1. What are the three principal tools of monetary policy? Explain how they can be used.
ANSWER:
text: pp. 263-267The Federal Reserve Banks use three principal tools (techniques or instruments) to control the reserves of banks and the size of the money supply.
(1) The Federal Reserve can buy or sell government securities in the open market to change the lending ability of the banking system:(a) buying government securities in the open market from either banks or the public increases the excess reserves of banks;(b) selling government securities in the open market to either banks or the public decreases the excess reserves of banks.
(2) The Fed can raise or lower the reserve ratio:
(a) raising the reserve ratio decreases the excess reserves of banks and the size of the monetary (checkable-deposit) multiplier;(b) lowering the reserve ratio increases the excess reserves of banks and the size of the monetary multiplier.
(3) The Fed can also raise or lower the discount rate:
(a) raising the discount rate discourages banks from borrowing reserves from the Fed;(b) lowering the discount rate encourages banks to borrow from the Fed.
2. The following are simplified balance sheets for the commercial banking system and the Federal Reserve system. All figures are in billions of dollars.
Consolidated Balance Sheet: Commercial Banking System
ASSETS
Reserves
$45
_____________
Securities
80
_____________
Loans
80
_____________
LIABILITIES
Deposits
$200
_____________
Loans from FRB
5
_____________
Consolidated Balance Sheet: Federal Reserve Banks
ASSETS
Column 1
Securities
80
_____________
Loans to CBs
5
_____________
LIABILITIES
Column 1
Reserves of CBs
$45
_____________
Treasury Deposits
5
_____________
Federal Reserve Notes
35
_____________
Suppose a drop in the discount rate causes commercial banks to borrow an additional $2 billion from the Fed. Show the new sheet figures in column 1.
Also, answer these three questions for each part:
(a) What change, if any, took place in the money supply as a direct result of this transaction?
(b) What change, if any, occurred in commercial bank reserves?
(c) What change occurred in the money-creating potential of the commercial banking system if the reserve ratio is 20%?
3. The following are simplified balance sheets for the commercial banking system and the Federal Reserve system. All figures are in billions of dollars.
Consolidated Balance Sheet: Commercial Banking System
ASSETS
Reserves
$45
_____________
Securities
80
_____________
Loans
80
_____________
LIABILITIES
Deposits
$200
_____________
Loans from FRB
5
_____________
Consolidated Balance Sheet: Federal Reserve Banks
ASSETS
Column 1
Securities
80
_____________
Loans to CBs
5
_____________
LIABILITIES
Column 1
Reserves of CBs
$45
_____________
Treasury Deposits
5
_____________
Federal Reserve Notes
35
_____________
The Fed buys $3 billion of government bonds from the public. Show the new sheet figures in column 1.
Also, answer these three questions for each part:
(a) What change, if any, took place in the money supply as a direct result of this transaction?
(b) What change, if any, occurred in commercial bank reserves?
(c) What change occurred in the money-creating potential of the commercial banking system if the reserve ratio is 20%?
4. The following are simplified balance sheets for the commercial banking system and the Federal Reserve system. All figures are in billions of dollars.
Consolidated Balance Sheet: Commercial Banking System
ASSETS
Reserves
$45
_____________
Securities
80
_____________
Loans
80
_____________
LIABILITIES
Deposits
$200
_____________
Loans from FRB
5
_____________
Consolidated Balance Sheet: Federal Reserve Banks
ASSETS
Column 1
Securities
80
_____________
Loans to CBs
5
_____________
LIABILITIES
Column 1
Reserves of CBs
$45
_____________
Treasury Deposits
5
_____________
Federal Reserve Notes
35
_____________
The Treasury spends $1 billion on research on new farm products. Show the new sheet figures in column 1.
Also, answer these three questions for each part:
(a) What change, if any, took place in the money supply as a direct result of this transaction?
(b) What change, if any, occurred in commercial bank reserves?
(c) What change occurred in the money-creating potential of the commercial banking system if the reserve ratio is 20%?
ANSWERS to questions 2, 3, and 4 :
For help see; [text: pp. 263-267]
Consolidated Balance Sheet: Commercial Banking System
Assets: (1) (2) (3)
Reserves $45 ($47) ($48) ($46)
Securities 80 80 80 80
Loans 80 80 80 80
Liabilities:
Checkable Deposits 200 200 (203) (201)
Loans from FRBs 5 (7) 5 5
Consolidated Balance Sheet: Federal Reserve Banks
Assets: (1) (2) (3)
Securities $80 80 (83) 80
Loans to CBs 5 (7) 5 5
Liabilities:
Reserves of CBs 45 (47) (48) (46)
Treasury deposits 5 5 5 (4)
Federal Reserve notes 35 35 35 35
(a) No direct change in the money supply; bank reserves up by $2 billion; money-creating potential up by $10 billion (5 times $2 billion).
(b) Money supply up by $3 billion; bank reserves up by $3 billion; money-creating potential up by 5 times $2.4 (excess reserves) = $12 billion.
(c) Money supply up by $1 billion; bank reserves up by $1 billion; money creating potential up by 5 times $.8 = $4 billion. (Assumes $1 billion comes from account in Fed.)
5. What is the difference between the Federal Reserve Banks' purchases of securities from the commercial banking system and those from the public? Give an example.
ANSWER:
text: 263-264Assume that the commercial banks are "loaned up." Purchases of bonds by the Fed from commercial banks increase actual reserves and excess reserves of the commercial banks by the full amount of the bond purchase. Purchases of bonds by the Fed from the public increase actual reserves, but also increase checkable deposits. Some of the checkable deposits must be kept as legal reserves, so the commercial banking system has fewer excess reserves to lend out. Despite this difference the end result is the same amount of increase in the money supply.
