Open Market Operations
- Purchase of securities and bonds – Decrease in interest rates – Increase in the money supply
- Sale of securities and bonds – Increase in interest rates – Decrease in the money supply
Federal Funds Rate
- Increase in federal funds rate – Increase in interest rates – Decrease in the money supply
- A decrease in federal funds rate – Decrease in interest rates – Increase in the money supply
Reserve requirements
- Increase in reserve requirements – Increase in interest rates – Decrease in the money supply
- A decrease in reserve requirements – Decrease in interest rates – Increase in the money supply
Further Reading
Monetary Policy Tools: Open Market Operations, Federal Funds Rate, and Reserve Requirements
Fiscal Policy Tools: Taxation and Government spending
Differences between monetary policy and fiscal policy
- Fiscal policy involves changes in government spending and tax rates. Monetary policy involves interest rates and money supply changes.
- Fiscal policy is set by the government (president and congress). Monetary policy is usually set by the Federal Reserve as directed by the FOMC
- Fiscal policy does not target a specific factor. Monetary policy usually targets inflation
How Monetary Policy Tools work to change money supply and interest rates
Open Market Operations
Expansionary – When the Fed wants to expand the economy
Purchase of government securities and bonds from commercial banks
When the Fed wants to expand the economy during the recession, it purchases government securities and bonds from the commercial banks which in turn raises the amount of cash available for borrowing. More loanable funds cause a decrease in interest rates which increases the money supply in the economy, increasing aggregate demand, investment, and economic output
Contractionary – When the Fed wants to contract the economy to prevent inflation
The Fed sells government securities and bonds back to the commercial banks which exchanges cash with securities that cannot be offered as loans to borrowers. This decreases loanable funds forcing the banks to raise interest rates, decreasing money supply in the economy. This, in turn, decreases aggregate demand and output.
Federal Funds Rate
Expansionary – When the Fed wants to use the federal funds rate to expand the economy
Fed decreases federal funds rate – which is the interest rates commercial banks pay to get overnight loans when customer withdrawals and loans exceed available cash in vaults. As banks get these loans at low-interest rates, they, in turn, charge low-interest rates on loans which increases demand raising money supply.
Contractionary – When the Fed wants to use federal funds rate to contract the economy
The Fed increases the Federal Funds rate making it costly for commercial banks to get overnight loans to offer loans. This, in turn, causes interest rates on loans to go up, which decreases the demand for loans and hence a lower money supply in the economy.
Reserve Requirements
Expansionary – When the Fed wants to use reserve requirements to expand the economy
Reserve requirements refer to the amount of cash that commercial banks are required by the central bank to hold in the vaults and not lend out to borrowers for the sake of unexpected withdrawals. When the Fed decreases reserve requirements, commercial banks have excess reserves which they can offer as loans which caused a decrease in interest rates and hence the high demand for loans. More loans mean more money supply in the economy, which stimulates aggregate demand and investment.
Contractionary – When the Fed wants to use reserve requirements to contract the economy
The Fed increases reserves requirements which reduce excess reserves or amount of cash that commercial banks can offer as loans to borrowers. This causes banks to raise interest rates decreasing demand for loans. Fewer loans mean less money supply in the economy which decreases output and economic growth.
Revision
Income from interest on the government securities it owns
The Federal Reserve’s main source of income is
a. fees charged to banks.
b. funds budgeted by Congress.
c. fees charged to the public every time they use an ATM.
d. income from interest on the government securities it owns.
a trade
If one country is hit with a shock that increases its income and demands more imports of goods and services from other countries, thus increasing aggregate demand in those countries, then the business cycle is being transmitted internationally through __ effect.
a. a trade
b. an interest-rate
c. an exchange-rate
d. an expected-inflation
an interest-rate
If one country engages in a contractionary monetary policy that causes its income to decline and its interest rate to rise, and investors from other countries increase their financial investments in that country, causing the interest rate in those countries to rise and income in those countries to decline, then the business cycle is being transmitted internationally through __ effect.
a. a trade
b. an interest-rate
c. an exchange-rate
d. an expected-inflation
appreciated; appreciated
From 1970 to 2000, the U.S. dollar _ against the British pound and _ against the Canadian dollar.
a. appreciated; appreciated
b. appreciated; depreciated
c. depreciated; appreciated
d. depreciated; depreciated
depreciated; depreciated
From 1970 to 2000, the U.S. dollar _ against the Japanese yen and _ against the German mark.
a. appreciated; appreciated
b. appreciated; depreciated
c. depreciated; appreciated
d. depreciated; depreciated
appreciated; depreciated
In 1990, exchange rates were: 1.61 U.S. dollars per British pound and 144 Japanese yen per U.S. dollar. In 1980, the exchange rates were: 2.22 U.S. dollars per British pound and 240 Japanese yen per U.S. dollar. Based on these data, from 1980 to 1990 the U.S. dollar _ versus the British pound and the U.S. dollar _ versus the Japanese yen.
