15 Section Exercise Answers- The Federal Reserve and the Money Supply Process - SPRING 2015 ECONOMICS 100B GSI KRISTYN ABHOLD Section Exercise Answers

15 Section Exercise Answers- The Federal Reserve and the Money Supply Process

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Unformatted text preview: SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD Section Exercise Answers: The Federal Reserve and the Money Supply Process Section 15 Agenda 1. The Federal Reserve System 2. The Federal Open Market Committee 3. The Fed’s Balance Sheet 4. The Fed’s Control of the Monetary Base 5. The Money Multiplier 6. Quantitative Easing 1. The Federal Reserve System • Created by an Act of Congress o on December 23, 1913. o The nation’s central bank. • Responsibilities: o Functions as the government’s bank. o Regulates and supervises banks and thrifts. o Acts as lender of last resort. o Implements monetary policy. • Consists of: o Board of Governors o In Washington, DC o 12 regional Federal Reserve Banks o Located throughout the country o Federal Open Market Committee (FOMC) • The Board of Governors: o 7 members with overlapping 14-­‐year terms ! Appointed by the President ! Confirmed by the Senate o Chairman and Vice Chairman with 4-­‐year terms ! Appointed by the President ! Confirmed by the Senate • Regional Bank Presidents: o Appointed by regional Federal Reserve Bank’s Board of Directors ! Renewable 5-­‐year terms ! Approved by the Board of Governors • Independent within the Government. o Independent: ! Appointment of Governors ! Appointment of Bank Presidents 1 SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD Financed from its own resources • Surplus turned over to Treasury Within the government: ! Established by and ultimately responsible to Congress ! o 2. The Federal Open Market Committee (The FOMC) • • Federal Open Market Committee (FOMC) was created by an Act of Congress on March 1, 1936 as the primary monetary policy decision-­‐making body. The FOMC consists of the 12 voting members: • 7 members of the Board of Governors. • President of the New York Fed. o Operational responsibility for open market operations. • 4 other regional Federal Reserve Presidents. o Who serve on an annual rotating basis. ! and 7 non-­‐voting members: • The other regional Federal Reserve Presidents. ! Chairman: • Traditionally the Chairman of the Board of Governors. ! Vice Chairman: • Traditionally the President of the New York Federal Reserve Bank. ! Meetings: • 8 per year at 5 – 8 week intervals. o Minimum of 4 meetings per year is required. o Also have conference calls when warranted. • Provides direction for open market operations to the New York Federal Reserve Bank. ! Meetings: • Policy statement follows meeting announcing: o Any policy action taken. o Summary of economic and inflationary conditions. o The policy bias: ! Symmetrical ! Asymmetrical o The vote. • Minutes released 3 weeks after the meeting. • Press conference conducted by chairman quarterly. • Monetary Policy Report released semi-­‐annually. o Typically in February and July. o Presented by Chairman to Congress. • Meeting transcripts released after a 5-­‐year lag. • FOMC -­‐ Open Market Operations: o The primary method for changing the money supply is through open-­‐market operations. o Open market operations involve the Fed’s buying and selling of U.S. government securities in the open market. ! Conducted by the New York Federal Reserve Bank. 2 SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD Open Market Operations: o When the Fed buys U.S. government securities in the open market, it will: ! Increase banks’ deposits and reserves. ! Banks will now increase their lending. ! Households and firms deposit their borrowings in their checking accounts, which are part of the money supply. o This is an open-­‐market purchase. o When the Fed sells U.S. government securities in the open market, it will: ! Decrease banks’ deposits and reserves. ! Banks will now decrease their lending. ! Households and firms checking accounts will decline, which are part of the money supply. o This is an open-­‐market sale. • 3. The Fed’s Balance Sheet • The money supply process is based on changes in the central bank’s balance sheet. This balance sheet consists of Assets and Liabilities • Assets Liabilities Government securities: Fed’s holding of securities (a bond or debt obligation) issued by the US Treasury. The Fed provides reserves (money) to the banking system by purchasing securities => increasing its holding of assets • Acquired through open market operations Currency in circulation: amount of currency in the hands of the non-bank public. Discount Loans: the Fed makes loans to commercial banks at a discount to the loan’s face-value. Banks refer to it as “borrowing from the Fed” or “borrowed reserves”, which is a liability on commercial banks’ balance sheet • Called borrowed reserves • Discount rate is the interest rate the Fed charges banks for discount loans Reserves: deposits at the Fed PLUS (+) currency that is held by depository institutions or in bank vaults, known