ECON Exam 3
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100 Terms
the model of how the money supply is determined includes what groups
the federal reserve: responsible for controlling the money supply and regulating the banking system
the banking system: creates the checking accounts that are a major compoent of M1
the nonbank public (all households and firms): decides the form in which they wish to hold money (ex. currency vs. checking deposits)
what does the process start with
the monetary base (or high powered money): the sum of bank reserves and currency in cirrculation
what links the monetary base to the money supply
the money multplier
when the money multiplier is stable, the fed can control the money supply by controling the monetary base
there is a close connection with the monetary base and the fed’s balance sheet
who determines monetary base
the fed
who determines the money multiplier
the bed, the banking system, and the nonbank public
who determines the money supply
the fed, the nonbank public, and the banking system
what are assets to the federal reserve
us government securities, and discount loans to banks
what are liabilities to the fed
currency in circulation, and reserves of banks
what is currency in circulation
paper money circulating outside of the fed
what is vault cash
currency held by banks
what is currency in M1
currency held by the nonbank public
currency in circulation + vault cash
what are bank reserves
are bank deposits with the fed plus vault cash
what is an assets for the bank and why
reserves because banks can request that the fed repay the deposits on demand with federal reserve notes
what are required reserves
reserve that the fed requires banks to hold against demand deposit and now account balances
what are excess reserves
reserves that banks hold above those necessary to meet reserve requirements
what is the required reserve ratio
the percentage of checkable deposits that the fed specifies that banks must hold as reserves
how does the fed change the monetary base
by changing the levels of its assets — through buying and selling treasury securities or making discount loans to banks
what do open market operations do for the fed
a way for the fed to purchase and sell securities usually US treasury securities in financial markets
what is an open market purchase
the fed purchase of securities (B goes up)
what is an open market sale
the fed sale of securities (B goes down)
how are open market operations carried out
electronically with primary dealers by the fed’s trading desk
in 2020, how many dealer were there
24 primary dealers (commercial banks, investment banks, and securities dealers)
does the pubic’s preference for currency relative to checkable deposits affect monetary base
no
what is a discount loan
a loan made by the fed to a commercial bank
what do discount loans alter
bank reserves
what does a discount loan affect in terms of sides of the fed’s balance sheet
both sides
what two systems change the monetary base
open market operations and discount loans, but the fed has greaer control over open market operations
what is a discount rate
the interest rate the fed charges on discount loans
why does the discount rate differ from most interest rates
because it is set by the fed, whereas most interest rates are determined by demand and supply in financial markets
what does the monetary base include
the nonborrowed monetary base, and borrowed reserves (same as discount loans)
does the fed have control over nonborrowed monetary base
yes
what does the money multiplier help us understand
the factors that determine the money supply
what is multiplue deposit creation (when the banking system responds to an increase in reserves)
part of the money supply process in which an increase in bank reserves results in rounds of bank loans and creation of checkable deposits
as a result, an increase in the money spply is a multiple of the initial increase in reserves
what is the simple deposit multiplier
the ratio of the amount of deposits created by banks to the amount of new reserves
what are the key assumptions for deriving the money multiplier
banks hold no excess reserves
the nonbank public does not increase its holdnigs of currency
in order to build a complete amount of the money supply process, we change the simple deposit multiplier in three ways
rather than a link between the reserves and deposits, we need a link between the monetary base and the money supply
we need to include the effects of changes in the nonbank public’s desire to hold currency relatice to checkable deposits
the more currency the nonbank public holds relative to checkable deposits, the smaller the multiplier deposit creation process
we need to include the effects of changes in bank’s desire to hold excess reserves
the more excess reserves banks hold relatice to their checkable deposits, the smaller the multiplier deposit creation process
what is the currency to deposit ratio
the ratio of currency held by the nonbank public, C, to checkable deposits, D
what does the excess reserves to deposit ratio measure
bank’s holdings excess reserves relatice tot heir checkable deposits
what are the key points about the multiplier expression
the money supply will change in the same direction of a change in the monetary base or the money multiplier
an increase in C/D causes the value of the money multiplier and the money supply to decline
an increase in rrD causes the value of the money multiplier and the money supply to decline
an increase in ER/D causes the value of the money multiplier and the money supplu to decline
an increase in the nonborrowed base is based on the actions of
the fed through open market operations causes the money supply to increase because the monetary bade increases, and more reserves are available for deposit creation
an increase in the required reserve ration (rrD) based on the actions of
