ECON 311 Ray TAMU Exam 4 Study

Two Types of Monetary Policy

Expansionary and Contractionary

Contractionary Policy

A decrease in monetary expansion by the Federal Reserve

Use contractionary policy when...

When the economy has inflation

Expansionary Policy

An increase in monetary expansion by the Federal Reserve

Use expansionary policy when...

The economy is in a recession (to stimulate economy)

Conventional (Traditional) Monetary Policy

Policy used by the Federal Reserve to control either 1) interest rate payable for short-term borrowing or 2) money supply

Why use conventional monetary policy?

To promote maximum output and stable prices

What are conventional monetary policy tools?

Discount rates (borrowed reserves), reserve requirements, OMOs (open market operations)

What is the newest monetary policy tool (2008)?

Interest on reserves

Unconventional (Nontraditional) Monetary Policy

Nonstandard monetary policies

Unconventional monetary policy tools

Negative interest rates, forward guidance, quantitative easing, collateral adjustments

Open Market Operations (OMOs)

Consist of purchases and sales of short-term Treasury securities and other securities on the secondary market that the Federal Reserve conducts to affect market interest rates and economic activity.

According to the textbook, the two types of OMOs are...

1) Outright purchases or sales of securities, and 2) repurchase agreements and reverse repurchase agreements

Outright OMOs

A permanent purchase or sale of securities in the open market by the Federal Reserve; not reversible and have a lasting economic effect.

Why are all Outright OMOs Dynamic OMOS, but not all Dynamic OMOs are Outright OMOs? What's the difference?

Dynamic Open Market Operations are defined by their purpose: to change the level of reserves and the monetary base to influence the economy.

Outright (or Permanent) Open Market Operations are defined by their method: buying or selling securities permanently (without a reversal date).

Dynamic OMOs

A monetary policy enacted to cause a direct change in the bank reserves and the monetary base.

What's the opposite of Dynamic OMOs?

Defensive OMOs

What's the opposite of Defensive OMOs?

Dynamic OMOs

Defensive OMOs

An open market operation intended to offset movements in other factors that influence the monetary base, such as changes in Federal Reserve float.

What are Outright OMOs classified as? Defensive or Dynamic?

Dynamic

How are Defensive OMOs used?

To increase or decrease reserves available to the banking system on a short-term basis, addressing reserve needs that are considered to be temporary in nature.

What are the two types of Defensive OMOs?

Repos and Reverse Repos

Repo (Repurchase Agreement)

A transaction in which the Federal Reserve buys securities from a counterparty subject to an agreement to resell the securities later, thus temporarily increasing the supply of reserves in the banking system.

Purpose of repos?

Temporarily increases a bank's reserves

What does the difference between the purchase price and repurchase price imply?

Adjusted for the term of the repurchase agreement, it implies the interest rate for the repurchase agreement

Reverse Repo (reverse repurchase agreement)

A transaction in which the Federal Reserve sells securities to a counterparty subject to an agreement to repurchase the securities later, thus temporarily decreasing the supply of reserves in the banking system.

Purpose of reverse repos?

Temporarily decrease the supply of reserves in the banking system.

What do reverse repos indicate?

Excess liquidity in the banking system, suggesting that banks have money left over after covering their liabilities

Quantitative Easing

A monetary policy action in which the Federal Reserve buys government bonds or other financial assets to inject monetary reserves into the economy, thus stimulating economic activity.

That is, the Federal Reserve can "create money out of thin air."

What is the Fed Reserve doing with quantitative easing?

Targeting a particular quantity of securities and bank reserves, and then implements open market transactions to achieve this target.

Intention of quantitative easing?

To result in an increase in the money supply, a decline in long-term interest rates, an increase in bank lending, and a rise in economic activity. That is, the Federal Reserve can "create money out of thin air."

Forward Guidance

Communication from the Federal Reserve about the path of the economy and the likely future direction of monetary policy.

Intention of forward guidance?