as vault cash. It is assets for commercial banks and a liability for the Fed b/c the banks can demand payment on them at any time. • • Increases in assets must be matched by increases in liabilities. Important to note – The Fed’s holding of currency following an open market sales are not counted as part of the money supply, the currency in NOT in circulation in the economy. Total reserves have 2 categories: 1) required reserves: what Fed requires banks to hold. a. This is a fraction of total deposits, which is called the required reserve ratio, denoted as (rr) 2) excess reserves: additional reserves that banks can hold above their required reserves. Increases in monetary liabilities lead to increases in in the monetary base. • 3 SPRING 2015 • • ECONOMICS 100B GSI: KRISTYN ABHOLD A central bank “creates” money when: o It acquires real assets from the public. o The liabilities it issues are used to create money. These liabilities are called: o The monetary base or o High-­‐powered money 4. The Fed’s Control of the Monetary Base • • The monetary base, MB, equals o Currency in circulation, C PLUS o Reserves in the banking system, R MB = C + R • • Reserves in the banking system are primarily affected by the Fed’s open-­‐market operations. o Reserves can also be affected by: ! Bank borrowings from the Fed. Suppose the Fed buys $100 of government securities from the public. Banking System Assets Securities Reserves Liabilities -­‐$100 +$100 Federal Reserve System Assets Securities • • Liabilities +$100 Reserves +$100 Both reserves AND the monetary base (MB) increase. In a fractional reserve banking system, an increase in the monetary base leads to a multiple expansion of the money supply. o For each additional dollar of reserves the Fed supplies the banking system, deposits (i.e., money) increase by a multiple amount. ! A fractional reserve banking system is one in which bank reserves are only a fraction of their total deposits. 5. The Money Multiplier • The money multiplier, m, indicates how much money supply can be supported by the monetary base: M = m * MB or m = M / MB or ∆M = m * ∆MB 4 SPRING 2015 • Let: o o o • • • • • • • • • ECONOMICS 100B GSI: KRISTYN ABHOLD c = C / D, the currency holding ratio. ! Currency holding (C) is in proportion to deposits (D). ! c > 0 and determined by the public rr = RR / D, the required reserve ratio. ! Required reserves (RR) as a fraction of deposits (D). ! 0 ≤ rr ≤ 1 and determined by the central bank. er = ER /D, the excess reserve ratio. ! Excess reserves (ER) in proportion to deposits (D). ! er ≥ 0 and determined by the commercial banks. The monetary base is: MB = R + C and reserves are: R = RR + ER The monetary base is also: MB = RR + ER + C o then: MB = (rr * D) + (er * D) + (c * D) o or MB = (rr + er + c) * D If the monetary base is: MB = (rr + er = c) * D 1 Then deposits are: D= × MB rr+er+c Now the money supply is: M = D + C and C = c * D => M = (1 + C) * D With deposits: D = [1 / (rr + er + c)] * MB This yields: M = [(1 + c) / (rr + er + c)] * MB 1 + c The money multiplier is: m = M/MB or m = rr+er+c o As long as rr + er < 1, then m > 1 Money Supply Responses Player Federal Reserve System Commercial Banks Federal Reserve System Depositors Commercial Banks Variable Change in Variable Money Supply Response ↑ ↑ ↑ ↑ ↑ ↓ ↑ ↓ ↑ ↓ Monetary Base (MB) Borrowed Reserves (BR) Required Reserve Ratio (rr) Currency Holding Ratio (c) Excess Reserves Ratio (er) Reason More MB for deposit creation More MB for deposit creation Less multiple deposit expansion Less multiple deposit expansion Less loans and deposit creation 6. Quantitative Easing • • • Quantitative easing (QE) is the term given to a central bank’s large scale asset purchases (LSAPs). o These purchases are still conducted through open-­‐ market operations. o However, QE usually involves purchases of longer-­‐ term assets, typically government bonds and high quality mortgage-­‐backed securities. Quantitative easing (QE) is intended to reduce longer term interest rates, thereby reducing the cost of borrowing for consumers and businesses. It does lead to a substantial increase in the central bank’s balance sheet, i.e., the monetary base. o A major criticism of QE is that it can fuel sharply higher inflation. 5 SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD Multiple Choice Questions 1. Suppose that the central bank conducts an open market purchase of government securities of $100 billion while the commercial banking system increases its excess reserves by $100 billion. This would: a. Increase the monetary base and increase the money supply. b. Increase the monetary base but decrease the money supply. c. Increase the monetary base but not change the money supply. d. Decrease the monetary base and decrease the money supply. e. Decrease the monetary base but increase the money supply. f. Decrease the monetary base but not change the money supply. Explanation: MB increases because reserves have increased from open market purchase. Commercial banking system’s increase in its excess reserves reduces the money it could have loaned by the same amount. The increase in MB is perfectly offset by increase in ER, so there’s no change to money supply. 