the fed through changes in reserve requirements causes the money supply to decrease because fewer reserves can be lent out, and the value of the money multiplier falls
an increase in the currency to deposit ratio (C/D) based on the actions of
the nonbank public causes the money supply to decrease because the value of the money multiplier falls, reducing deposit creation
an increase in excess reserves to deposit ratio (ER/D) based on the actions of
banks causes the money supply to decrease because the value of the money multiplier falls, reducing deposit creation
what happened to the monetary base, money supply, and the money multiplier in the 2007-2009 financial crisis
the size of the monetary base soared beginning in the fall of 2008 when the fed bought huge amounts of financial assets\
the money multiplier declines from about 1.9 in 2000 to below 1 in 2020
the monetary base increased more than M1 during and after the financial crisis as C/D fell and ER/D rose
which money supply is broader
M2 because it does not only include currency and checkable deposits, but also nontransaction accounts
what are nontransaction accounts
they consist of savings accounts (including small time deposits and money market deposit accounts) which is reffered to as N and retain money market mutual funds reffered to as MM
what are the goals of monetary policy that the fed has set
price stability
high employment
economic growth
stability of financial markets and institutions
interest rate stability
foreign exchange market stability
why is price stability a goal
inflation erodes the value of money as a medium of exchange and as a unit of account
who has set price stability as a policy goal
most industrial economiesw
what are problems caused by inflation
inflation makes prices less useful as signals for resource allocation
uncertain future prices complicate decisions households and firms have to make
inflation can also arbitarily redistribute income
hyperinflation can severely damage an economy’s productive capacity
what is hyper inflation
inflation in the hundreds or thousands of percent per year
what does unemployment do
reduces output and causes financial and personal distress
what unemplyment occurs even under the best economic condisions
frictional and structural unemployment
what types of unemployment is monetary policy tools unable to reduce
frictional and structural unemployment
what do most economists estimate the natural rate of unemployment to be
4%
what unemployment does the fed attempt to reduce
cyclical unemployment that is associated with business cycle recessions
what is ecnomic growth
an increase in the economy’s output of goods and services over time
what does economic growth provide
the only source of sustained real increases in household incomes
what does economic growth depend on
high employment
what happens to businesses productive capacity when unemployment occurs
they have unused productive capacity and are much less likely to invest in capital improvements
what does stable economic growth allow
allows firms and households to plan accurately and encourages long term investment
what happens when financial markets and institutions are not efficient in matching savers and borrowers
the economy loses resources
what does the stability of financial markets and instituions make possible
the efficient matching of savers and borrowers
what does fluctuations in interest rates do
makes planning and investment decisions difficult for households and firms
what is the feds goal of interest rate stability motivated by
political pressure and a desire for a stable financail environemnt
what do sharp interest rate fluctuations cause
problems for financial institutions. therefore stabalizing interest rates can help stabalize the financial system
what is an important monetary policy goal of the fed in the global economy
stability in the foreign exchange value of the dollar
what does a stable dollar simplify
planning for commercial and financial transactions
what does fluctuations in the dollars value change
the international compettitiveness of us industries (ex raising the dollar makes US goods more expensive abroad, reducing exports
what does the US Treasury and the feed do for feoreing exchange market stability
the treasury often orginiates changes in foreign exchange policy, and the fed implements these policy changes
what are the six goals of monetary policy related to
price stability and high employment
what happens if the fed will attain price stanility and high eployemnt
then it will typically attain all the other goals as well
what is price stabiltiy and high employment also known as
the fed’s dual mandate
what is the fed’s traditional policy tools
open market operations: the fed’s purchases and sales of securities, usually US Treasury securities, in financial markets
discount policy: the policy tool of setting the discount rate and the terms of discount lending (discount window: the means by which the fed makes discount loans to banks. this serves as the channel for meeting the liquidity needs of banks)
reserve requirement: the fed’s regulation that banks must hold a fraction of checkable deposis as vault cash or deposits with the fed: on marhc 2020 the fed eliminated reserve requirements
what are the new tools to manage the federal funds rate
interest on bank reserve balances: the fed began for the first time to pay interest on banks required reserve and excess reserve deposits. this interest is called the interest rate on excess reserves (IOER)
overnight reverse repurchase agreement facility: the fed sells a sercurity to a financial firm and promises to buy it back the next day
term deposit facility: in april of 2020, the fed announces that it would offer banks the opportunity to purchase term deposits, whcih are similar to the certificates of deposit that banks offer to households and firms
which tools to manage the federal funds rate are the most important compared to the fed’s three traditional tools