a. appreciated; appreciated
b. appreciated; depreciated
c. depreciated; appreciated
d. depreciated; depreciated
fall and rise
When a country’s currency depreciates, the prices of its exports _ and the prices of its imports _.
a. rise; rise
b. rise; fall
c. fall; fall
d. fall; rise
depreciates; appreciates
Suppose that participants in the underground economy in Europe suddenly decide to switch from using dollars to using euros. Thus they supply a huge volume of dollars to the market in exchange for euros. As a result, the dollar _ and the euro _.
real exchange rate
If three bushels of rice produced in Japan trade for 2 bushels of rice produced in Guatemala, the __ is equal to 1.5.
a. inflation rate
b. interest rate
c. nominal exchange rate
d. real exchange rate
relative purchasing-power parity.
If a currency depreciates relative to another currency by the amount by which the inflation rate is higher in the first country than in the second country, there is said to be
a. one price fits all.
b. absolute purchasing-power parity.
c. relative purchasing-power parity.
d. interest-rate parity.
absolute purchasing-power parity.
If the exchange rate equals the ratio of price indexes in two countries, there is said to be
a. one price fits all.
b. absolute purchasing-power parity.
c. relative purchasing-power parity.
d. interest-rate parity.
a currency depreciates relative to another currency by the amount by which the inflation rate is higher in the first country than in the second country.
Under relative purchasing-power parity,
a. the exchange rate equals the ratio of price indexes in two countries.
b. a currency depreciates relative to another currency by the amount by which the inflation rate is higher in the first country than in the second country.
c. absolute purchasing-power parity also holds.
d. interest-rate parity holds.
the exchange rate equals the ratio of price indexes in two countries.
Under absolute purchasing-power parity,
a. the exchange rate equals the ratio of price indexes in two countries.
b. a currency depreciates relative to another currency by the amount by which the inflation rate is lower in the first country than in the second country.
c. relative purchasing-power parity cannot hold.
d. interest-rate parity holds.
interest-rate parity.
If the interest rate on a domestic bond equals the interest rate on a foreign bond minus the expected appreciation of the domestic currency, there is said to be
a. interest-rate parity.
b. one price fits all.
c. absolute purchasing-power parity.
d. relative purchasing-power parity.
money multiplier multiplied by monetary base.
The money supply equals
a. monetary base plus money multiplier.
b. monetary base divided by money multiplier.
c. money multiplier divided by monetary base.
d. money multiplier multiplied by monetary base.
securities
The main asset on the Federal Reserve’s balance sheet is
a. discount loans.
b. securities
c. monetary base.
d. capital.
monetary base
The main liability on the Federal Reserve’s balance sheet is
a. discount loans.
b. securities.
c. monetary base.
d. capital.
the monetary base.
Currency held by the nonbank public plus banks’ vault cash plus banks’ deposits at the Fed equals
a. the Fed’s capital stock.
b. discount loans.
c. the monetary base.
d. required clearing balances.
the monetary base.
Currency held by the nonbank public plus banks’ reserves equals
a. the Fed’s capital stock.
b. discount loans.
c. the monetary base.
d. required clearing balances.
reserves plus currency.
The monetary base can be divided into
a. currency plus transactions deposits.
b. vault cash plus reserves held at the Fed.
c. required clearing balances plus currency.
d. reserves plus currency.
required clearing balances.
Reserves held by banks at the Fed that earn implicit interest payments in the form of earnings credits for Fed services are known as
a. required clearing balances.
b. reserve requirements.
c. excess reserves.
d. non-transaction deposits.
not change.
If the Fed uses open-market operations to change the monetary base, the money multiplier is likely to
a. rise.
b. fall.
c. not change.
d. rise at first, then decline later.
decrease.
If the M2 multiplier is currently 8 and people decide to increase the ratio of currency they hold relative to the amount of transactions deposits they hold, the M2 multiplier will
a. not change.
b. increase substantially.
c. decrease.
d. increase slightly.
increase; increase
Suppose the M1 multiplier is currently 1.95 and the M2 multiplier is currently 8.03. If banks decide to decrease the ratio of required clearing balances they hold relative to the amount of transactions deposits they hold, the M1 multiplier will _ and the M2 multiplier will _.
not change; decrease
Suppose the M1 multiplier is currently 1.95 and the M2 multiplier is currently 8.03. If people decide to decrease the ratio of nontransaction deposits they hold relative to the amount of transactions deposits they hold, the M1 multiplier will _ and the M2 multiplier will _.
federal funds rate increases.