2. In 2009 the monetary base increased by 80%. However, the money supply increased by only 8%. This might have been due to: a. Banks increasing their excess reserves and consumers increasing their cash-­‐holding ratio. b. Banks decreasing their excess reserves and consumers increasing their cash-­‐holding ratio. c. Banks increasing their excess reserves in response to the central bank reducing reserve requirements. d. Banks decreasing their excess reserves in response to the central bank reducing reserve requirements. Explanation: The money multiplier If the money supply has increased by so little while the monetary base increased so much, then the money multiplier m must be very small or declined sharply during the period. (I think it’s 0.1, 8/80 – cannot know this without knowing the currency holding, required reserve, and excess reserve ratios). M = m (MB) m = (1 + c)/(rr + er + c) To decrease m, the denominator must get larger. As c is in the numerator as well, the biggest impact would be if er or rr went up by a lot, then we’d see a huge difference in changes in MB & M. Increasing excess reserves have to be a part of the correct answer, so options b & d are wrong. Option c doesn’t make any sense, as banks would lend out more reserves, not hold onto more of it, if the Fed reduced reserve requirements. That leaves us with option a, which is exactly what’s happened since the recession due to stricter lending requirements. 6 SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD 3. Suppose that the central bank increases the monetary base and reduces the required reserve ratio. However, the money supply declines. This could be due to: a. Consumers shifting deposits from their saving accounts to their checking accounts. b. Consumers increasing their deposit balances by reducing their currency holdings. c. Banks selling government securities to the central bank but not making any additional loans. d. Banks selling government securities to the central bank and using the proceeds to make additional loans. e. None of the above. Explanation: a) incorrect because moving money from one account to another does not affect money supply b) incorrect because increasing deposits means banks have more money they can lend out, especially now with a lower reserve ratio requirement. c) is correct because by selling securities they receive more reserves and by not making loans there is no increase in deposits and the money supply. d) incorrect because making additional loans would increase the money supply, not decrease it. 4. Suppose that the government initially has a balanced budget but then undertakes a large, permanent fiscal expansion. In which case would inflation accelerate the most? a. When the deficit is caused by lowering taxes. b. When the deficit is financed by borrowing from the public. c. When the deficit is financed by increasing the money supply. d. When the deficit is caused by increasing government purchases. Explanation: option (c) is the best because you have both an increase in planned expenditures (either higher G or lower T with higher C) AND an increase in the money supply which causes the MP curve to shift down. So two rightward shifts of the AD curve. All the other choices only affect the IS curve and AD curve once. 5. Suppose that the central bank conducts a massive open market sale of government securities but the money supply does not change. This could be due to: a. A decrease in the velocity of money. b. An increase in the required reserve ratio. c. Commercial banks holding more excess reserves. d. Households and businesses holding more currency. e. None of the above, the money supply would definitely change. Explanation: The open market sale reduces the monetary base but the money supply does not change. This means that the money multiplier has to increase. If the required reserve ratio or excess reserve ratio increases that would reduce the money multiplier so b and c are incorrect. However, if the currency holding ratio rose then (if the required reserve ratio plus the excess reserve ratio is greater than one) the money multiplier would increase. The velocity of money has nothing to do with the question. 7 SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD Analytical Question 1. IS – MP – AD/AS Model. There are two scenarios in this problem. a. Scenario #1. Suppose that the economy is in equilibrium and is characterized by sticky wages and prices. Based only on this information, use IS – MP – AD/AS diagrams to clearly and accurately show the economy’s initial (1) economic output, (2) inflation, and (3) real interest rate. These diagrams should be drawn in BLACK. 