Module 11: Effects of Monetary Policy

According to the Quantity Theory of Money, what four factors are related?

The money supply, the price level (inflation), real GDP, and the velocity of money.

What are the three types of money demand?

Transactions demand, precautionary demand, and asset demand.

What is the term for a situation with slow GDP growth, high unemployment, and high inflation?

Stagflation.

What are the four main tools of the Federal Reserve mentioned in the module?

Interest Rates on Reserves, Open Market Operations, Reserve Ratio, and the Discount Rate.

What is the effect of the Fed raising the interest rates on reserves?

It discourages banks from lending.

What are Open Market Operations (OMO)?

The purchase and sale of existing U.S. government securities in the open private market by the Federal Reserve.

The Federal Open Market Committee (FOMC) conducts _____ _____ _____.

Open Market Operations

What happens to bank reserves and the money supply when the Fed buys securities through OMO?

Bank reserves and the money supply both increase.

How does the Fed pay for securities it buys from banks during OMO?

The Fed creates new money to make the purchase.

What happens to bank reserves and the money supply when the Fed sells securities through OMO?

Bank reserves and the money supply both fall.

Define the 'Reserve Ratio'.

The required percentage of deposits that banks must hold as reserves, either at the Fed or in their vault.

What is the effect of raising the reserve ratio on the money supply?

It decreases the money supply by increasing required reserves and decreasing excess reserves.

What is the effect of lowering the reserve ratio on the money supply?

It increases the money supply.

What is the 'Discount Rate' in the context of monetary policy?

The interest rate the Federal Reserve charges for reserves it lends to depository institutions.

How does decreasing the discount rate affect the money supply?

It encourages borrowing by banks, thereby increasing reserves and the money supply.

How does increasing the discount rate affect the money supply?

It discourages borrowing by banks, thereby decreasing reserves and the money supply.

What is the equation for the Quantity Theory of Money?

$M \times V = P \times Y$

In the equation $M \times V = P \times Y$, what does 'M' represent?

The actual money held by the public (money supply).

In the equation $M \times V = P \times Y$, what does 'V' represent?

The income velocity of money; the average number of times a monetary unit is spent on final goods and services.

In the equation $M \times V = P \times Y$, what does 'P' represent?

The price level.

In the equation $M \times V = P \times Y$, what does 'Y' represent?

Real national output, or real GDP.

How is the Quantity Theory of Money expressed in terms of growth rates?

Growth rate of money supply + Growth rate of velocity = Inflation rate + Growth rate of real GDP.

Define 'Transactions Demand' for money.

Holding money as a medium of exchange to make payments.

Transactions demand for money varies directly with _____ _____ _____.

nominal national income

Define 'Precautionary Demand' for money.

Holding money to meet unplanned expenditures and emergencies.

Define 'Asset Demand' for money.

Holding money as a store of value instead of other assets.

What is the relationship between the interest rate and the quantity of money demanded?

When the interest rate rises, the opportunity cost of holding money increases, and the quantity of money demanded falls.

What two factors cause the money demand curve to shift?

Changes in the level of income (GDP) or the price level.

What is 'Discretionary Monetary Policy'?

Discretionary changes in monetary policy tools to affect the money supply and interest rates to achieve national economic goals.

What are the four national economic goals of discretionary monetary policy?

High employment, price stability, economic growth, and stability of financial markets.

Which two factors determine the demand for money in the money market model?

Real GDP (Income) and the Price Level.

What is another name for expansionary monetary policy?

Easy monetary policy.

List the four actions the Fed can take to conduct expansionary monetary policy.

Buy securities, lower the reserve ratio, lower the discount rate, or lower the interest rate on reserves.

Expansionary monetary policy is used to close a _____ gap.

recessionary

How does expansionary monetary policy affect aggregate demand (AD)?

It increases aggregate demand.

Describe the transmission mechanism from an expansionary OMO to aggregate demand.

The Fed buys securities, increasing the money supply, which lowers the interest rate, stimulating investment and thereby increasing AD.

List the four actions the Fed can take to conduct contractionary monetary policy.

Sell securities, raise the reserve ratio, raise the discount rate, or raise the interest rate on reserves.

Contractionary monetary policy is used to close an _____ gap.

inflationary

How does contractionary monetary policy affect aggregate demand (AD)?

It decreases aggregate demand.

In the complex AD/AS model, what does an outward shift of the LRAS curve represent?

Long-run economic growth.

In the complex AD/AS model, what policy could be used to close a recessionary gap that occurs despite long-run growth?

Expansionary monetary policy, which shifts the AD curve further to the right.

In the complex AD/AS model, what policy could be used to close an inflationary gap that occurs due to excessive AD growth?

Contractionary monetary policy, which shifts the AD curve leftward to align with the new LRAS.

Define 'hyperinflation'.

Extremely high rates of inflation.

What is a primary reason governments might find themselves in a situation of hyperinflation?

Paying off debt by creating excessive amounts of new money.

What is the 'Net Export Effect' of expansionary monetary policy?

An increase in the money supply leads to lower interest rates, causing the value of the dollar to fall, which in turn increases net exports.

Does the net export effect complement or oppose expansionary monetary policy's effect on aggregate demand?

It complements it, as the increase in net exports further boosts aggregate demand.

What is the cause of a recessionary gap in the AD/AS model?

Insufficient Aggregate Demand (AD).

What effect does expansionary monetary policy have on the price level, real GDP, and employment when closing a recessionary gap?

It increases the price level, real GDP, and employment.

Precautionary and asset demand for money vary with the _____ _____.

interest rate