For example, if the Fed buys a $1,000 bond from commercial banks, the banks have $1,000 in excess reserves to lend. If the reserve ratio is 20 percent, then the commercial banks can increase the money supply by $5,000. If the Fed buys a $1,000 bond from the public, then $1,000 in checkable deposits is created. The bank can lend the excess reserves, which in this case will be $800 because 20 percent of $1,000 must be kept as legal reserves. The $800 in excess reserves increases the money supply by $4,000. Adding this $4,000 in bank lending to the $1,000 in new checkable deposits results in a total increase in the money supply of $5,000.
6. Both Federal Reserve Banks and commercial banks buy and sell government securities, but for substantially different reasons. Explain.
ANSWER:
text: 263-265The Federal Reserve Banks buy and sell securities with the macroeconomy in mind. They are pursuing either an easy or tight money policy when they buy or sell securities. However, commercial banks buy and sell securities in order to improve their individual bank's profitability.
Securities are liquid assets which pay interest, and therefore are attractive investments for banks to obtain with their idle reserves. If their cash reserves fall, they can easily sell securities to obtain the needed reserves.
7. Explain how a change in the reserve ratio affects the money supply.
ANSWER:
text: 265-266An increase in the reserve ratio will decrease the size of the monetary multiplier and decrease the excess reserves held by commercial banks, thus causing the money supply to decrease. A decrease in the reserve ratio will increase the size of the monetary multiplier and increase the excess reserves held by commercial banks, thus causing the money supply to increase.
8. Differentiate between easy (expansionary) and tight (contractionary) monetary policies.
ANSWER:
text: p. 273An easy monetary policy is where the Federal Reserve attempts to expand the money supply to stimulate aggregate expenditures in order to increase employment and output. Buying securities, reducing the reserve ratio, and lowering the discount rate are the appropriate directional changes that lead to an expanded money supply. A tight monetary policy is the opposite. It is where the Federal Reserve attempts to reduce the money supply to dampen spending and inflation. Selling securities, raising the reserve ratio, and raising the discount rate are the appropriate changes leading to a reduced supply of money.
9. Which tool of monetary policy is most important? Why?
ANSWER:
text: p. 267Open-market operations are the most important tool of monetary policy. Changes in the discount rate are less effective because bank reserves are relatively small and require action by commercial banks. Reserve requirements are rarely changed. Reserves do not earn interest so an increase in reserve requirements would be costly to banks, making this policy move less attractive. Open-market operations are used most often because they are very flexible and have an immediate effect on bank reserves.
10.Trace the mainstream view of the cause-effect chain that results from an easy money policy.
ANSWER:
According to the mainstream perspective an easy money policy will cause bank reserves to grow and the money supply to expand. Interest rates will fall and this encourages investment spending. Real GDP will rise by a multiple of the increase in investment. [text: E pp. 278-279; MA pp. 278-279]
11. Trace the cause-effect chain that results from a tight (contractionary) money policy.
ANSWER:
text: p. 273A tight money policy will cause bank reserves to decline and the money supply to decrease. Interest rates will rise and this discourages investment spending. Real GDP will fall by a multiple of the decline in investment.
12. Suppose the economy is experiencing a recession and high unemployment. What would be the interpretation of how an easy money policy would address this problem?
ANSWER:
text: pp. 272-373With an easy money policy, the Federal Reserve buys bonds, lowers the reserve ratio, or lowers the discount rate. As a consequence of these actions, excess reserves increase, which in turn increases the money supply. When this happens, interest rates fall, investment spending increases and aggregate demand increases. The end result is a rise in real GDP by a multiple of the increase in investment.
13. Suppose the economy is experiencing inflation. What would be the interpretation of how a tight money policy would address this problem?
ANSWER:
text: p. 273With a tight money policy, the Federal Reserve sells bonds, raises the reserve ratio, or raises the discount rate. As a consequence of these actions, excess reserves decrease, which in turn decreases the money supply. When this happens, interest rates rise, investment spending decreases and aggregate demand decreases. The end result is a fall in real GDP by a multiple of the decrease in investment.
14. Explain two strengths of monetary policy for achieving economic stability.
ANSWER:
text: p. 274Monetary policy is relatively speedy and flexible relative to fiscal policy because the decision-making body is smaller and the decisions to change monetary policy can be implemented immediately. A second strength is that monetary policy is largely removed from political pressure since the members of the Board of Governors are appointed to 14-year terms. Unpopular, but necessary, changes can thus be made which might not be possible with fiscal policy where the decision makers are elected officials who may be reluctant to make unpopular decisions.
15. How is the Federal funds rate established? What role does the Federal Reserve play?
ANSWER:
text:> pp. 267-268The Federal funds rate is established in the market for overnight excess reserves held by banks. It is based on the supply and demand for excess reserves. The Federal funds rate has been the recent target of monetary policy. The Federal Reserve can influence the Federal funds rate by buying or selling government bonds. When the Federal Reserve buys bonds, this action increases the supply of excess reserves of banks. The Federal funds rate falls so it becomes cheaper for banks to borrow excess reserves overnight. Conversely, when the Federal Reserve seeks to increase the Federal funds rate, it sells bonds and this action reduces the excess reserves of banks. As a consequence, the Federal funds rate rises so it becomes more expensive for banks to borrow excess reserves overnight.
16. Explain what is meant by cyclical asymmetry with regard to monetary policy effects.
ANSWER:
text: p. 275Cyclical asymmetry refers to the observation that a tight monetary policy seems to achieve its objective of reducing aggregate demand much more effectively and consistently than an easy monetary policy is able to achieve its objective of increasing aggregate demand. During recession an expanded money supply and low interest rates may not be enough to encourage more borrowing and spending if investors are pessimistic about the future and lenders are cautious about lending.