Chapter 13 Monetary Policy
Terms in this set (72)
What is the federal reserve
the central bank of the usa
what are the functions of the central bank
(what does the federal reserve do)
-accepting deposits from and making loans to commercial banks
-acting as a banker for federal government
-controlling the money supply
why did congress create the federal reserve system
-bank failures and panics convinced law makers that the usa needed control of the money supply and ability to make loans to commercial banks, when those banks needed extra reserves.
how is the Federal Reserve Bank broken up and why
-the country is split into 12 districts each with its own federal reserve system which makes it a decentralized system
-government did this because Americans tend not to trust just one main banking system controlling everything
How does the board of governors work for federal reserve banking
who is the second most powerful person in the country
-Monetary Policy is set by Board of Governerners in DC. Made up of 7 members
-chairman=most important. "second most powerful person in the country"
each of the Fed's 12 banks is directed by
--9 person board of directors
(what each person represents: 3 commercial banks, 3 nonbanking interest, 3 fed board of governors. )
Federal Open Market Committee (FOMC)
the official policymaking body of the federal reserve system
-made up of: 7 members of board of governors and 12 district bank presidents
What are the functions of the Federal Reserve:
most important function:
1. Banking Services and Supervision- gives currency to banks, holds banks reserves, clears checks, supplies us currency through 12 districts, makes loans to banks, supervises the nations banks
"fed is like "bankers bank"
2. controlling the money supply- (most important job is managing the nations money supply) changes happen in economy because of income or seasons (ex Christmas feds give out lot more money)
why is controlling money so important
-affects: inflation rate, interest rate, equilibrium level of national income
-incorrect monetary policy has made currencies worthless and toppled governments.
what is the ultimate goal of Monetary policy
the objective of monetary policy is Economic growth with Stable Prices
(low steady rate of inflation)
an objective used to achieve some ultimate policy goal
example: the money supply/ or growth of the money supply-- helps Fed to achieve ultimate policy objective (economic growth with stable prices)
strong relationship between:
change in money supply
change in income
change in prices
equation of exchange
an equation that relates the quantity of money to nominal gdp (money times the velocity of money will always be equal to nominal gdp)
MV=PQ (nominal gdp)
m=quantity of money (amount of money in economy)
v=velocity of money (average amount of times money is respent in the economy)
q= the quantity of output, like real income or real gdp(the amounts of goods and services produced in the economy)
if money supply goes up
if velocity of money goes up
then it will increase nominal gdp (is a gross domestic product (GDP) figure that has not been adjusted for inflation)
velocity of money doesn't really change, as well as quantity of output
so money supply goes up it will directly effect price level= the more money supply you print the higher inflation will be
velocity of money
the average number of times each dollar is spent on final goods and services in a year
pq (nominal gdp)=$1000
this means that each dollar must be spent 5X during the year if money supply of $200 is going to support the purchase of $1000 worth of goods and services
quantity theory of money
the theory that, with constant velocity, changes in the quantity of money change nominal GDP
uses the equation of exchange to relate changes in the money supply to changes in prices and output
***velocity constants, country is maximal level of output (q) then an increase in money supply (m) will directly increase price level (p)
we don't want prices to increase dramatically the fed regulates this by:
sets money growth that are consistent with rising output and low inflation.
The fed wants to increase M that is steadily rising with Q (level of output).
= uses money supply to achieve the ultimate goal (higher output (q) with slow increase in price level (p))
when are there problems with using money growth rate as an intermediate target
when velocity is not growing at a steady predictable rate.
unpredictable changes in velocity are due to new deposits and innovations in banking... bank customers switching to different types of financial assets.
what are other variables that the fed uses to indicate future coarse of the economy
(what helps to consider when setting policies)
-foreign exchange rates
what is inflation targeting
countries that are focusing on ultimate goal "a low inflation rate" instead of like money growth rate
public typically likes: economic growth supported by: low inflation, low unemployment, low inflation rate---
when you fight inflation you often have higher interest rates. .. central bank finds it politically attractive to stimulate the economy...means inflation takes second positon. The only way for this to work is for the central bank to be independent of fiscal policy.
instructions issued by the FOMC to the Federal Reserve Bank of New York to implement monetary policy.
mechanism for translating policy into action
Federal Fund Rates
what happens if rate goes above 2.5%
the interest rate that a bank charges when it lends excess reserves to another bank
interest rate that one bank charges another for overnight lending, between 0-2.5% if the rate goes above 2.5% new York Fed will buy bonds from bond dealers. what this does is it injects more money into the banking system this increases banks excess reserves, giving banks more money to lend... which keeps cost of interest rates low.
during a recession the federal reserve will set the rate to
during normal times the federal reserve will do what
zero this will hopefully stimulate spending in the economy.
-positive interest rate which will cause dealers to pay for bonds with funds drawn from commercial banks..this will drain money from the banking system.
what are the tools of monetary policy
**the fed controls the money supply and interest rate by changing bank reserves.
-open market operation
two ways to hold onto reserve requirements
-fed requires banks to hold a fraction of their transaction deposits as reserve (the fraction is reserve requirement)
-small banks have to hold a lot less for reserves then do big banks.
