Download CHAPTER 3 ANSWERS TO "DO YOU UNDERSTAND?" TEXT

CHAPTER 3
ANSWERS TO "DO YOU UNDERSTAND?" TEXT QUESTIONS
DO YOU UNDERSTAND?
1. What is likely to happen to the monetary base if (a) the Treasury department sends out Social Security
checks payable from its account at the Fed, (b) the Fed buys more government securities, (c) banks in
general borrow less from the Fed’s discount window and repay their past borrowings?
Answer: (a) the MB will increase as the Treasury checks clear the Fed providing increased bank
reserves; (b) the MB will increase as the Fed buys securities, increasing the bank reserve deposit
account in the Fed; (c) the repayment of Fed borrowings will reduce the bank reserve component of
the MB.
2. What is likely to happen to the fed funds rate if the Fed increases the reserve requirement? Explain.
Answer: An increase in reserve requirements on a given level of deposits will immediately convert
more total reserves into required reserves or create a reserve deficiency if total reserves on hand are
not adequate to comply. Either way, the reallocation of resources to comply with the higher reserve
requirement will pull loanable funds out of the system, pressuring the FFR upward.
3. Why do the financial markets pay so much attention to the fed funds rate given that the Fed can’t
really control that interest rate in the long run?
Answer: In the short run open-market operations can influence the fed funds rate, money market
rates, and indexed rates in lending agreements. The FFR is a “benchmark” rate in the financial
system, usually representing the lowest available cost of loanable funds to a depository institution.
4. What is the basic difference between fiscal and monetary policy?
Answer: Fiscal policy is the control over government spending and taxes over the business cycle.
Congress and President determine, and the Treasury Department carries out fiscal policy in the U.S.
Monetary policy is the control of money supply; it is determined and carried out by the Federal
Reserve in the U.S.
DO YOU UNDERSTAND?
1. Describe the likely consequences for GDP growth when the FOMC directs the trading desk at the New
York Fed to sell Treasury securities.
Answer: Assuming the sale is of “monetary policy” magnitude and not “technical” magnitude, selling
securities reduces reserves and thus pressures interest rates upward, serving to slow the economy.
2. What defensive actions do you suppose the Fed takes during periods of time when cash holdings by
the public increase? In other words, how does the Fed offset these cash drains?
Answer: The Fed seeks to control the total monetary base, not the individual components, so when
the public cash holdings increase, decreasing bank reserves, the Fed would purchase Treasury
securities via open-market operations, increasing reserves and offsetting the public’s increased cash
holdings.
3. As a college student who will be entering the workforce soon, if you have not already, which of the
objectives of monetary policy would you like the Fed to focus on in the coming years?
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Answer: As you near graduation, full employment is likely to be your main concern in the short term,
but you should also care about the long-term purchasing power of your earnings.
4. What causes an asset bubble? When a bubble bursts, what impact can it have on the economy?
Answer: Asset bubbles are formed when asset prices are over-inflated due to excess demand. Asset
bubbles are often driven by low interest rates and a credit boom. Many investors buying the assets are
driven by speculative motives, i.e., they hope to resell the asset later at a higher price. Since this cannot
continue forever, asset bubbles burst sooner or later, and the price of assets declines. Holders of the
assets lose part of their net worth, which means they will be able to borrow less against their assets and
spend less, which will cause the economy to slow down.
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