Download Econ 130

Econ 130: Money and Banking
Final Exam Review
March. 11, 2009
Mahir Binici
Part A: Chapter Review ( Please go through each chapters for details. The following material
is mainly an outline of each chapter)
Chapter 12: Structure of Central Banks and the Federal Reserve System
Structure of the Federal Reserve System
1) Federal Reserve Banks
– Quasi-public institution owned by private commercial banks in the district that are
members of the Fed system
Functions of the Federal Reserve Banks
– Clear checks
– Issue new currency
– Withdraw damaged currency from circulation
– Administer and make discount loans to banks in their districts
– Evaluate proposed mergers and applications for banks to expand their activities
– Act as liaisons between the business community and the Federal Reserve System
– Examine bank holding companies and state-chartered member banks
– Collect data on local business conditions
– Use sta¤s of professional economists to research topics related to the conduct of monetary
policy
Federal Reserve Banks’Role in Monetary Policy
– Directors “establish” the discount rate
– Decide which banks can obtain discount loans
– Directors select one commercial banker from each district to serve on the Federal Advisory Council which consults with the Board of Governors and provides information to
help conduct monetary policy
– Five of the 12 bank presidents have a vote in the Federal Open Market Committee
(FOMC)
2-Board of Governors of the Federal Reserve System
– Seven members headquartered in Washington, D.C.
– Appointed by the president and con…rmed by the Senate
– 14-year non-renewable term
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– Required to come from di¤erent districts
– Chairman is chosen from the governors and serves four-year term
Duties of the Board of Governors
– Votes on conduct of open market operations
– Sets reserve requirements
– Controls the discount rate through “review and determination” process
– Sets margin requirements
– Sets salaries of president and o¢ cers of each Federal Reserve Bank and reviews each
bank’s budget
– Approves bank mergers and applications for new activities
– Speci…es the permissible activities of bank holding companies
– Supervises the activities of foreign banks operating in the U.S.
3-Federal Open Market Committee (FOMC)
– Meets eight times a year
– Consists of seven members of the Board of Governors, the president of the Federal
Reserve Bank of New York and the presidents of four other Federal Reserve banks
– Chairman of the Board of Governors is also chair of FOMC
– Issues directives to the trading desk at the Federal Reserve Bank of New York
Functions of FOMC
– Directs OMO
– Give advice on setting reserve requirements and discount rate.
Central Bank Independence
Instrument Independence: the ability of central banks to set monetary policy tools such as
setting short term interest rates.
Goal Independence: the ability of central bank to set the goals of monetary policy such is
in‡ation target or output growth rate.
Chapter 13: Multiple Deposit Creation and the Money Supply Process
Four Players in the Money Supply Process
– Central bank (Federal Reserve System)
– Banks (depository institutions; …nancial intermediaries)
– Depositors (individuals and institutions)
– Borrowers (individuals and institutions): Central banks; banks; depositors; borrowers.
The Fed’s Balance Sheet
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Assets
Government Securities
Discount Loans
Liabilities
Currency in Circulation
Reserves
– Monetary Liabilities:
Currency in circulation— in the hands of the public
Reserves— bank deposits at the Fed and vault cash [RR+ER]
– Assets:
Government securities— holdings by the Fed that a¤ect money supply and earn
interest
Discount loans— provide reserves to banks and earn the discount rate
Control of the Monetary Base [High Powered Money]
Monetary Base =CC+R
– Federal Reserve exercise control over monetary base through;
1. (a) Open market operations: purchase or sale of government securities,
(b) Making a Discount Loan to a Bank
Open market purchase increases the monetary base by the amount of the purchase
Open market sale reduces the monetary base by the amount of the sale,
Monetary base increases by the amount of loan extended.
Multiple Deposit Creation: A Simple Model
– When Fed supplies the banking system with $1 of additional reserves, deposit increase
by a multiple of this amount-a process called multiple deposit creation.
– In a simple model, we can see how changes in the monetary base a¤ect the total money
supply process
– Two simlifying assumptions
Required reserves (RR) = Total reserves (R) [ this implies no excess reserve holding,
remember R = ER+RR, therefore ER= 0]
No currency holding by depositors.
