In the short run, in a recession the Federal Reserve might lower the federal funds rate and increase the growth rate of the quantity of money to combat the recession.. The Fed’s policy w
Trang 1A n s w e r s t o t h e
R e v i e w Q u i z z e s
Page 390 (page 798 in Economics)
1 What are the objectives of monetary policy?
As set out in law, the objectives of monetary policy are to achieve “maximum employment, stable prices, and moderate long-term interest rates.”
2 Are the goals of monetary policy in harmony or in conflict (a) in the long run and (b) in the short run?
The monetary policy goals are essentially in harmony for the long run In the long run, stable prices will bring about maximum employment because firms and households can make the best possible decisions against a backdrop of stable prices With stable prices, the inflation rate is low—perhaps even zero if prices are precisely stable The nominal interest rate equals the real interest rate plus the (expected) inflation rate If the inflation rate is low, then the nominal interest rate will be as low as possible In the short run, however, the monetary policy goals might conflict with each other In the short run, in a recession the Federal Reserve might lower the federal funds rate and increase the growth rate of the quantity of money to combat the recession The Fed’s policy will increase employment and real GDP but also increase the price level and eventually the nominal interest rate
3 What is the core inflation rate and how does it differ from the overall CPI inflation rate?
The core inflation rate is the rate of increase in the core PCE deflator The core PCE deflator is the personal consumption expenditure deflator excluding food and fuel The Federal Reserve believes that food and fuel prices are more volatile than other prices and largely respond to factors other than the state of inflation in the general economy Accordingly, the core inflation rate is smoother, that is, less volatile than the actual inflation rate
4 Who is responsible for U.S monetary policy?
The Governors of the Federal Reserve System and the Federal Open Market
Committee (FOMC) are responsible for the conduct of U.S monetary policy
Page 392 (page 800 in Economics)
1 What is the Fed’s monetary policy instrument?
1 4
MONETARY
C h a p t e r
225
Trang 2While the Fed could use the quantity of money, the exchange rate, or a short-term
interest rate, the Fed chooses to use a short-term interest rate, in particular, the federal funds rate The federal funds rate is the interest rate on overnight loans of reserves that commercial banks make to each other
2 How is the federal funds rate determined in the market for reserves?
The federal funds rate is determined by equilibrium in the reserve markets The federal funds rate is the rate that sets the quantity of reserves demanded equal to the quantity of reserves supplied
226
Trang 3in its targeted federal funds rate, the Fed seems to respond to the inflation rate, the unemployment rate, and the output gap when determining its federal funds target rate
Page 401 (page 809 in Economics)
1 Describe the channels by which monetary policy ripples through the economy and explain how each channel operates
When the Federal Reserve lowers the federal funds rate, other short-term interest rates also fall As a result, the exchange rate falls because investors decrease their demand for U.S dollars since the interest yield on dollars is lower When the
Federal Reserve lowers the federal funds rate it does so by buying securities in the open market Bank reserves increase so that banks have excess reserves Because banks have excess reserves, they loan the excess Loans increase and a multiple expansion of the quantity of money results The supply of loanable funds increases
so that the long-term real interest rate falls and consumption and investment increase Net exports increase because of the lower exchange rate All three of these changes increase aggregate demand, so that real GDP growth and the inflation rate both increase
2 Do interest rates fluctuate in response to the Fed’s actions?
Yes, interest rates fluctuate in response to the Fed’s actions Indeed, the first effect
of a change in monetary policy is a change in the federal funds interest rate
3 How do the Fed’s actions change the exchange rate?
A change in the U.S interest rate changes the U.S interest rate differential For example, a rise in the U.S interest rate, other things remaining the same, means that the U.S interest rate differential increases When the U.S interest rate
differential increases people want to move funds from other countries into the United States to obtain the relatively higher returns on U.S assets To move funds into the United States, people buy dollars and sell other currencies, driving the price of the dollar up A higher dollar means that foreigners must pay more for U.S.-made goods and services and Americans pay less for foreign goods and services So the rise in the interest rate means that exports decrease and imports increase, corresponding to a fall in net exports
4 How do the Fed’s actions influence real GDP and how long does it take for real GDP to respond to the Fed’s policy changes?