-two ways that can hold onto the money is vault cash (coins and currency in the banks vault) and deposits in the Fed (legal reserves)
the cash a bank holds in its vault plus its deposit in the Fed
when legal reserves=required reserves=
when legal reserves are >required reserves
-bank cant make any new loans
-the bank has excess reserves for lending
checking accounts and other deposits that can be used to pay third parties
equation of how much money bank will need to keep on hand for required reserve
reserve requirement=10% (.1)
rr=.1 x $1,000,000 (rr=$100,000)
how does the feds alter required reserves
1. if banks lowers reserve requirement it does what
2. by raising reserve requirement it does what
-changing reserve requirement number
1. puts more money into the economy, more money to loan
2. reduces the money creating potential in the banking system and reduce money in the economy.
the amount of money that the bank can lend is determined by its excess reserves
(excess reserve equation)
this is the maximum loan that the bank can make
deposit expansion multiplier
(this is how much the bank can expand their money supply by loaning out excess reserve)
1/r x excess reserve in the bank
reserve requirement=20% (goes up-bf 10%)
with the change have extra 100,000 (max loan the bank can now make)
how much can the bank expand its money supply?
1/.20 ($100,000)= $500,000
raising reserve requirement=
lowering reserve requirement=
1. feds can reduce the money-creating potential of the banking system and money supply
2. can increase the money creating potential of the banking system and money supply
the interest rate that the Fed charges commercial banks when they borrow from it
federal funds market
if a bank needs more reserves so that it can make more loans it has to borrow from other banks in the federal funds market.
this market is called this because funds are being loaned from one commercial banks excess reserves on deposit with the federal reserve to another banks deposit account
when a bank borrows it pays rate of interest called federal fund rate
a way that the Fed can control the level of bank reserves is by charging discount rate
1. raise discount rate:
2. when lower discount rate:
1. it raises the cost of borrow money= reduces the amount borrowed. =limit money and expansion
2. lowers the cost of borrowing reserves=increase the amount of borrowing= loans increase and money supply increase
2 different discount rates (set above the federal funds target rate)
1. primary credit
2. secondary credit
1. loans made to banks that are in good financial conditions. interest rate set .75%.
2. rate for banks that are having financial difficulties. 1.25%. short term, typically over night
open market operations
the buying and selling of government and federal agency bonds by the Fed to control bank reserves, the federal fund rate, and the money supply
-this is the major tool for monetary policy,
1. if fed wants to increase federal fund rates
2. if fed wants to decease federal fund rate
1. decrease money supply, it sells US government bonds. (if a reserve on hand it will not decrease right away)
2. increase money supply, fed buys US government bonds
buying financial assets to stimulate the economy when the central bank target interest rate in near or at zero and the interest rate cannot be lowered further
this Is when the interest rate is already at zero and it needs to stimulate the economy more. about buying financial assets to ease credit conditions and make loans more available. goal is to flood economy with money and boost gdp growth
announcing a commitment by the central bank to maintain policy for a period of time until certain conditions are met
another new tool for monetary policy. lower interest rate for prolong period of time. make public think that interest rates will stay low until unemployment reached 6.5%
FOMC ultimate goal
economic growth at stable prices.
how do central banks play in the foreign exchange market
-the value of the dollar compared to other currencies can contribute to trade deficit debt.
federal reserve and other central banks (from other developed countries) devote more attention to maintaining exchange rate within certain target band of values.
foreign exchange market interventions
the buying and selling of currencies by a central bank to achieve a specified exchange rate
if usa buys more from another country than what another country buys from us---the American dollar will depreciate against the other country, aka the other country will be appreciated against the dollar.
What does this do to the usa?
when our dollar depreciates it makes our goods cheaper to other country (ex japan). that means that other country will want to buy more of our goods. also makes us less likely to purchase from other country because there money has appreciated.
the use of domestic open market operations to offset the effects of a foreign exchange market intervention on the domestic money supply
what is demand for money
the quantity of dollars that you want to hold is your demand for money
transaction demand for money
the demand to hold money to buy goods and services
(holding money is demand for it, spending it is getting rid of it)
precautionary demand for money
the demand for money to cover unplanned transactions or emergencies
speculative demand for money
the demand for money created by uncertainty about the value of other assets
(is most liquid stored value-holding money is less risky then buying assets today)
people hold money in order to
1. carry out transactions
2. be prepared for emergencies
3. speculate on purchases of various assets
interest rate is the
1. low interst
2. high interest
opportunity cost of holding money
1. cost of foregone interest is small
2. cost of holding wealth in the form of money is means of giving up more interest
the greater nominal income is, the greater
demand for money is (if the prices are goods and services increase, more money must be used to purchase them)
as income increases, more transactions are carried out and more money is required for those transactions.
money supply function
federal reserve is responsible for setting the money supply.
it is independent of current interest rate and income.
equilibrium interest rate and quantity of money
have to combine money demanded and money supplied.
on graph if money falls bellow 9%=excess demand for money (want more than what is supplied). Bonds and other nonmonetary assets will be sold for money= interest rates will go up.
an excess supply of (demand for money) can increase (decrease)
consumption as well as investment
current interest rate
(to determine interest rate relationship with buying and selling bonds) (more bonds sold= higher interest rate)
current interest rate= annual interest payment /bond price
bond pays $100/ yr in interest
sells for $1000
interest rate is?
what happens if bond sells for now $800
(supply of bonds increase because people want to concert it to money)
interest rate= 100/1000= 10%
this is how the excess demand for money changes interest rates. As interest rates go up, excess demand for money disappears.
interest rates above equilibrium
creates excess supply of money. people want to convert excess money into bonds. demand for bonds rises= bond price increases. interest rates will falls
interest rates rise
(interest rate=cost to borrow funds)
-interest rates rise= return of investment falls=amount of investment falls.
-interest rate falls=investment return increases=
how does monetary policy effect equilibrium income?
1. as money supply increases
2. decrease money supply
1. equilibrium interest rate falls. investment rises. increase aggregate demand and equilibrium income.
2. works in reverse) interest rates rise, investment falls, aggregate demand and equilibrium go down.
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