Money, ir, monetary policy

What components are included in the M1 monetary aggregate?

M1 consists of currency (banknotes and coins, C) plus sight deposit accounts at banks (D).

How is the M2 monetary aggregate defined?

M2 is composed of M1 plus savings deposits (or time deposits) at banks.

What does the M3 monetary aggregate add to M2?

M3 includes M2 plus larger, fixed-term deposits and accounts at non-bank institutions.

What is the term for the sum of currency in circulation (C) and reserves (R) held by commercial banks?

This is known as M0, the monetary base, or high-powered money.

Who issues the currency in circulation (C) and the reserves (R) that commercial banks hold?

The Central Bank (CB) issues both currency and reserves.

What is the primary activity of commercial banks in the money creation process?

They issue short-term demand deposits (D) and make long-term loans (L).

The process where commercial banks issue short-term, liquid deposits and make long-term, illiquid loans is known as _.

Maturity transformation.

What inherent risk arises from the maturity mismatch in commercial banking?

The maturity mismatch creates the risk of a bank run.

What policy measure is typically implemented to mitigate the risk of bank runs?

Deposit insurance, which in turn necessitates bank supervision and regulation.

What is the defining characteristic of a fractional-reserve banking system?

Commercial banks hold only a fraction of their customer deposits as reserves at the central bank.

How can a Central Bank indirectly control the amount of deposits (D) in a fractional-reserve system?

By setting the reserve ratio requirement (rr).

What is the name for the concept where an initial deposit leads to a larger final increase in total deposits?

The Money Multiplier (or Reserve Multiplier).

What is the formula for the simple Reserve Multiplier?

The Reserve Multiplier is calculated as $1/rr$, where $rr$ is the reserve ratio.

Using the Reserve Multiplier, what is the formula to calculate the total change in deposits ($ΔD$) resulting from a change in reserves ($ΔR$)?

The formula is $ΔD = (1/rr) \cdot ΔR$.

If an economy has a reserve ratio (rr) of 5% and the central bank injects an additional €2,000 in reserves, what will be the total increase in deposits (D)?

The total increase in deposits will be €40,000, calculated as $(1/0.05) \cdot 2,000$.

How does an increase in the reserve ratio (rr) affect the money supply (M1)?

An increase in the reserve ratio decreases the money multiplier, thereby reducing the money supply (M1).

In the context of the money supply equation $M1 = C + (1/rr) \cdot R$, what does changing the reserve ratio (rr) represent?

It represents one of the main instruments of monetary policy, though it is so powerful it is rarely used.

According to the 2015 data, what was the mandatory reserve ratio requirement in the Euro area for deposits with a maturity up to 2 years?

The mandatory reserve ratio was 1.0%.

According to the 2015 data, which country had the highest reserve requirement for large financial institutions?

China, with a reserve requirement of 18.5% for deposits at large financial institutions.

Name one of the three primary instruments a central bank uses to control the money supply.

Reserve requirements, open-market operations, or the interbank rate.

What is the effect of a central bank buying bonds in an open-market operation?

It increases reserves (R), which leads to an increase in the money supply (M1), representing an expansionary policy.

How does a central bank conduct contractionary monetary policy using open-market operations?

The central bank sells bonds, which decreases reserves (R) and consequently reduces the money supply (M1).

What is the likely effect on the money supply if a central bank lowers the interbank interest rate?

Banks borrow more reserves, offer cheaper loans, and create more deposits, leading to an increase in the money supply (M1).

What is the effect on the money supply if a central bank increases the interbank interest rate?

It becomes more expensive for banks to borrow reserves, leading to fewer loans, fewer deposits, and a decrease in the money supply (M1).

What is the Cambridge equation for money demand?

The Cambridge equation is $M^D = kPY$.

In the augmented Cambridge equation, $M^D = k(i)PY$, how does the interest rate (i) affect the demand for money?

The demand for money is negatively related to the interest rate, as 'i' represents the opportunity cost of holding money.

In the money market model, what is the 'derived demand' for the monetary base (M0)?

Households and firms demand M1, which causes commercial banks to demand reserves (R), thus creating a derived demand for M0.

In a money market diagram with the interbank rate on the y-axis, what happens to the interest rate if GDP (Y) increases and the central bank does not change the money supply ($M0^s$)?

The money demand curve shifts to the right, causing the equilibrium interest rate to increase.

How can a central bank 'accommodate' an increase in GDP to keep the interest rate constant?

It must increase the money supply ($M0^s$) to meet the increased money demand at the existing interest rate.

What are the two main strategies a central bank can use to determine the money market equilibrium?

It can either set the interest rate (i) and supply the required money, or set the money supply ($M0^s$) and let the market determine the interest rate.

What was the major consequence of the U.S. having no central bank before 1914, particularly regarding interest rates?

Nominal short-term interest rates were very volatile because the money supply was inelastic to shifts in money demand.

What happened to U.S. interest rate volatility after the Federal Reserve was established in 1914?

Interest rates became much smoother as the Fed began setting the interest rate and accommodating temporary money demand shocks.

What is the term for the situation where a central bank's main policy interest rate is at or near zero?

This is known as the Zero Lower Bound (ZLB).

When conventional interest rate policy is constrained by the Zero Lower Bound, what type of policies might a central bank employ?

Unconventional Monetary Policies.

What is Quantitative Easing (QE)?

It is an unconventional monetary policy where the central bank buys long-term government and corporate bonds to lower long-term interest rates.

What is the goal of 'Forward Guidance' as an unconventional monetary policy tool?

Its goal is to lower long-term interest rates by having the central bank announce its intentions about future policy.

What unconventional policy involves the central bank directly crediting a government's account with reserves?

Monetary Financing.

What is 'helicopter money'?

It is an unconventional policy where new money is distributed directly to citizens to stabilize income and demand.

What are the two primary, sometimes conflicting, objectives of a central bank?

Price stability (controlling inflation) and promoting employment and economic growth.

What is the typical inflation target for the European Central Bank (ECB)?

The ECB's primary objective is price stability, defined as a 2% inflation rate.

What is the main difference in the official objectives of the European Central Bank (ECB) and the U.S. Federal Reserve (Fed)?

The ECB has a primary focus on price stability, while the Fed gives equal importance to both price stability and maximum employment (a dual mandate).

What is 'monetary targeting' as a central bank strategy?

It is a strategy where the central bank uses the money supply as an intermediate target to achieve its ultimate goals.

What is 'inflation targeting' as a central bank strategy?

It is a strategy where the central bank explicitly sets a target for inflation and uses inflation forecasts to guide its policy rate decisions.

Under an inflation targeting regime, how would a central bank react to forecasts of high inflation?

It would increase its policy interest rate.

The _ Rule is a guideline for how a central bank might set its policy interest rate in response to deviations in inflation and output from their desired levels.

Taylor

What is the 'natural interest rate'?

It is the equilibrium interest rate at which the economy operates at its potential output, determined by structural factors like technology and demographics.

In the Taylor Rule framework, what should a central bank do if inflation is higher than its target ($π > π^*$)?

The central bank should increase its policy interest rate (i).

In the Taylor Rule framework, what should a central bank do if output is below its potential ($Y < Y^*$)?

The central bank should decrease its policy interest rate (i).