The Fed’s actions affect real GDP by changing expenditure plans For instance, an expansionary policy by the Fed that lowers the interest rate increases consumption expenditure, investment, and net exports All three of these changes boost
aggregate demand so that real GDP growth increases The effect on real GDP is far from immediate because there are time lags in the process Real GDP initially responds about two years after the policy is initiated
5 How do the Fed’s actions influence the inflation rate and how long does it take for inflation to respond to the Fed’s policy changes?
The Fed’s actions affect the inflation rate and the price level by changing
expenditure plans For instance, an expansionary policy by the Fed that lowers the interest rate increases consumption expenditure, investment, and net exports All three of these changes boost aggregate demand so that the price level rises and the inflation rate increases The effect on the price level and inflation rate is far from immediate because there are time lags in the process The change in inflation
is slower than the change in real GDP
Trang 4Page 405 (page 813 in Economics)
1 What are the three ingredients of a financial and banking crisis?
A financial and banking crisis occurs when there is a widespread fall in assets
prices, a significant currency drain, and a run on banks When these events
occur, banks and other financial institutions face incipient failure and so they
drastically decrease their lending activities
2 What are the policy actions taken by the Fed and the U.S Treasury in
response to the financial crisis?
The Fed and the U.S Treasury have undertaken eight policies designed to combat the financial crisis The Fed conducted massive open market operations to provide liquidity to banks To provide liquidity to money market funds, the Fed also created
an asset-backed commercial paper money market mutual fund liquidity facility To provide liquidity to other financial institutions, the Fed allowed created programs
that allowed term auction credit and also primary dealer and other broker credit
The U.S Treasury engaged in two Troubled Asset relief Programs, TARP 1 and TARP
2 TARP 1 was designed to give banks more liquidity Under it banks were to sell
troubled assets to the U.S Treasury in exchange for U.S government assets This
program did not work well and was replaced by TARP 2 Under TARP 2 the U.S
Treasury directly purchased stock in financial institutions, thereby increasing their solvency and making their failure less likely Finally, accounting rules were
changed to allow financial institutions to use fair value accounting rather than
mark-to-market accounting to value assets This change also increased their
solvency and made failure less likely
3 Why was the recovery from the 2008–2009 recession so slow?
The recovery from the recession has been slow because investment has not
rebounded Investment has remained low because of uncertainty about the future
4 How might inflation targeting improve the Fed’s monetary policy?
Inflation targeting, under which the Fed would make public its inflation target and face penalties if the target was missed, would improve the Fed’s monetary policy
because it would remove uncertainty The public would know what the Fed’s policy was and would not need to guess at what the inflation rate would be the future
This certainty would improve people’s decision making about saving and
investment and thereby improve economic performance
5 How might using the Taylor rule improve the Fed’s monetary policy?
The Taylor rules is a formula that sets the federal funds rate according to the
inflation rate and the output gap This rule has worked well in computer
simulations when it comes to avoiding excessive inflation or recessions Given this track record, it might improve the Fed’s monetary policy and make the Fed better able to avoid high inflation and recessions It also has the advantage of inflation
targeting insofar as it removes uncertainty about what will be the Fed’s policy
Trang 5A n s w e r s t o t h e S t u d y P l a n P r o b l e m s a n d
A p p l i c a t i o n s
1 “Unemployment is a more serious economic problem than inflation and it should be the focus of the Fed’s monetary policy.” Evaluate this statement and explain why the Fed’s primary policy goal is price stability
The Fed’s primary goal is price stability because price stability helps the Fed reach
all three of its goals of maximum employment, stable prices, and moderate
long-term interest rates Price stability directly meets the second goal of price stability And because price stability means that the inflation rate is low, it helps keep nominal long-term interest rates close to the long-term real interest rate Finally price stability helps consumers and businesses make better decisions about saving and investment and thereby keep unemployment close to the natural rate
2 “Monetary policy is too important to be left to the Fed The President should
be responsible for it.” How is responsibility for monetary policy allocated among the Fed, the Congress, and the President?