By signaling the Federal Reserve's intentions, and clarifying its view of the economy, the Federal Reserve can guide long-term interest rates and other market decisions.

What do critics say about forward guidance?

Forward guidance can be a policy failure

What happened pre-2008 without Interest on Reserves?

Depository institutions had the incentive to minimize their reserves at Federal Reserve Banks because they earned no interest on these deposits.

How might the Fed Reserve combat inflation using Interest on Reserves?

The Federal Reserve can accomplish this policy by raising the interest rate that it pays on reserves maintained at Federal Reserve Banks.

What does a higher rate on reserve holdings do?

Provides banks greater incentive to decrease risky lending and thus increase their reserve deposits at Federal Reserve Banks, which earn a riskless interest rate.

What might the Fed Reserve do to combat recession? (Regarding Fed Reserves)

It will reduce the interest rate that it pays on bank holdings of reserves at Federal Reserve Banks.

What does a lower rate on reserve holdings do?

Will make it less attractive for banks to hold reserves, thus increasing the incentive for them to increase lending that stimulates the economy.

Who does payment of interest on reserves apply to?

Depository institutions that maintain reserve balances at Federal Reserve Banks: commercial banks, savings and loan associations, mutual savings banks, and credit unions.

Negative Interest Rate

A strategy of the Federal Reserve that establishes its target nominal interest rate at less than zero percent.

When has the Federal Reserve used a policy of negative interest rates (as of April 2026)?

Never

Why has a negative interest rate been used previously?

To stimulate a weak economy

How can a negative interest rate be problematic?

It can punish savers

Lender of Last Resort

An institution, usually a country's central bank, that provides loans to banks that are near collapse. In the U.S., it is the Fed Reserve Banks.

What is the interest on discount loans called?

Discount rate

What does the Fed Reserve provide to regional banks?

Discount loans

Primary Credit Program

A Federal Reserve lending program that serves as the main safety valve for providing sufficient liquidity in the banking system.

Who qualifies for primary credit?

Only banks that are in sound financial condition are eligible for primary credit.

Restrictions on use of primary credit?

No restrictions on the borrower's use of primary credit as long as borrowing appears to be consistent with the backup nature of the facility.

Secondary Credit Program

A Federal Reserve lending program available to depository institutions that are not eligible for primary credit.

Who qualifies for secondary credit?

Banks that are not in generally sound financial condition

What questions will the Fed Reserve Banks ask secondary borrowers?

They will ask questions about the borrower's financial situation and the reasons for a loan from the Federal Reserve.

What is the rate on secondary credit?

Primary credit rate plus one-half of a percentage point

Seasonal Credit Program

A Federal Reserve lending program to help small depository institutions with liquidity pressures of a seasonal nature.

Who does seasonal credit target/apply to?

Banks serving farmers or resort area motels and restaurants, seasonal-in-nature

What is the discount rate on seasonal credit?

Floating rate that fluctuates in accordance with the federal funds rate and the rate on three-month CDs

What economic effect does changing the discount rate have?

Changes in the discount rate result in negligible economic effects

Required Reserve Ratio

The fraction of checkable deposits that a depository institution must hold as reserves at its local Federal Reserve Bank, or in its own bank vault.

To combat recession, what might happen to the Required Reserve Ratio?

The Federal Reserve would reduce the required reserve ratio

What does a decrease in the Required Reserve Ratio do to the money multiplier?

A decrease in the required reserve ratio increased the money multiplier

To combat inflation, what might happen to the Required Reserve Ratio?

The Fed Reserve would raise the required reserve ratio

What happens to the money multiplier when there is an increase in the Required Reserve Ratio?

An increase in the required reserve ratio decreased the money multiplier

Primary mission of the Federal Reserve's founding?

Make the American financial system more stable in view of bank panics which plagued the U.S. economy.