– Consider the following identity:
D = 1r R where R is total reserves, r is required reserve ratio, and D is total checkable
deposit. Taking the change of both sides yields;
D = 1r R; where 1=r is the deposit (money) multiplier. Therefore, additional $1 of
reserves increase total amount of deposit by 1r $1.
– Higher required reserve ratio means lower deposit creation ( lower the money supply):
@D
@r < 0:
Chapter 14: Determinants of the Money Supply
The Money Supply Model
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– De…ne money as currency plus checkable deposits: M 1 = C + D
– The Fed can control the monetary base better than it can control reserves
– Link the money supply (M ) to the monetary base (M B) and let m be the money
multiplier;
M = m MB
– Some Identities:
c = C=D ) Currency ratio
e = ER=D ) Excess Reserve ratio
r = RR=D ) Required Reserve ratio
R = ER + RR
Linkage between deposit and monetary base:
D=
1
r+e+c
MB
1
Deposit Multiplier = r+e+c
Linkage between money supply and monetary base:
M=
1+c
r+e+c
MB
Money Multiplier: m =
1+c
r+e+c
Factors that Determine the Money Multiplier:
– Changes in the required reserve ratio r.
(1+c)
@m
@r = (r+e+c)2 < 0
The money multiplier and the money supply are negatively related to r
– Changes in the currency ratio c
r+c 1
@m
@c = (r+e+c)2 < 0 [notice that r + c < 1]
The money multiplier and the money supply are negatively related to c.
– Changes in the excess reserves ratio e
(1+c)
@m
@e = (r+e+c)2 < 0
The money multiplier and the money supply are negatively related to the excess
reserves ratio e.
Additionally, the excess reserves ratio e is ;
negatively related to the market interest rate,
positively related to expected deposit out‡ow.
Additional Factors that Determine the Money Supply
– Open market operations are controlled by the Fed
– The Fed cannot determine the amount of borrowing by banks from the Fed
– Split the monetary base into two components: Non-borrowed M B and borrowed reserves
from Fed;
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M Bn = M B BR
M = m(M Bn + BR)
– The money supply is positively related to both the non-borrowed monetary base M Bn
and to the level of borrowed reserves, BR, from the Fed.
– Over long periods, the primary determinant of movements in the money supply is the
nonborrowed monetary base, which is controlled by the Fed’s open market operations.
Chapter 15: Tools of Monetary Policy
– Open market operations
A¤ect the quantity of reserves and the monetary base
– Changes in borrowed reserves
A¤ect the monetary base
– Changes in reserve requirements
A¤ect the money multiplier
– Federal funds rate— the interest rate on overnight loans of reserves from one bank to
another
Primary indicator of the stance of monetary policy
Demand in the Market for Reserves
– What happens to the quantity of reserves demanded, holding everything else constant,
as the federal funds rate changes?
– Two components: required reserves and excess reserves
Excess reserves are insurance against deposit out‡ows
The cost of holding these is the interest rate that could have been earned
– As the federal funds rate decreases, the opportunity cost of holding excess reserves falls
and the quantity of reserves demanded rises
– Downward sloping demand curve
Supply in the Market for Reserves
– Two components: non-borrowed and borrowed reserves
– Cost of borrowing from the Fed is the discount rate
– Borrowing from the Fed is a substitute for borrowing from other banks
– If if f < id , then banks will not borrow from the Fed and borrowed reserves are zero
– The supply curve will be vertical
– As if f rises above id , banks will borrow more and more at id , and re-lend at if f
– The supply curve is horizontal (perfectly elastic) at id
Insert Graph Here
A¤ecting the Federal Funds Rate
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– An open market purchase causes the federal funds rate to fall; an open market sale
causes the federal funds rate to rise ! shifting the supply curve
– If the intersection of supply and demand occurs on the vertical section of the supply
curve, a change in the discount rate will have no e¤ect on the federal funds rate
– If the intersection of supply and demand occurs on the horizontal section of the supply
curve, a change in the discount rate shifts that portion of the supply curve and the
federal funds rate may either rise or fall depending on the change in the discount rate
– When the Fed raises reserve requirement, the federal funds rate rises and when the Fed
decreases reserve requirement, the federal funds rate falls ! shifting the demand curve
Chapter 16: What Should Central Banks Do? Monetary Policy Goals, Strategy,
and Tactics
The Price Stability Goal
– Low and stable in‡ation
– In‡ation
Creates uncertainty and di¢ culty in planning for future
Lowers economic growth
Strains social fabric: Con‡ict might result, because each group in the society may
compete with other groups to make sure that its income keeps up with the rising
level of prices.