interest rate on bank reserve balances and overnight reverse repurchase agreement facility
what were the tools introduced by the fed to deal with the zero lower bound problem
quantitative easing and forward guidance
what is quantitative easing
it is a central bank policy whose goal is to stimulate the economy by buying long term securities
timeline for quantitative easing
2009 to early 2010: the fed bought more than 1.7 trillion in mortgage backed secutieis and long term treasury securities
november 2010 to june 2011: the fed bought 600 billion in long term treasury securities
september 2012 to october 2014: the fed focused on buying mortgage backed securities
march 2020: the fed purchased 700 billion of treasury and mortgage backed securities
what is forward guidance
refers to statements by the federal open market committee about how it will conduct monetary policy in the future
monetary policy needs to affect long term interest rates, which have a greater effect on the spending of households and firms
what is the federal funds rate
the interest rate that banks charge each other on very short term loans
what is the federal funds rate determined by
the demand and supply for reserves in the federal funds market
where is the targe for the federal funds rate set
at FOMC meetings
what is the federal funds rate influenced by
the demand and supply of reserves
what is the traditional assumption of scarce reserves
there are many banks that meet their need for reserves by borrowing them from other banks in the federal funds market
what are the demand for reserves determined by
the banking system
who controlls the supply of reserves
the fed
what changes were made to the discount rate
the fed has kept the dicount rate higher than the target for the federal funds rate, so the discount rate is a penalty rate, as banks pay a penalty by borrowing from the fed rather than other banks
what changes were made in the required reserve ratio
the fed rarely changes the RRR. this action will likely carry out offsetting open market operations to keep the target for the federal funds rate unchanged
before lowering the RRR to 0% in march 2020, the last time the fed changed it was in april of 1992
what kind of policiy is an open market purchase and sale
an expansionary policy: because the purchase of treasury securities causes their prices to increase, and so their yield to decrease. as the monetary base increases, the money supply will expand
contractionary policy
how is open market operations implemented
the FOMC issues a policy directive to the federal reserve systems account manager who is a vice president of the federal reserve bank of new york
the open market trading desk is linked electronically through the trading room automated processing system (TRAPS) to 24 primary dealers
each morning the trading desk notifies the primary dealers of the size of the open market purchase or sale and asks them to submit offers to buy or sell treasry securities
dynamic open market operations
defensive open market operations
what are dynamic open market operations
are intended to change monetary policy as directed by the FOMC
likely to be conducted as outright purchases and sales of treasry securities to primary dealers
what is defensive open market operations
are intended to offset temporary fluctuations in the demand or supply for reserves, not to carry out changes in monetary policy
much more common, and are conducted through a reverse repurchase agreement (matched sale-purchase transactions or a reverse repo)
Open market operations versus other policy tools
benefits of OMO: control, flexibility, and ease of implementation
discount loans depend in part of the willingness of banks to request the loans and so are not as completely under the feds control
the fed can make both large and small open market operations. often dynamic operations require large purchases or sales, whereas defensive operations call for small purchases or sales
reversing open market operations is simple for the fed. discount loans and reserve requirement changes are more difficult to reverse quickly
the fed can implement its open market operations with no administrative delays. changing the discount rate or reserve requirements require lengthier deliberation
what does each federal reserve bank maintain
its own discount window, although all reserve banks charge the same discount rate
what are the categories of discount loans
primary credit: consits of discount loans available to healthy banks experienceing temporary liquidity problems
secondary credit: consists of discount loans to banks that are not eligible for primary credit
seasonal credit: consists of discount loans to smaller banks in areas where agriculture or tourism is important
what did the inisital stages of the financail crisis involve
shadow banks rather than commercial banks. so the fed was handicapped in its role as a lender of last resort because it typically lends to banks, but then the fed used its authority to set up tempoary lending facilities
what are the types of lending facilities
primary dealer credit facility: intended to allow investment banks and large securities firms to obtain emergency loans
term securities lending facility: intended to allow financial firms to borrow against liquid assets
commercial paper funding facility: the fed purchased three month commercial paper directly from corporations so they could continue normal operations
term asset backed securities loan facility (TALF): the new york fed extended three year or five year loans to help investors fnd the purchase of asset backed securities
what are the two categories of the lending facilities the fed operated in 2020
liquidity facilities, which build on the feds original role as a lender of last resort
credit facilities, which allow the fed to provide funds directly to nonfinancial firms and state and loacal governments
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