Liquidity Provisions

Discount window expansion, term auction facility (borrowing at lower rate and with less stigma than the

discount window), Fed lending to investment banks and nonfinancial institutions

Large Scale Asset Purchases

Mortgage-backed securities, long-term treasury bonds

Credit Easing

Credit easing changes the composition of the Fed's balance sheet to improve functioning of specific segments (e.g. housing)

Why are reverse repos and repos defensive?

They offset temporary fluctuations in the demand or supply of bank reserves.

What was the main tool used by the early Fed Reserve?

Discount-window loans were its main monetary tool

When did OMOs become popular with the Fed Reserve?

In the 1920s

When was the dual mandate established?

In 1977

Dual Mandate

Promote maximum employment and stable prices

Limited Reserve Market v.s. Ample Reserve Market

Limited reserves refer to a situation where the central bank has the minimum amount of reserves required to meet its immediate obligations.

Ample reserves refer to a situation where the central bank has an abundant amount of excess reserves, meaning it has reserves that are more than what are considered necessary for immediate financial stability.

Operation of Monetary Policy

1) Federal Open Market Committee (FOMC) defines federal funds target range

2) Impacts short-term interest rates

3) Impacts long-term interest rates and overall financial conditions

4) Impacts aggregate spending of consumers and businesses and also net exports

5) Impacts the economy's employment and price levels

Federal Funds

Overnight borrowings of reserves between banks or other depository institutions to maintain their reserves balances at regional Federal Reserve Banks.

Federal Funds Rate (FFR)

Interest rate paid on borrowings of federal funds.

How to determine the federal funds rate?

Determined in the market for federal funds reserves, which embodies the supply and demand schedules of bank reserves.

Why set a target for the federal funds rate?

Acts as a guidepost for monetary policy.

According to Feldstein, how many points must short-term interest rates be reduced by to revive an economy after a recession?

To revive the economy after a recession, the Federal Reserve typically must reduce short-term interest rates by about five percentage points

The Taylor Rule (Definition)

A guideline that the Federal Reserve can use to adjust interest rates to stabilize the economy.

Taylor Rule Equation

Federal Funds Rate (Target) = Real Risk-Free Interest Rate + Current Actual Inflation Rate + Inflation Gap - Unemployment Gap

Inflation Gap

Equals the current actual inflation rate minus the 2 percent inflation target of the Federal Reserve.

Unemployment Gap

Equals the current actual unemployment rate minus the full-employment rate of unemployment, which is thought to be between 4 and 5 percent for the American economy.

Bank Reserves (Equation)

Required Reserves + Excess Reserves

Relationship between FFR and quantity of reserves demanded

Inverse (law of demand)

What will the FFR not exceed?

Discount rate

What will the FFR not go below?

The interest on reserves

Changing the FFR: Limited Reserves

Changing the FFR: Ample Reserves

Demand for Reserves

Costs of Inflation

Social and economic

Uncertainty hampers economic growth (imperfect information and decision making)

"Public hostility"

What to do with cost of inflation?

Tie the price level to a nominal anchor, e.g. inflation rate.

The "time-Inconsistency" problem

Need a "behavior rule" for the central bank to prevent

expansionary policy to lower unemployment/raise output from creating inflation. Day-to-day

discretionary policy leads to poor long-term outcomes.

Inflation Targeting

Long-run goal of price stability + nominal anchor

The central bank announces a target for inflation, commits to achieving it, and is transparent

Advantages of Inflation Targeting

Reduce time-inconsistency problem, Transparency, Accountability, Democratic (accountability to elected officials), Improved performance

Disadvantages of Inflation Targeting

Lags between policy and effect, inflexibility, Increased output/employment fluctuations, Low economic growth

NAIRU

The rate of unemployment at which there is no tendency for inflation to change

Monetary Policy Lags

Data, Recognition, Legislative, Implementation, Effectiveness

Why will the ffr NOT exceed the discount rate?

because banks would borrow at the discount rate rather than pay more in the market.

Why will the ffr not go below the IOR?

No bank would loan funds at a lower rate than they can earn by keeping them at the Fed.