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MT2guide ECO 3203 - Midterm 2 Study Guide This is a basic...

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Midterm 2 Study Guide This is a basic guide to get you started. I would review your notes and reread the chapters as necessary. I would review Aplia problems, the homework assignments, and classwork. The format of the exam is the same as exam 1. Chapter 4 Summary The Federal Reserve controls the growth of the real money supply to influence interest rates in the short run. maintain low and stable inflation in the long run. The Federal Reserve conducts open market operations (buying and selling of existing government bonds) to maintain a target federal funds rate (the rate banks charge each other on overnight loans). If banks fall short on reserves they can borrow funds from another bank. These are overnight loans. The Federal Reserve directly controls the monetary base. The money supply can be measured as M1 or M2. Real money demand depends on real income (Y) and the real interest rate (r). Real money demand increases if Y increases Real money demand decreases if r increases. The price level (P) depends on nominal money supply and real money demand. In the long run, a 10% increase in M will lead to a 10% increase in P (all else the same). In the long run, the nominal money supply should grow faster than real money demand to prevent the price level from falling. The quantity theory of money is MV = PY. For a given velocity (V) and real GDP (Y) the price level (P) increases proportionately with the nominal money supply (M). In the money market, real money demand equals real money supply. In the short run, the interest rate adjusts to balance real money demand and real money supply, and output is not equal to potential. In the long run, the interest rate adjusts to balance the loanable funds market and output is equal to potential. Chapters 4 and 19 – Money, Banking, and the Federal Reserve What is money? Functions of money Measuring the money supply - M1 vs. M2
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Bank balance sheet Required reserve ratio Money multiplier (two versions) How banks create money Open market operations The Federal Reserve Money demand (real and nominal) Money supply (real and nominal) The discount rate The federal funds rate How does the Fed determine long run money growth? How does the Fed set monetary policy in the short run? Money neutrality Long run: price adjusts to balance real money demand and nominal money supply Short run: interest rate adjusts to balance real money demand and real money supply (price level is fixed) Quantity theory of money: if velocity constant then % Δ P = % Δ M % Δ Y Too much money growth causes inflation Money market equilibrium: first look M P = L ( r + π e , Y ) P = M L ( r + π e , Y ) In the long run, the real interest rate is determined by the loanable funds market and Y is equal to potential GDP: price adjusts accordingly.
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