Other Goals of Monetary Policy
– High employment
– Economic growth
– Stability of …nancial markets
– Interest-rate stability
– Foreign exchange market stability
Should Price Stability be the Primary Goal?
– In the long run there is no con‡ict between the goals
– In the short run it can con‡ict with the goals of high employment and interest-rate
stability
– Hierarchical mandate: put the goal of price stability …rst, and say that as long as its
achieved other goals can be pursued.
– Dual mandate: to achieve two co-equal objectives: for instance price stability and maximum employment.
Monetary Targeting
– Central bank announces that it will achieve a certain value (the target) of the annual
growth rate of monetary aggregate, such as 3% growth rate of M1.
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– The central bank is accountable for hitting the target.
– Advantages
Almost immediate signals help …x in‡ation expectations and produce less in‡ation
Almost immediate accountability
– Disadvantages
Must be a strong and reliable relationship between the goal variable and the targeted
monetary aggregate
In‡ation Targeting
– Public announcement of medium-term numerical target for in‡ation
– Institutional commitment to price stability as the primary, long-run goal of monetary
policy and a commitment to achieve the in‡ation goal
– Information-inclusive approach in which many variables are used in making decisions
– Increased transparency of the strategy
– Increased accountability of the central bank
– Advantages
Does not rely on one variable to achieve target
Easily understood
Reduces potential of falling in time-inconsistency trap
Stresses transparency and accountability
– Disadvantages
Delayed signaling
Too much rigidity
Potential for increased output ‡uctuations
Low economic growth during disin‡ation
Monetary Policy with an Implicit Nominal Anchor
– Forward looking and preemptive
– Advantages
Uses many sources of information
Avoids time-inconsistency problem
Demonstrated success
– Disadvantages
Lack of transparency and accountability
Strong dependence on the preferences, skills, and trustworthiness of individuals in
charge
Tactics: Choosing the Policy Instrument
– Tools
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Open market operation
Reserve requirements
Discount rate
– Policy instrument (operating instrument)
Reserve aggregates
Interest rates
May be linked to an intermediate target
Criteria for Choosing the Policy Instrument
Observability and Measurability
Controllability
Predictable e¤ect on Goals
– Interest-rate and aggregate targets are incompatible
The Taylor Rule, NAIRU, and the Phillips Curve
– The Fed and other major central banks currently conduct monetary policy by setting a
target for short-term interest rates like the federal funds rate.
– How the target should be chosen? Answer: Taylor rule
i = t + i + 0:5( t
) + 0:5(y y )
where i is Fed fund rate target, t is in‡ation rate, i is the equilibrium real fed funds
rate, yt is actual level of output, t
is in‡ation gap ( is in‡ation target), yt y
is output gap (y is the potential level of output)
– An in‡ation gap and an output gap
Stabilizing real output is an important concern
Output gap is an indicator of future in‡ation as shown by Phillips curve
– NAIRU
Rate of unemployment at which there is no tendency for in‡ation to change
Chapter 19: The Demand for Money
Velocity of Money and Equation of Exchange
– The concept that provides the link between the money supply [M ] and total spending
[P Y ] is called the velocity of money, which is the average number of times per year
that a dollar is spent in buying the total amount of goods and services produced in the
economy.
– Velocity V is de…ned as;
V =
P Y
M
– Accordingly, the equation of exchange, the relationship between nominal income and the
quantity of money and velocity, is de…ned as
M
V =P
Y
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Quantity Theory
– Velocity fairly constant in short run
– Aggregate output at full-employment level
– Changes in money supply a¤ect only the price level
– Movement in the price level results solely from change in the quantity of money
Quantity Theory of Money Demand
– The quantity theory of money tells us how much money is held for a given amount of
aggregate income, therefore, it can be considered as a theory of the demand for money,
too.