8 SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD b. Provide an economic explanation of what you have shown in your diagrams above. The economy is initially in equilibrium. This indicates that the economy is in a general equilibrium at the joint intersection of the AD curve, the SRAS curve, and the LRAS curve. As a result, actual economic output is at its potential level, i.e., Y0 = YP, inflation is constant at π0, and actual inflation is equal to expected inflation, i.e. πe = π0. With inflation at π0, the monetary policy or MP curve indicates that the central bank will set the real interest rate to r0. With the real interest rate at r0, the IS curve indicates that planned expenditures and equilibrium economic output are at Y0 which is equivalent to potential output, i.e., Y0 = YP c. Now suppose that the government increases government purchases. Based only on this additional information, clearly and accurately show the effects of this fiscal policy action on (1) economic output, (2) inflation, and (3) the real interest rate. These effects should be drawn in RED. d. Now, immediately after the increase in government purchases, suppose the central bank changes monetary policy by enough to keep the actual economic output at its original level. Based only on this additional information, clearly and accurately show the effects of this monetary policy action on (1) economic output, (2) inflation, and (3) the real interest rate. These effects should be drawn in BLUE. e. Provide an economic explanation of what you have shown in your diagrams above as a result of both the increase in government purchases and the change in monetary policy. The increase in government purchases also increases planned expenditures at any real interest rate. This can be represented by a rightward shift of the IS curve from IS0 to IS1. The increase in government purchases also increases aggregate demand at any inflation rate. This can be represented by a rightward shift of the AD curve from AD0 to AD1. At the initial inflation rate of π0, the increase in aggregate demand generates excess demand in the economy. This excess demand causes inflation to increase. Higher inflation induces businesses to produce more so that economic output rises along the SRAS curve. As inflation increases, the central bank increases the real interest rate along the MP curve. As the real interest rate increases, planned expenditures decline along the new IS curve, IS1, and aggregate demand declines along the new AD curve, AD1. A new short-­‐term equilibrium is reached after inflation has increased from π0 to π1, the real interest rate has increased from r0 to r1, and economic output has increased from Y0 to Y1. However, the economy is no longer in general equilibrium because economic output has increased above potential output. If the central bank immediately changes monetary policy by enough to keep economic output at its original level it enacts a discretionary (or autonomous) monetary policy tightening, increasing the real interest rate at any inflation rate. This can be represented by an upward (or leftward) shift of the MP curve from MP0 to MP2. Because the discretionary monetary policy tightening increases the real interest rate it reduces planned expenditures along the new IS curve, IS1, which reduces economic output at every inflation rate. This can be represented by a leftward shift of the AD curve from AD1 to AD2. Because economic output returns to it’s original level, the AD curve has shifted back to its initial position, i.e., AD2 = AD0. 9 SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD At the inflation rate of π1, the decrease in aggregate demand generates excess supply (or insufficient demand) in the economy. This excess supply causes inflation to decline. Lower inflation induces businesses to produce less so that economic output declines along the SRAS curve. As inflation declines, the central bank decreases the real interest rate along the MP curve. As the real interest rate decreases, planned expenditures increase along the new IS curve, IS1. A new short-­‐term equilibrium is reached once inflation has decreased from π1 to π2, which is equal to the initial inflation rate, i.e., π2 = π0, and economic output has decreased from Y1 to Y2, which is equal to it initial level, i.e., Y2 = Y0. Although inflation has returned to its initial rate, the real interest rate has increased from r0 to r2 which is just high enough to completely offset the effect of higher government purchases on planned expenditures and economic output. f. Scenario #2. Suppose that the economy is in equilibrium and is characterized by sticky wages and prices. Based only on this information, use IS – MP – AD/AS diagrams to clearly and accurately show the economy’s initial (1) economic output, (2) inflation, and (3) real interest rate. These diagrams should be drawn in BLACK. 10 SPRING 2015 ECONOMICS 100B GSI: KRISTYN ABHOLD g. Now suppose that the government increases tax revenues. Based only on this additional information, clearly and accurately show the effects of this fiscal policy action on (1) economic output, (2) inflation, and (3) the real interest rate. These effects should be drawn in RED. h. Now, immediately after the increase in tax revenues, suppose the central bank changes monetary policy by enough to keep the economi...
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