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Terms in this set (34)
- the actions the Federal Reserve takes to manage the money supply an intreat latest to pursue macroeconomic policy goals
4 main monetary policy goals
- price stability
- high employment
- stability of financial markets and institutions
- economic growth
the dual mandate of the Federal Reserve
- price stability and high employment
3 monetary policy tools
- open market operations
- discount policy
- reserve requirements
- it uses these books to try and influence the unemployment and inflation rates by directly influencing its monetary policy targets.
2 monetary policy targets
- the money supply
- the interest rate
shifts in the money demand curve
- a change in the need to hold money, to engage in transactions.
- increasing the amount of money is needed for each transactions (higher price level) will increase the demand for money. (also works adversely)
equilibrium in the money market
- the money supply curve is a vertical line, it does not depend on the interest rate.
- equilibrium occurs in the money market where the two curves cross
the money market model
- concerned with short-term nominal rate of interest
- most relevant for the Federal Reserve, changes in money supply directly affect this interest rate.
federal funds rate
- the interest rate banks charge each other for overnight loans.
- the Federal Reserve does not set the federal funds rate but rather affects the supply of bank reserves through open market operations.
- the low federal fund rate was designed to encourage banks to make loans instead of holding excess reserves, which banks were holding at unusually high levels.
how do interest rates affect aggregate demand?
- consumption: lower interest rates encourage buying on credit, which typically affects the sale of durables. Lower rates also discourage saving.
- investment: lower interest rates encourage capital investment by firms by making it cheaper to borrow and by making stocks more attractive for households to purchase, allowing firms to raise funds by selling additional stock. Lower rates also encourage new residential investment.
- net exports: high US interest rates attract foreign funds, raising the $US exchange rate, causing next exports to fall, and vice versa.
expansionary monetary policy
- the federal reserve conducts this when it takes action to decrease interest rates to increase real GDP.
- this works because decreases in interest rates raise consumption, investment, and net exports
- the federal reserve would take this action when the short-run equilibrium real GDP was below potential real GDP.
1. decreasing the reserve requirement
2. decreasing the discount rate
3. conducting an open market purchase of government securities
contractionary monetary policy
- increasing interest rates to reduce inflation.
- the federal reserve would perform this if the economy was producing above potential GDP.
1. increasing the reserve requirement
2. increasing the discount rate
3. conducting an open market sale of government securities
- aggregate demand shifts to the left and the price level falls
- actual real GDP falls
- potential GDP does not change as a result of the policy, rather it shifted due to economic growth
- unemployment rises
the federal reserve
- is mostly concerned with long-run growth.
- If it determines that inflation is a danger to long run growth, it can contract the money supply in order to discourage inflation.
- they can't eliminate recessions but they can reduce them
the taylor rule
- federal funds target rate = current inflation rate + real equilibrium federal funds rate + (1/2Inflation gap) + (1/2output gap)
- the difference between the current inflation rate and the targeted inflation rate
- the percentage difference between real GDP and potential GDP
- conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.
advantages of targeting inflation
- makes it clear that the federal reserve cannot affect real GDP in the long run.
- easier for firms and households to form expectations about future inflation, improving their planning.
- reduces chance of abrupt changes in monetary policy (for example, when members of the FOMC change).
- promotes federal reserve accountability.
disadvantages of targeting inflation
- reduces the federal reserve's flexibility to address other policy goals.
- assumes the federal reserves can correctly forecast inflation rates, which may not be true.
- increased focus on inflation rate may result in Fed being less likely to address other beneficial goals.
- a situation in which prices are too high relative to the underlying value of the asset.
- they can form due to herding behavior and/or speculation
- failing to correctly evaluate the value of the asset, and instead relying on other people's apparent evaluations
- believing that prices will rise even higher, and buying the asset intending to sell it before prices fall.
government sponsored enterprises
- sell bonds to investors and use the funds to purchase mortgages from banks.
short term nominal interest rate
- considered the most relevant interest rate when conducting monetary policy
- the opportunity cost of holding money
impact of a change in the money supply on the interest rate
- when the federal reserve increases the money supply, the short term interest rate must fall until it reaches a level at which firms and households are willing to hold the extra money.
what two institutions did congress create in order to increase the availability of mortgages in a secondary market?
- fannie mae
- freddie mac
- tends to reduce the severity of the recession or the inflationary period.
- the federal reserve is interested in this
- if the federal reserve is late in recognizing a recession, the implementation of an expansionary monetary policy to reduce the severity of the recession could potentially take effect during the next expansion.
- the increase in aggregate demand that results from the expansionary policy will come too late and cause an increase in the inflation rate in the next phase
- if the federal reserve is late in recognizing an expansion, then its attempts to control inflation with contractionary monetary policy could potentially take effect at the beginning of the next contractionary phase of the business cycle.
- the decrease in aggregate demand that results from the contractionary policy comes too late and actually worsens the contracting economy
how do investment banks differ from commercial banks?
- investment banks do not take deposits
- investment banks generally do not lend to households
why did the federal reserve help JP Morgan Chase buy Bear Stearns?
- failure of Bear Stearns would lead to a larger investment bank failure
- commercial banks would be reluctant to lend to investment banks
dynamic AD-AS model assumptions
- the economy experiences inflation
- the economy experiences long run growth
- the federal reserve should adopt the monetary growth rule
- the federal reserve should target the money supply, not the interest rate.
what interest rate does the Fed target?
the federal funds rate
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Final Exam Study Guide
What are open market operations and who oversees them for the Federal Reserve?
If the Fed raises the reserve requirement on checking deposits from 20 percent to 25 percent, what would happen to the monetary base?
What is the result of hyperinflation?
The group within the Federal Reserve System that determines the general course for the nation's money supply is the?