– Using the equation of exchange and the equilibrium condition in the market for money
[M d = M s ];
M=
1
V
PY ) Md = k
P Y , where k =
1
V
– Here, k is constant, then the level of transaction generated by a …xed level of nominal
income [P Y ] determines the quantity of money demanded.
Keynes’s Liquidity Preference Theory
– The classical view that velocity is constant is abandoned,
– Interest rates are introduced in the theory of money demand
– Why do individuals hold money? For three motives behind the demand for money:
1. (a) Transactions Motive [this component of money demand is proportional to income]
(b) Precautionary Motive [this component of money demand is proportional to income]
(c) Speculative Motive [through this motive the role of interest rates is introduced,
accordingly money demand is negatively related to the level of interest rates]
– Putting three motives together gives us the demand for money equation, known as the
liquidity preference function;
Md
P
= f(i; Y )
+
This function implies that the demand for real money balances is negatively
related to the interest rate i; and positively related to the real income.
– What is the implication of the liquidity preference theory for the velocity?
Md
P
= f (i; Y ) )
P
Md
=
1
f (i;Y )
)
PY
Md
=
Y
f (i;Y )
Equilibrium condition in money market dictates M d = M; accordingly,
V =
PY
M
=
Y
f (i;Y )
Since the demand for money is negatively related to interest rates, when interest
rates go up, f(i,Y) does down, and therefore the velocity rises,
Velocity has substantial ‡uctuations due to substantial ‡uctuations in the interest rates.
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Friedman’s Modern Quantity Theory of Money
– The demand for money is de…ned as a function the individuals wealth and the expected
return on other assets relative to the expected return on money.
– The demand for money [real balances] is formulated as follows:
Md
P
= f (Yp ; rb
rm ; r e
rm ;
e
rm )
+
Yp is permanent income [wealth]
rb is expected return on bonds, re expected return on equity,
rate, rm expected return on money,
e
expected in‡ation
– Variables in the Money Demand Function:
Permanent income (average long-run income) is stable, the demand for money will
not ‡uctuate much with business cycle movements
Wealth can be held in bonds, equity and goods; incentives for holding these are
represented by the expected return on each of these assets relative to the expected
return on money
The expected return on money is in‡uenced by:
The services proved by banks on deposits
The interest payment on money balances
Di¤erences between Keynes’s and Friedman’s Model
– Friedman
Includes alternative assets to money
Viewed money and goods as substitutes
The expected return on money is not constant; however, rb
as interest rates rise
Interest rates have little e¤ect on the demand for money
The demand for money is stable ) velocity is predictable
Money is the primary determinant of aggregate spending
rm does stay constant
Chapter 22: Aggregate Demand and Supply Analysis
Aggregate Demand
– The relationship between the quantity of aggregate output demanded and the price level
when all other variables are held constant
– Based on the quantity theory of money
Determined solely by the quantity of money
– Based on the components parts
Consumption, investment, government spending and net exports
– Behavior of Aggregate Demand’s Component Parts
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Y ad = C + I + G + N X
Aggregate demand curve is downward sloping because [remember IS-LM analysis]
P #) M=P ") i #) I ") Y ad "
Factors that Shift Aggregate Demand
–
An increase in the money supply shifts AD to the right because it lowers interest
rates and stimulates investment spending
An increase in spending from any of the components C, I, G, NX, will also shift AD
to the right
Aggregate Supply
– Long-run aggregate supply curve
Determined by amount of capital and labor and the available technology
Vertical at the natural rate of output generated by the natural rate of unemployment
– Short-run aggregate supply curve
Wages and prices are sticky
Generates an upward sloping SRAS as …rms attempt to take advantage of short-run
pro…tability when price level rises
– Factors that Shift SRAS
Costs of production
Tightness of the labor market
Expected price level
Wage push
Change in production costs unrelated to wages (supply shocks)
– Self-Correcting Mechanism
Regardless of where output is initially, it returns eventually to the natural rate
Slow
Wages are in‡exible, particularly downward
Need for active government policy
Rapid
Wages and prices are ‡exible
Less need for government intervention