The Fed has primary responsibility for the nation’s monetary policy It is the FOMC that decides upon monetary policy The Congress plays, at best, a minor role Each year the Fed must make two reports to Congress about its monetary policy and the Fed chairman testifies before Congress at these times The President’s role is limiting to appointing the members and the chairman of the Board of Governors, though Presidents have tried to influence the Fed’s decisions
3 Fed’s Easing Has Little Impact So Far
The Federal Reserve’s latest easing program may be nicknamed “QE Infinity”
on Wall Street, but it’s having a limited effect on the economy so far
Source: cnbc.com, October 3, 2012
a What does the Federal Reserve Act of 2000 say about the Fed’s control of the quantity of money?
The Federal Reserve Act of 2000 says that the Fed “shall maintain long-run growth
of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
b How can the massive increase in the monetary base resulting from
“quantitative easing” or QE be reconciled with the Federal Reserve Act of 2000?
The Fed is charged with setting monetary growth to “promote effectively the goal(s) of maximum employment.” The massive increase in the monetary base attempts to decrease the unemployment rate from its level at the time, near 9.5 percent, to something closer to the natural unemployment rate, thereby helping to achieve its goal of maximum employment
4 What are the two possible monetary policy instruments, which one does the Fed use, and how has its value behaved since 2000?
The Fed could use either the monetary base or the federal funds rate as its
monetary policy instrument The Fed has chosen to use the federal funds rate Since 2000 the federal funds rate has been on a roller coaster Starting from about 6.5 percent in early 2000, the federal funds rate fell for the next four years until it reached 1 percent in the second quarter of 2004 From that time the federal funds rate rose to slightly more that 5 percent in 2006 and 2007 After 2007 the federal funds rate fell until it hit its historic low, 0.2 percent in 2008 From 2008 until 2015, the federal funds rate has stayed at or below this historic low
Trang 65 How does the Fed hit its federal funds
rate target? Illustrate your answer with
an appropriate graph
To hit its federal funds rate target, the Fed
uses open market operations to change
the quantity of reserves Figure 14.1
illustrates this process Initially the federal
funds rate target is 5.25 percent The
quantity of reserves is $100 billion, as
indicated by RS0 If the Fed wants to lower
the federal funds rate to 2 percent, the
Fed will use open market purchases of
government securities to increase
reserves to $200 billion These open
market operations will shift the supply of
reserves curve to RS1 and thereby lower
the equilibrium federal funds rate to the
targeted value, 2.00 percent
6 What does the Fed do to determine whether the federal funds rate should be raised, lowered, or left unchanged?
The Fed changes in the federal funds rate based on its forecasts of the three
economic variables: the inflation rate, the unemployment rate, and the output
gap If the inflation rate is forecasted to rise, the unemployment rate is forecasted
to fall, or the output gap is forecasted to fall and perhaps become an inflationary
gap, the Fed might be concerned about inflation and push the federal funds rate
up If the inflation rate is forecasted to fall, the unemployment rate is forecasted to rise, or the output gap is forecasted to rise, the Fed might be concerned about
unemployment and push the federal funds rate down
Use the following news clip to work Problems 7 and 8
Fed Sees Unemployment and Inflation Rising
It is May 2008 and the Fed is confronted with a rising unemployment rate and
rising inflation
Source: CNN, May 21, 2008
7 Explain the dilemma faced by the Fed in May 2008
Rising unemployment calls for expansionary monetary policy, that is, a cut in the interest rate to lower the unemployment rate This policy, however, raises the
inflation rate Rising inflation calls for a contractionary monetary policy, that is, a hike in the interest rate to lower the inflation rate This policy, however, raises the unemployment rate So if the Fed combats unemployment, it worsens the inflation problem But if the Fed combats inflation, it worsens the unemployment problem
8 a Why might the Fed decide to cut the interest rate in the months after May
2008?
The Fed might have decided to cut the interest rate after May 2008 if
unemployment worsened and became a more severe problem than inflation
Trang 7b Why might the Fed have decided to raise the interest rate in the months after May 2008?
