AP Economics-Monetary Policy
Terms in this set (88)
What are the three basic functions of money?
medium of exchange
measure of value
store of value
store of value
if money is saved for future use, it is being used as what?
If money is expressing the value of a good or service, it is being used as what?
unit of account
currency + checkable deposits. Has the highest liquidity
advantage of money over other assets
money is the perfect liquid
the degree to which an asset can be converted quickly into cash with little or no loss of purchasing power
federal reserve notes
demand/ checkable deposit
any deposit in a commercial bank or thrift institution against which a check may be written
M1 + Savings Deposit + Money Market + Accounts + CODs less than $100,000. Second highest liquid, next to actual cash
Money market deposit account (MMDA)
interest-bearing accounts containing a variety of interest-bearing short-term securities
money that can get converted to cash quickly:
savings accounts, money market accounts, small time deposits, money market mutual funds
stocks, bonds, bills, notes and other financial documents that attest to financial obligation
time deposits that become available at their maturity, which is usually a year and cannot be withdrawn before then. The financial institution pays a higher interest rate on time deposits than MMDAs
Money market mutual fund (MMMF)
mutual funds that invest in short-term securities
M2 + CODs greater than $100,000. Has the lowest liquidity.
What four things give money value?
any form of currency that by law must be accepted by creditors (lenders) for the settlement of a financial debt
Things that "back"/ support the Money Supply
1) The government's ability to keep the value of money relatively stable
2) Paper money is a debt of the Federal Reserve
The Federal Reserve System/ The Fed
the U.S. central bank, established in 1913, that controls the banking system and money supply.
the 12 Federal Reserve Banks
central banks, quasi banks, and banker's banks
Who is the current fed chair?
What are the three levels of the fed?
Board of Governors
Federal Open Market Committee
Federal Reserve Banks
How many members of the Board of Governors are there? ?For how long
Federal Open Market Committee (FOMC)
the 12 member group that aids the BOG in conducting monetary policy by voting on open-market operations . Consists of the seven members of the BOG, the president of the New York FRB, and four of the presidents of the remaining 11 regional banks
What drives the FOMC's decision making?
Price stability (2%)
Maximum employment (4-5%)
Open-Market Operations (OMO)
buying and selling of securities aka bonds
Functions of the Fed
- Monetary Policy
- Issues Federal Reserve Notes
- Set reserve requirements and hold reserves deposited by banks and thrifts
- Fractional reserve banking system
- Total Reserve
- To increase money supply, you should increase excess reserves
- Discount Rate
- Lenders of last resorts in national financial emergencies
- Provide check collection service
- Acts as the fiscal agent for the federal government
- Supervise member banks
Why did Congress make the Fed an independent agency of government? to protect them from political pressures and maintain price stability/ avoid inflation
to protect the Fed from political pressures and to maintain price stability/ avoid inflation
The Financial Crisis of 2007-2008
an unprecedented rise in mortgages loan defaults, the collapse of several major financial institutions, and the generalized freezing up of credit availability that led to the recession of 2007-2009
Subprime mortgage loans
high interest rate loans to home buyers with higher than average credit risk
bonds backed by mortgage payments
the process of slicing up and bundling groups of loans, mortgages, corporate bonds, or other financial debts into distinct new securities
The main factors that contributed to the Financial Crisis of 2007-2008
subprime mortgage loans
collateralized default swaps
basically insurance policies designed to compensate holders of loan-backed securities if the loans underlying these investments went into default
Troubled Asset Relief Program (TARP)
a 2008 federal government program that authorized the U.S. Treasury to spend up to $700 billion to make emergency loans to failing U.S. financial firms
tendency for financial investors and services firms to take on greater risks b/c they assume they are at least partially insured against losses
The Fed changes the money supply to influence interest rates, inflation, unemployment, and real GDP
What is the formula for the money multiplier?
the multiple by which the banking system can expand the money supply for each dollar of excess reserves
the interest rate that the Fed charges commercial banks that need to borrow additional reserves
percent of checkable deposits that banks must have on hand as cash and can not be lent out
amount of checkable deposits that can be loaned out
= actual reserves - required reserves
Interest on Reserves
the payment of a central bank of interest on the deposits (RR + ER, if any) held by commercial banks at the central bank
Term Limit Auction Facility
a monetary policy program used by the Fed to help increase liquidity in the U.S. credit markets.
Tools of Monetary Policy
1.) Open-market operations is used most often
2) Required Reserve Ratio
3) Discount Rate
4) Interest on Reserves
5) Term Limit Auction Facility
Contractionary/ Easy money policy
What type of monetary policy is implemented if there is negative GDP gap/ recession and cyclical unemployment?
