we consider the example of an open market sale by the Fed, the initial transaction or
"splash" would be the Fed sells a bond, and in exchange a person writes a check to the
Fed which the Fed presents to the person's bank for payment. The bank now must adjust
to this change, and the "ripples" will show up on its balance sheet. Paying cash to the Fed
means that the bank's reserves are too low, and the bank must figure out a way to meet its
reserve requirement. It may call in loans to do so, but that in turn could mean that
someone paid the loan from a checking account, which has further balance sheet
implications. Now that the bank wants to make fewer loans, it will increase its interest
rates, which will discourage investment and have further ripple effects on the economy.
14.
The Federal funds rate is the interest rate that banks charge one another for Fed funds or
reserves. As the Fed buys and sells bonds, it changes reserves, thereby changing the price
(interest rate) banks charge for loaning reserves overnight—the Federal funds rate. Other,
longer-term interest rates, such as the Treasury bill rate, are only indirectly affected.
16.
Throughout this period, the Fed engaged in contractionary monetary policy by raising the
Fed Funds Target Rate.
18.
The effective yield curve is horizontal because the Fed adjusts the money supply to
changes in the demand for money to target a specific interest rate.
20.
The nominal interest rate is equal to the real interest rate plus the expected inflation rate.
If the nominal interest rate is 6 percent and the expected inflation rate is 5 percent, the
real interest rate is 1 percent.
22.
Policy makers pay attention to the shape of the yield curve because it will tell them
whether their policies are likely to be effective.
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Chapter 28: Monetary Policy
24.
A policy regime is a predetermined statement about what policies will be followed in
various situations. It ties the hands of policy makers. A policy is a one-time action that
does not imply the course of future actions.
26.
By telling people what the Fed is doing, transparency enhances the credibility of the Fed.
With transparency, the Fed tells the people what it is doing and then the people see that in
fact, the Fed does what it says it will. This adds credibility to Fed policy.
Chapter 28: Problems and Exercises
28. a. If people hold no cash, the money multiplier is 1/r. If this is equal to 3, then the current
reserve requirement is 33 percent. To increase the money supply by 200, the Fed should
lower the reserve requirement to 32 percent.
b. Lowering the discount rate will encourage banks to borrow. This will increase the amount
of reserves in the system so that the money supply increases. If the Fed wishes to increase
the money supply by $200, and the multiplier is 3, reserves must be increased by $66.67.
If banks will borrow an additional $20 for every point the discount rate is lowered, the
Fed should lower the rate by 3.33 percentage points.
c. To increase the money supply by using open market operations, the Fed should buy
bonds, thus increasing the level of reserves in the banking system. To achieve an increase
of $200 (if the multiplier is 3) the Fed should buy $66.67 worth of bonds.
30. a. Increasing the reserve requirement would lower the multiplier, calculated as [l/(r + c)].
To calculate exactly how much, we would need to know the current money supply.
b. The money multiplier is [l/(r + c)] = 2.5. If the Fed sold $800,000 worth of bonds it
would decrease reserves by $800,000 and so decrease the money supply by $2 million.
c. This part of the question requires information from a local bank. Reevaluate a and b in
view of this information.
32. a. This would increase excess reserves enormously.
b. Banks would most likely favor this proposal because they would now earn interest on
their assets held at the Fed.
c. Central banks would likely oppose this because it would reduce their superiority to other
political institutions and may require that they ask Congress for appropriation to pay the interest, reducing their political independence.
d. This would increase the interest rate paid by banks because the additional interest would
increase their profit margin. The initial increased profit margin would shift the demand
for depositors out as new banks entered the market and as existing banks competed for
more deposits. This would increase the interest paid to depositors until the normal profits
are once again earned.
34. a. This Act will reduce float because money will be transferred almost immediately from
bank to bank.
b. Because checks will be less likely to be transferred by truck or air, weather will be less
likely to affect the level of float, so its variability will decline, unless computer glitches
arise.
c. If the variability of float declines so will the level of defensive Fed actions designed to
offset this variability.
36. a. The demand for money would decline. The Fed would have to reduce the supply of
money as shown in the graph below on the left.
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Chapter 28: Monetary Policy
b. The demand for money would rise. The Fed would have to increase the supply of money
as shown in the graph below on the right.
S0
S0
i0
Interest rate
Interest rate
S1
Q0
i0
D0
D1
Q1
S1
Quantity
D0
Q1
Q0
D1
Quantity
Chapter 28: Web Questions
2. a.
The steepness of the yield curve is a good predictor of recession because high short-term
interest rates tend to slow the economy. Also, low long-term interest rates caused by a
decline in the expectations of inflation are an indication that people expect the economy
to slow.
b. The economy is more likely to be headed toward a recession if the yield curve is flat or
inverted because higher short-term interest rates tend to reduce investment expenditures
and slow an economy. Also lower long-term interest rates might indicate that people
expect inflation to fall because they expect the economy to slow. Such expectations may
be self-fulfilling.
c. The current yield curve is inverted. That is, the interest rate on the 3-month bill is higher
than the interest rate on the 30-year bond. This suggests that people expect the economy
to slow or go into recession.
Chapter 28: Appendix A
2.
Let’s assume the following initial bank balance sheet:
Initial Bank Balance Sheet
Assets
Liabilities
Reserves
$100,000,000
Demand deposits
T-bill holdings
0
Net worth
Loans
905,000,000
Total assets
$1,005,000,000
Total liabilities
$1,000,000,000
5,000,000
$1,005,000,000
First, individuals sell $2 million in T-bills to the Fed, and deposit the $2 million in the
bank. The bank now has more reserves than is required:
Assets
Liabilities
Reserves
$102,000,000
Demand deposits
$1,002,000,000
T-bill holdings
0
Loans
905,000,000
Net worth
5,000,000
Total liabilities
$1,007,000,000
Total assets
$1,007,000,000
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Chapter 28: Monetary Policy
It has excess reserves of $1.8 million, which it lends out. These loans are redeposited at
the bank as demand deposits:
Assets
Liabilities
Reserves
$102,000,000
Demand deposits
$1,002,000,000
Loans given
-1,800,000
New deposits
+1,800,000
New deposits
+1,800,000
T-bill holdings
0
Net worth
5,000,000
Loans
906,800,000
Total assets
$1,008,800,000
Total liabilities
$1,008,800,000
It still has excess reserves of 1.62 million, which it lends out. Each round, the amount
called in gets smaller and smaller until the bank arrives at its final position with money
supply having risen by $20 million.
Assets
Liabilities
Reserves
$102,000,000
Demand deposits
$1,020,000,000
T-bill holdings
0
Net worth
5,000,000
Loans
923,000,000
Total assets
$1,025,000,000
Total liabilities
$1,025,000,000
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