– Shifts in Long-Run Aggregate Supply
Economic growth
Real business cycle theory
Real supply shocks drive short-run ‡uctuations in the natural rate of output
(shifts of LRAS)
No need for government intervention
Hysteresis
Departure from full employment levels as a result of past high unemployment
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Natural rate of unemployment shifts upward and natural rate of output falls
below full employment
Expansionary policy needed to shift aggregate demand
– Summary
Shift in aggregate demand a¤ects output only in the short run and has no e¤ect in
the long run
Shifts in aggregate demand a¤ects only price level in the long run
Shift in short run aggregate supply a¤ects output and price only in the short run
and has no e¤ect in the long run
The economy has a self-correcting mechanism
Chapter 23: Transmission Mechanisms of Monetary Policy: The Evidence
Structural Model
– Examines whether one variable a¤ects another by using data to build a model that
explains the channels through which the variable a¤ects the other
– Transmission mechanism
The change in the money supply a¤ects interest rates
Interest rates a¤ect investment spending
Investment spending is a component of aggregate spending (output)
Reduced-Form
– Examines whether one variable has an e¤ect on another by looking directly at the relationship between the two
– Analyzes the e¤ect of changes in money supply on aggregate output (spending) to see if
there is a high correlation
– Does not describe the speci…c path
Structural Model: Advantages and Disadvantages
– Possible to gather more evidence) more con…dence on the direction of causation
– More accurate predictions
– Understand how institutional changes a¤ect the links
– Only as good as the model it is based on
Reduced-Form: Advantages and Disadvantages
– No restrictions imposed on the way monetary policy a¤ects the economy
– Correlation does not necessarily imply causation
Reverse causation
Outside driving factor
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Early Keynesian Evidence
– Monetary policy does not matter at all
– Three pieces of structural model evidence
Low interest rates during the Great Depression indicated expansionary monetary
policy but had no e¤ect on the economy
Empirical studies found no linkage between movement in nominal interest rates and
investment spending
Surveys of business people con…rmed that investment in physical capital was not
based on market interest rates
Objections to Early Keynesian Evidence
– Friedman and Schwartz publish a monetary history of the U.S. showing that monetary
policy was actually contractionary during the Great Depression
– Many di¤erent interest rates
– During de‡ation, low nominal interest rates do not necessarily indicate expansionary
policy
– Weak link between nominal interest rates and investment spending does not rule out a
strong link between real interest rates and investment spending
– Interest-rate e¤ects are only one of many channels
Timing Evidence of Early Monetarists
– Money growth causes business cycle ‡uctuations but its e¤ect on the business cycle
operates with “long and variable lags”
Transmission Mechanisms of Monetary Policy
– Traditional Interest Rate Channel
Expansionary Monetary policy ) i #) I ") Y "
– Other Asset Price Channels [such as exchange rate, and wealth e¤ects]
– Credit View [Bank lending channel, balance sheet channel, and others]
The basic idea in Monetary Transmission Mechanism can be formulated as;
M onetary P olicy )
in ,
ir ; Ps ; P e )
C,
I;
NX )
GDP
Lessons for Monetary Policy
1. (a)
i. It is dangerous always to associate the easing or the tightening of monetary policy
with a fall or a rise in short-term nominal interest rates
ii. Other asset prices besides those on short-term debt instruments contain important
information about the stance of monetary policy because they are important elements in various monetary policy transmission mechanisms
iii. Monetary policy can be highly e¤ective in reviving a weak economy even if shortterm interest rates are already near zero
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iv. Avoiding unanticipated ‡uctuations in the price level is an important objective of
monetary policy, thus providing a rationale for price stability as the primary longrun goal for monetary policy
Chapter 24: Money and In‡ation [in brief ]
Money and In‡ation: Evidence
– In‡ation is always and everywhere a monetary phenomenon
– Whenever a country’s in‡ation rate is extremely high for a sustained period of time, its
rate of money supply growth is also extremely high
– Reduced-form evidence
Views of In‡ation
– Money Growth : High money growth produces high in‡ation.
