Download CHAPTER 15

INSTRUCTOR’S MANUAL
46
CHAPTER 15
THE FEDERAL RESERVE AND MONETARY
POLICY
CHAPTER GOALS
This chapter deals with the Federal Reserve System and monetary policy. After reading this chapter,
students should be able to:
•
•
•
•
•
•
•
Describe the structure and operation of the Federal Reserve System.
Identify the services that the Federal Reserve System provides for the U.S. economy.
Explain the purpose and operation of monetary policy.
Describe the instruments that the Federal Reserve uses to control the money supply and interest rates.
Explain how monetary policy influences, and is influenced by, international developments.
Assess the advantages and disadvantages of monetary policy.
Evaluate whether Congress should reduce the independence of the Federal Reserve.
LECTURE HINTS AND IDEAS
The chapter details the structure and functions of the Federal Reserve System. Its major policy tools are
identified, followed by some insight into the importance of monetary policy. The chapter covers the
monetary policy process followed by the Fed, and relates it to international events. The strengths and
weaknesses of monetary policy are explained, and the issue of Fed independence is visited.
This is an exciting chapter in which students are invited to make up their own minds about whether
active monetary policy is desirable. The debate itself can be disconcerting to those students who are
looking for one correct answer. Encourage them first to master the facts and then to explore the
controversial aspects, with the understanding that their political preferences about government intervention
can influence their ultimate opinion.
BREAK-THE-ICE DISCUSSION STARTERS
1. “Do we still need 12 separate Federal Reserve Banks in this age of instant electronic communication?
Why not consolidate to just one?” Having many banks allows for regional feedback that may not be
considered if the Federal Reserve were located in, say, New York. However, some people do feel that
there is too much duplication and that the number of banks should be reduced. One could also argue
that the growth of electronic communication has reduced the need for the Fed to have 12 distinct
physical buildings.
INSTRUCTOR’S MANUAL
47
2. “What should the Fed do to interest rates if it wishes to slow down the economy’s inflation rate?”
This is a good question to introduce monetary policy. Raising rates will reduce demand for interestrate-sensitive goods, so will lower aggregate demand.
3. “Why do we need monetary policy? Isn’t discretionary fiscal policy enough?” Draw student’s
attention to the fact that monetary and fiscal policies are carried out by different groups and have
different lags, responses, and so on.
4. “Should Federal Reserve meetings be televised on C-Span so that the public can know what they’re
going to do to interest rates?” This question relates to the independence of the Fed and its
accountability to the public. But the issue of stability also arises here—if people hear that the Fed is
about to change interest rates, they may rush out to do all kinds of things such as refinance
mortgages, open or close savings accounts, withdraw or deposit money into the stock market, and the
like. Chaos could result.
5. “How do the actions of the Federal Reserve affect other countries?” Changes in interest rates affect
the attractiveness of U.S. investments to foreigners, and this can affect the value of the dollar relative
to foreign currencies. This, in turn, affects aggregate demand in foreign countries.
BRIEF ANSWERS TO STUDY QUESTIONS AND PROBLEMS
1. The chairperson of the Board of Governors of the Federal Reserve System exerts great influence on
the Fed’s monetary policy, which has widespread effects on the U.S. economy.
2. The main argument for Fed independence is that monetary policy is too important to be determined
by politicians. Because elections occur frequently, politicians may be mainly concerned with the
short-run benefits rather than the long-run costs of their economic policies. Supporters of the Fed’s
independence maintain that monetary policy would likely become too expansionary if left to policy
makers with short-run horizons, thus intensifying inflationary pressures.
3. When the Fed purchases government securities from banks, businesses, or individuals, bank reserves
increase. This enhances their ability to make loans, which results in an increase in the nation’s money
supply.
4. The discount rate is the interest rate that the Fed charges when it lends to commercial banks.
Increases (decreases) in the discount rate discourage (encourage) loans and thus decrease (increase)
the money supply.
