Monetary Policy

                                                                      CHAPTER SIXTEEN
                                                                      MONETARY POLICY

16-1   What is the basic determinant of (a) the strength of the transactions demand for money and (b)
       the amount of money demand for assets? How is the equilibrium interest rate in the market for
       money determined? Use a graph to show the impact of an increase in the total demand for
       money on the equilibrium interest rate (no change in the money supply). Use your general
       knowledge of equilibrium prices to explain why the previous interest rate is no longer
       (a) The level of nominal GDP. The higher this level, the greater the amount of money demanded
       for transactions. (b) The interest rate. The higher the interest rate, the smaller the amount of
       money demanded as an asset.
       The equilibrium interest rate is found where money supply and money demand intersect (See
       Figure 16.1c).

               Rate of interest, i

                                     ie1                      Dm2

                                              Amount of money
                                           demanded and supplied

       An increase in money demand from Dm1 to Dm2 will increase the equilibrium interest rate from i e1
       to ie2.
       When money demand increases, the interest rate ie1 is no longer sustainable because the quantity
       of money demanded exceeds the quantity supplied at that interest rate. This will put upward
       pressure on interest rates as prospective borrowers compete for the limited funds available.
16-2   Assume that the following data characterize a hypothetical economy: money supply = $200
       billion; quantity of money demanded for transactions = $150 billion; quantity of money
       demanded as an asset = $10 billion at 12 percent interest, increasing by $10 billion for each
       2-percentage-point fall in the interest rate.
       a. What is the equilibrium interest rate? Explain.
       b. At the equilibrium interest rate, what are the quantity of money supplied, the total quantity of
          money demanded, the amount of money demanded for transactions, and the amount of
          money demanded as an asset?

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       (a) The equilibrium interest rate is 4% where the quantity of money supplied is equal to the total
           quantity demanded.
       (b) At the equilibrium interest rate the quantity of money supplied is 200 and the asset demand
           for money is 50, the transactions demand for money is 150 and the total quantity of money
           demanded is 200.

16-3   What is the basic objective of monetary policy? State the cause-effect chain through which
       monetary policy is made effective. What are the major strengths of monetary policy?
       The basic objective of monetary policy is to assist the economy in achieving a full-employment,
       non-inflationary level of total output.
       Cause-effect chain: Changes in the money supply affect interest rates, which affect investment
       spending and therefore aggregate demand. Changes in aggregate demand affect output,
       employment, and the price level.
       The major strengths of monetary policy are its speed and flexibility compared to fiscal policy, the
       Board of Governors is somewhat removed from political pressure, and its successful record in
       preventing inflation and keeping prices stable. The Fed is given some credit for prosperity in the

16-4   What is the impact of each of the following transactions on commercial bank reserves?
       a. The New York Federal Reserve Bank purchases government securities from private
          businesses and consumers.
       b. Commercial banks borrow from the Federal Reserve Banks.
       c. The Fed reduces the reserve ratio.
       (a) If the private businesses and consumers deposit the proceeds from their sale of government
           securities to the Fed, commercial bank reserves will rise. If they hold the proceeds as cash,
           no change in reserves will occur.
       (b) Reserves will rise if commercial banks borrow from the Fed.
       (c) Reducing the reserve ratio will not directly change the reserves of commercial banks. It will,
           however, change some of the bank reserves from required to excess reserves. To the extent
           that it also encourages greater lending, the increase in the money supply will generate more
16-5   Why do changes in bank reserves resulting from open-market operations by the Fed produce
       multiple changes in checkable deposits (and therefore money) in the economy?
       When the Fed buys government securities from a commercial bank, for example, it increases the
       reserves of that bank. Assuming these new reserves are excess reserves, the bank can then loan
       them out, creating new money. As this new money is deposited, it creates additional excess
       reserves, which can then also be loaned out to create new money. The process can continue as
       long as there are excess reserves to be lent and deposits to be made, and it all started with the
       purchase of government securities from a single commercial bank.
       The same process works if the Fed buys securities from the public, and the process works in
       reverse if the Fed is selling securities.
16-6   Suppose that you are a member of the Board of Governors of the Federal Reserve System. The
       economy is experiencing a sharp and prolonged inflationary trend. What changes in (a) the