– Fiscal Policy : High in‡ation can not be driven by …scal policy alone
– Supply Shocks : Supply side phenomena can not be the source of high in‡ation
– Always a monetary phenomenon
Origins of In‡ationary Monetary Policy
– Cost-push in‡ation: Cannot occur without monetary authorities pursuing an accommodating policy
– Demand-pull in‡ation
– Budget de…cits: Can be the source only if the de…cit is persistent and is …nanced by
creating money rather than by issuing bonds
– Two underlying reasons
Adherence of policymakers to a high employment target
Presence of persistent government budget de…cits
Part B: Review Questions [from chapters covered after midterm]
1. In what ways can the regional FED banks in‡uence the conduct of monetary policy?
2. Which entities of the FED system control the discount rate? Reserve req.? OMO?
3. What is the primary tool that the Congress uses to exercise some control over the FED?
4. If the Fed sells $2 million of bonds to the 1st National Bank, what happens to the reserve
and money base?
5. Using T-accounts, show what happens to Checkable Deposits in the banking system when
the Fed sells $2 million of bonds to the 1st National Bank. Assume required reserve ratio of
10%, and no ER.
6. If the required reserve ratio is increased to %20 percent from 10%, how much multiple deposit
creation will take place when reserves are increased by $100.
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7. “If reserve requirements on the checkable deposits were set to zero, the amount of multiple
deposit expansion would go on inde…nitely.” T/F ?- Explain
8. Why might the pro-cyclical behavior of interest rates (rise during business cycle expansion,
and fall during recession) lead to pro-cyclical movement in the money supply?
9. FED buys $100 million of bonds from the public and also lowers reserve requirement ratio
(r), What will happens to the money supply?
10. “The only way that the Fed can a¤ect the level of borrowed reserves is by adjusting the
discount rate.” True/False, uncertain? Explain.
11. Using the demand and supply analysis of the market for reserves, show what happens to the
Fed fund rate, all else constant, if the economy is surprisingly strong, leading to an increase
in the amount of checkable deposits.
12. If there is a switch from deposit into currency, what happens to the Fed fund rate? Use the
demand and supply analysis of the market for reserves.
13. If the Fed has an interest rate target, why will an increase in the demand for reserves lead to
a rise in the money supply?
14. What procedures can the Fed use to control the Fed fund rate? Why does control of this
interest rate imply that the Fed will lose the control of non borrowed reserves?
15. “Because in‡ation targeting focuses on achieving the in‡ation target, it will lead to excessive
output ‡uctuations.” True/False? Explain
16. Calculate what happens to nominal GDP if velocity remains at 5 and the money supply
increases from $200 billion to $300 billion.
17. Why is Keynes’s analysis of the speculative demand for money important to his view that
velocity will undergo substantial ‡uctuations and thus can not be treated as constant?
18. Why does Friedman’s view of the demand for money suggest that velocity is predictable,
whereas Keynes’s view suggest the opposite?
19. Suppose that government spending is raised and at the same time that money supply is
lowered. What will happen to the position of the aggregate demand curve?
20. Predict what will happen to aggregate output and the price level if the Fed increases the
money supply at the same time that Congress implements an income tax cut.
21. Suppose that the public believes that a newly announced anti-in‡ation program will work
and so lowers its expectations of future in‡ation. What will happen to the aggregate output
and the price level in the short run?
22. Discuss three channels by which monetary policy a¤ects stock prices and aggregate spending.
23. “The cost of …nancing investment is related only to interest rates; therefore, the only way
that monetary policy can a¤ect investment spending is through its e¤ect on interest rates.”
True/False? Explain
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24. “The monetarists have demonstrated that the early Keynesian were wrong in saying that
money does not matter at all to economic activity. Therefore, we should accept the monetarist
position that money is all that matter.” Agree/Disagree? Why?
25. “Because increase in government spending raise the aggregate demand curve, …scal policy by
itself can be the source of in‡ation.” True/False? Explain
26. How can the Fed’s desire to prevent high interest rates lead to in‡ation?
27. Explain and show graphically why continuous monetary growth is needed to generate in‡ation.
Describe how the in‡ation process is generated.
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