If the Open-Market Desk at the Fed sells securities today, the most likely effect is that the
a. federal funds rate decreases.
b. primary credit discount rate decreases.
c. primary credit discount rate increases.
d. federal funds rate increases.
federal funds rate decreases.
If the Open-Market Desk at the Fed buys securities today, the most likely effect is that the
a. federal funds rate decreases.
b. primary credit discount rate decreases.
c. primary credit discount rate increases.
d. federal funds rate increases.
defensive open-market operations.
In November and December, people use more currency than usual, so the Fed increases the money supply through
a. defensive open-market operations.
b. dynamic open-market operations.
c. discount loans for profit.
d. discount loans for business needs
a primary credit discount loan.
A bank in good condition may take out a loan without the Fed questioning the purpose or nature of the loan. Such a loan is known as
a. a primary credit discount loan.
b. a no documentation discount loan.
c. a haircut.
d. a covenant.
a haircut.
The extra collateral the Fed requires above the value of a discount loan is known as
a. a primary credit discount loan.
b. a no documentation discount loan.
c. a haircut.
d. a covenant.
a secondary credit discount loan.
A bank in poor condition may take out a loan under close Fed scrutiny. Such a loan is known as
a. a secondary credit discount loan.
b. a haircut.
c. a covenant.
d. a primary credit discount loan.
federal funds rate decreases.
If the Open-Market Desk at the Fed buys securities when the federal funds rate is below the primary credit discount rate, the most likely effect is that the
a. federal funds rate decreases.
b. primary credit discount rate decreases.
c. primary credit discount rate increases.
d. federal funds rate increases.
sell; increase
If the federal funds rate is below its target, the Fed is likely to want to _ securities in the open market, which will cause the federal funds rate to _.
a. sell; increase
b. buy; increase
c. buy; decrease
d. sell; decrease
the impact is too large.
The Fed does not generally change reserve requirements to affect the money supply because
a. the impact is too large.
b. the Fed needs the approval of Congress to do so.
c. it’s not legal for the Fed to do so.
d. the Fed needs the approval of the President of the United States to do so.
expansionary; an increase
The Fed uses _ monetary policy to cause the economy to grow faster in the short run; _ in the money supply is an example of such a policy.
a. expansionary; a decrease
b. expansionary; an increase
c. contractionary; an increase
d. contractionary; a decrease
higher; lower
Under contractionary monetary policy, the unemployment rate is _ in the short run and inflation is _ in the long run.
a. higher; higher
b. higher; lower
c. lower; lower
d. lower; higher
stabilization policy.
When the Fed uses its policy tools to smooth out the business cycle, reducing output during economic expansions and increasing output during recessions, the policy is known as
a. stabilization policy.
b. procyclical policy.
c. contractionary policy.
d. expansionary policy.
recognition
The idea that policymakers may not immediately understand the state of the economy is known as the __ lag.
a. implementation
b. recognition
c. effectiveness
d. decision
the federal funds rate.
Since 1992, the Fed’s main operating target has been
a. the M1 measure of the money supply.
b. the M2 measure of the money supply.
c. the discount rate.
d. the federal funds rate.
price stability and full employment
The highest priority goals of the Fed (its “dual mandate”) are:
a. price stability and full employment
b. a balanced national budget and full employment
c. full employment and GDP growth of 3%
d. full employment and a balanced budget
they would not be able to pursue time-inconsistent policies.
A benefit to policymakers of following rules rather than discretion is
a. they could employ a larger staff of economists.
b. they will contribute to the formation of an expectations trap.
c. they would not be able to pursue time-inconsistent policies.
d. they would gain flexibility in case the economy’s structure changed.
nonactivist
A money-growth rule that does not respond to the state of the economy is a type of __ rule.
a. lagging
b. leading
c. nonactivist
d. activist
time inconsistency.
When the central banks chooses a policy at one date, which leads people to make decisions based on that policy, which then causes the central bank to choose a different policy at a later date, then there is said to be
a. irrational expectations.
b. time inconsistency.
c. Ricardian equivalence.
d. an expectations trap.
time inconsistency.
People know that the Fed has the incentive to announce that the inflation rate will be 3 percent next year, so people will build 3 percent inflation into their wage negotiations. But then the Fed has the incentive to increase inflation above 3 percent, so that real wages will decline and the economy will grow faster. This type of phenomenon is known as
a. inflation targeting.
b. time inconsistency.
c. McCallum’s rule.
d. an expectations trap.
increases; decreases
The Fed eases policy when it _ money growth and _ the federal funds rate.
a. increases; decreases
b. decreases; decreases
c. decreases; increases
d. increases; increases