Monetary Policy

       reserve ratio, (b) the discount rate, and (c) open-market operations would you recommend?
       Explain in each case how the change you advocate would affect commercial bank reserves, the
       money supply, interest rates, and aggregate demand.
       (a) Increase the reserve ratio. This would increase the size of required reserves. If the
           commercial banks were fully loaned up, they would have to call in loans. The money supply
           would decrease, interest rates would rise, and aggregate demand would decline.
       (b) Increase the discount rate. This would decrease commercial bank borrowing from the Fed.
           Actual reserves of the commercial banks would fall, as would excess reserves and lending.
           The money supply would drop, interest rates would rise, and aggregate demand would
       (c) Sell government securities in the open market. Buyers of the bonds would write checks to
           the Fed on their demand deposits. When these checks cleared, reserves would flow from the
           banking system to the Fed. The decline in reserves would reduce the money supply, which
           would increase interest rates and reduce aggregate demand.
16-7   Why is monetary policy easier to undertake than fiscal policy in a highly divided national
       political environment?
       Monetary policy is easier to undertake for a number of reasons. Decisions are made by a small
       number of (generally like-minded) people (the Board of Governors and FOMC). Fiscal policy
       decisions require the support of Congress, the Senate, and the President, all with their own
       agendas and constituents to satisfy. The objectives of monetary policy are more narrowly
       defined and generally agreed upon (economic growth with price stability). Fiscal policy involves
       the Federal budget, which is driven by many priorities, some unrelated or even antithetical to the
       objective of macroeconomic stability. Even when fiscal policy makers are focused exclusively
       on macroeconomic objectives, there is more room for disagreement as to what policies to
       implement. Tax cuts and spending packages go to generally well-defined groups; it is far less
       clear who will gain or lose from a particular monetary policy change.
16-8   What do economists mean when they say that monetary policy can exhibit cyclical asymmetry?
       Why is this possibility significant to policy makers?
       Cyclical asymmetry refers to the condition that a tight monetary policy is relatively potent at
       contracting economic activity, while an easy money policy is relatively weak at stimulating an
       economy. The weakness in easy money policy results when, even though the Fed increases
       liquidity (reserves) in the system, potential borrowers are unwilling to spend (often because of
       uncertainly over general weakness in the economy). The significance to policy makers is that an
       easy money policy along may be inadequate to bring the economy out of a recession.
16-9   Distinguish between the Federal funds rate and the prime interest rate. Which of these two rates
       does the Fed explicitly target in undertaking its monetary policy? In 2004 and 2005 the Fed used
       open-market operations to significantly increase the Federal funds rate. What was the logic of
       those actions? What was the effect on the prime interest rate?
       The Federal funds interest rate is the interest rate banks charge one another on overnight loans
       needed to meet the reserve requirement. The prime interest rate is the interest rate banks change
       on loans to their most creditworthy customers. The Fed explicitly targets the Federal funds rate.
       The Fed wanted to encourage banks to raise their prime interest rates, slowing growth in
       investment, consumption, and aggregate demand to a noninflationary pace. The tight money
       policy successfully raised the prime interest rate.

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16-10 What is inflation targeting, and how does it differ from the current Fed policy? What are the
      main benefits of inflation targeting, according to its supporters? Why do many economists
      oppose it?
       An inflation targeting policy would have the Fed announce each year a target range for the rate of
       inflation. Fed policy would then be geared to pursue that objective, and failure to meet the target
       would require the Fed to explain what went wrong.
       Supporters of inflation targeting argue that it increases the transparency and accountability of
       Fed policy. It would also keep the Fed focused on what should be its primary objective – stable
       prices. Some supporters would also argue that the success of past Fed action does not ensure that
       it will always make the right decision, especially if it attempts to pursue multiple objectives
       Opponents of inflation targeting believe that the Fed needs the discretion and flexibility to adapt
       policy to conditions that are changing (sometimes rapidly). They also believe that past success in
       inflation targeting is partially the result of ideal economic conditions, and opponents question its
       effectiveness during more economically difficult times.


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