5. A decrease in the required reserve ratio allows a bank to hold fewer required reserves, so it has more
excess reserves, which increases its ability to make loans and expand the money supply. For the
banking system as a whole, a decrease in the reserve requirement results in an increase in the money
multiplier.
6. Open market operations are the most frequently used instrument of monetary policy. A main
advantage of open market operations is flexibility: the Fed can purchase or sell government securities
in large or small amounts. Also, open market operations have a speedy effect on bank reserves.
7. To increase the value of the dollar in the foreign exchange market, the Fed would adopt a tight
monetary policy. Therefore, interest rates would increase, which provides more incentive for foreign
investors to purchase U.S. securities. To make such purchases, foreign investors must first go to the
foreign exchange market and buy dollars with their own currency. As foreigners demand more
INSTRUCTOR’S MANUAL
48
dollars, the price of the dollar increases in terms of foreign currencies. Conversely, the Fed would
adopt an expansionary monetary policy to decrease the foreign exchange value of the dollar.
8. To combat a recession, the Fed would adopt an expansionary monetary policy. By making more
reserves available to the banking system, the money supply would tend to increase. This would cause
interest rates to fall, investment spending to increase, aggregate demand to increase, and the level of
real output and employment to increase. To adopt an expansionary monetary policy, the Fed could
lower the discount rate, lower the reserve requirement, or buy securities on the open market.
9. A restrictive monetary policy results in a decrease in the money supply and an increase in interest
rates. In a closed economy, the increase in interest rates would cause a decrease in investment
spending and aggregate demand, which would reduce the rate of inflation. In an open economy, the
increase in interest rates would also cause foreign investors to purchase additional U.S. securities,
which would result in an increased demand for the dollar and an appreciation in the dollar’s exchange
value. As a result, net exports would decline, reducing aggregate demand and moderating inflation.
10. Critics maintain that active changes in the money supply by the Fed may destabilize the economy.
They note that the Fed does not have up-to-the-minute, reliable information about the state of the
economy and prices. Also, the Fed has a less-than-perfect understanding of the way the economy
works. Moreover, timing lags, which can’t be precisely predicted, limit the effectiveness of monetary
policy.
11. The Fed has certain checks and balances within it to limit the power any one group inside or outside
the Fed can wield. Each group inside the Fed has different authority to act. Only the Board of
Governors can change the reserve requirements. Subject to approval by the Board of Governors, the
12 regional Federal Reserve Banks have the authority to change the discount rate. Open market
operations are directed by the Federal Open Market Committee. To insulate the Fed from day-to-day
political pressures, Congress provided for 14-year terms for members of the Board of Governors,
made them ineligible for reappointment after they have served a full term, and staggered their terms
of office. Also the Fed finances its operations from internally-generated income, rather than from
taxpayer dollars.
12. Critics maintain that the policies of the Fed aggravate the income gap between the rich and the poor.
For example, during an economic expansion, the Fed is under pressure to boost interest rates to cool
off an overheating economy. Such a policy, however, contributes to economic slowdown and could
result in relatively higher unemployment for low-income workers.
13. The banking system could expand the money supply by (6.67)($10 million) = $66.7 million.
14. The bank’s total reserves and excess reserves each decline by $1.5 million.
15. a.
b.
Required reserves = $360 billion, excess reserves = $90 billion, money multiplier = 10,
maximum increase in the money supply = $900 billion
Excess reserves = $270 billion, money multiplier = 20, maximum increase in the money supply
= $5,400 billion
INSTRUCTOR’S MANUAL
16.
a.
b.
c.
Required reserves = $12 million, excess reserves = $78 million, maximum increase in the
money supply created by this bank = $78 million
Required reserves = $12 million, excess reserves = $68 million, maximum increase in the
money supply created by this bank = $68 million. The ability of the bank to increase the
money supply thus declines by $10 million.
The ability of this bank to increase the money supply rises by $10 million.
49