Contractionary/ Easy money policy
The Fed's actions to increase the money supply; lower interest rates; increase borrowing, AE, AD, price levels and real GDP
Federal Funds Rate (FFR)
banks charge one another on overnight loans made from temporary excess reserves
-set by banks, but targeted by the Fed
What happens to the reserve ratio in easy money policy?
What happens to the discount rate in easy money policy?
What happens to the OPO in easy money policy?
buy bonds (money that is not money is introduced into the economy)
Federal Fund Market
-X-axis: Quantity of reserves
-Y-axis: Federal funds rate
- Supply curve for federal funds has no slope/ horizontal line
-Downward sloping Demand curve for federal funds
Someone who is in favor of expansionary monetary policy
Monetary Dove (or Dove for short)
What type of policy is used in an overheated economy with a positive GDP gap when inflation is high?
Restrictive/ Tight money policy
the money supply in easy money goes what?
Why is the slope of the supply curve for federal funds zero?
The Fed uses OMO to manipulate it to reach equilibrium at the targeted interest rate
Fed's actions to reduce the money supply; increase interest rates; decrease borrowing, AE, AD, inflation, and real GDP
Restrictive/ Tight money policy
In a tight money policy, the reserve ratio what?
in a tight money policy, the discount rate what?
In a tight money policy, what happens to the OMO?
Why is the slope of the demand curve for federal funds downward sloping?
Lower interest rates give banks with reserve deficiencies a greater incentive to borrow FF instead of reducing their loans as a way to meet their reserve requirement
The Fed targets the FFR by using OMO to manipulate the supply of reserves that are offered on the FF market. The changes in total reserves affect the amount of excess reserves that are available for supply in the FF market, changing the amount of excess reserves a bank will temporarily have and loans to other banks overnight
Targeting the FFR
In an expansionary monetary policy, the Fed increase the reserves supply from Sf1 to SF2, but the FFR will decrease and shift down from 4% to 3.5%
Decreasing the FFR
In a restrictive monetary policy, the Fed decreases the reserves supply from Sf1 to SF3, but the FFR will increase and shift up from 4% to 4.5%
Increasing the FFR
Equilibrium Interest Rate
determined by money supply and money demand. Occurs when people are willing to hold the exact amount of money being supplied by the Fed
The _____ of bonds is determined by supply and demand
Who is the largest single holder of bonds?
Interest rates and bonds are __________ related
the sum of the transactions and assets demand. Inverse relationship between interest rate and the quantity of money demanded
--> money supply 1 expands and shifts right to money supply 2
Expansionary Monetary Policy
Restrictive Monetary Supply
<-- money supply 3 decreases to monetary supply 2
the rate at which banks lend to their most creditworthy customers/ A benchmark interest rate used by banks as a reference point for a wide range of interest rates charged on loans to their most trusted businesses and individuals.
Prime Interest Rate
Which is higher than the other, the FFR or the PIR?
The PIR because it involves longer and riskier loans than overnight loans between banks
Do the PIR and FFR closely track one another?
Policy in which a bank convinces the public that it will keep interest rates very low by providing substantial reserves for as long as is necessary to avoid deflation. The Treasury prints more $$; federal reserve buys loans→ banks loan money to businessman→ interests rates go down→ people spend money→ stimulates economy. Short sited—causes inflation, devalues US dollar, younger citizens have to pay back debt
a situation that exists when adding more liquidity has no effect on lending, borrowing, investment, or aggregate demand
the idea that monetary policy may be more successful in slowing expansions and controlling inflation than in extracting the economy from severe recession. The Fed may attempt to increase excess reserves by decreasing interest rates, but they can't force consumers, firms, or banks to take advantage this/ increase aggregate demand
What are the weaknesses of monetary policy?
recognition time lag, operational time lag, cyclical asymmetry, liquidity traps, and the velocity of money may be unstable and unpredictable
What are the strengths of monetary policy?
speed, flexibility, and isolation from political pressures
Milton Friedman thought that the Fed should change the money supply in relation to the nominal GDP: MV = PQ (m= money supply) (v= velocity of money) (pq= nominal GDP)
The Fundamental Equation of Exchange
The average number of times a dollar is used per year. Friedman believed it was relatively stable/ constant.
Velocity of Money
The Fundamental Equation of Exchange and Taylor's Rule
The Fed With Rules
What is the side effect of easy money?
increase in inflation
What is the side effect of tight money?
someone who is in favor of tight money policy
Monetary Hawk (of Hawk for short)
- Y-axis: Nominal interest rate
- X-axis: Quantity of Money Supply
- Downward slope labeled Dm = - Money demanded
- Vertical lines labeled Sm1, Sm2, and Sm3 = M1 supply, M2 supply, M3 supply
- Equilibrium interest Rate: Money demanded = Money supplied
Money Market model
Fed without rules =