The Fed might have decided to raise the interest rate after May 2008 if inflation worsened and became a more severe problem than unemployment
Trang 8Use the following data to work Problems 9 to
11
The Bureau of Economic Analysis reported
that business investment in the second
quarter of 2012 was $1,483 billion, $97
billion less than in 2008
9 Explain the effects of the Fed’s low
interest rates on business investment
and use a graph to illustrate your
explanation
The low interest rates are achieved by
increasing banks’ reserves, which leads
to an increase in the supply of loanable
funds Then, as illustrated in Figure 14.2,
the increase in the supply of loanable
funds lowers the real interest rate, in the
figure from 5 percent per year to 3
percent per year The fall in the real
interest rate increases firms’ purchase of investment items, such as factories,
plants, machine tools, and so forth, because it makes their purchase less
expensive
10 Explain the effects of business investment on aggregate demand Would you expect it to have a multiplier effect?
Why or why not?
The increase in investment increases
aggregate demand as illustrated in
Figure 14.3 It is likely that the increase
in investment has a multiplier effect
The initial increase in investment
increases real GDP and consumers’
disposable income In turn the increase
in disposable income induces additional
consumption expenditure, which serves
to further increase aggregate demand
and real GDP
11 What actions might the Fed take to
stimulate business investment further?
The Fed might commit to keeping the
inflation rate low by stating that it will
raise the interest rate at some specified
point in the future if inflation starts to
pick up This commitment would help dispel fears of inflation It would also make
clear that buying investment goods will be cheaper at the present time, when the interest rate is low, then in the future, when the interest rate rises This belief
would lead firms to increase their investment at the present time
Trang 9Use the following news clip to work Problems 12 to 14.
IMF Warns Global Economic Slowdown Deepens, Prods U.S., Europe
The IMF said the global economic slowdown is worsening and warned U.S and European policymakers that failure to fix their economic ills would prolong the slump
Source: Reuters, October 9, 2012
12 If the IMF forecasts turn out to be correct, what would most likely happen to the output gap and unemployment in 2013?
The “global economic slowdown” means that the output gap will probably increase and the unemployment rate will either rise or not change
13.a What actions taken by the Fed in 2011 and 2012 would you expect to have
influenced real GDP growth in 2013? Explain how those policy actions would transmit to real GDP
The Fed has undertaken monetary stimulus of almost historic proportions The Fed has driven the federal funds rate to its lowest level ever, virtually 0 percent The Fed has engaged in bouts of quantitative easing These expansionary policies are designed to increase consumption
expenditure, net exports, and particularly
investment and thereby increase
aggregate demand The Fed’s goal is to
increase aggregate demand and by so
doing increase real GDP and employment,
which would lower the stubbornly high
unemployment rate
b Draw a graph of aggregate demand
and aggregate supply to illustrate your
answer to part (a)
Figurer 14.4 shows the outcome described
in part (b) In the absence of the Fed’s
policy, the aggregate demand curve
would be AD0 and the aggregate supply
curve would be SAS The Fed’s
expansionary policies increased
aggregate demand so the aggregate
demand curve shifts to AD1 In the
absence of the Fed’s policies, real GDP would be $12.7 trillion and the price level would be 119 The Fed’s expansionary policies have raised the price level to 121 and increased real GDP to $12.9 trillion
14 What further actions might the Fed take in 2013 to influence the real GDP growth rate in 2014? (Remember the time lags in the operation of monetary policy.)
The time lags in the operation of monetary policy suggest that any further
expansionary policy the Fed takes in 2013 likely will have a small effect in 2014 If, early in 2013 the Fed conducts a further quantitative easing, by buying a
significant quantity of assets, there might be a positive impact on real GDP and employment in late 2014
Trang 1015 Prospects Rise for Fed Easing Policy
William Dudley, president of the New York Fed, raised the prospect of the Fed becoming more explicit about its inflation goal to “help anchor inflation
expectations at the desired rate.”
Source: ft.com, October 1, 2010 What monetary policy strategy is Mr Dudley raising? How does inflation
targeting work and why might it “help anchor inflation expectations at the
desired rate”?
Mr Dudley is suggesting that the Fed move toward inflation rate targeting
If the Fed followed a policy of inflation rate targeting, it would make a public
commitment about its inflation rate target and would explain how its policy actions will achieve its goal Inflation rate targeting gives the public guidance about what the central bank expects the inflation rate will be This will help “anchor inflation
expectations” and, as long as the announced inflation rate target is the desired
rate, it will help anchor the expectations “at the desired rate.”