Chapter 15 Monetary Policy
Economics Test Review Notes
are useful when preparing for final a final exam.
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    I. The Demand for Money 
       
A. Transaction D, Dt results because people hold money, often in a money market account, to use as a medium of exchange.
        B. Asset Demand, Dresults because people accumulate money, often held in an investment account, to buy assets.
        C. The demand for money, Dm= Dt + D
       
D  For more information visit Demand for money - Wiki

    II. Monetary policy
         A. Monetary policy is the regulation of the money supply to affect interest rates and economic activity.
         B. It is part of, but not the focal point of Keynesian economics.
         C. Objective is noninflationary full employment.
  
      D. Affecting interest rates and to change investment thus  affecting economic activity is one goal of the Fed.
             1. Controlling reserve requirement may affect the money supply which may 
affect interest rates
       
         a. Reserve requirement is the amount of demand deposits that must be kept in cash with the Federal Reserve or in the bank.
                 b. Often expressed as a percent called the reserve ratio.
                 c. Excess reserve can be loaned as demand deposits.
                 d. Excess reserves determine the potential money supply (M1).   
             2.
Changes interest rates change investment causing a change in AD which changes economic activity.
                
a) Increasing the money supply may lower interest rates. increasing investment which increases AD
                     which causes an increase in Real GDP.
           
 
    b) Decreasing  the money supply may increase interest rates lowering investment which increses AD
                     which causes an increase in Real GDP.
                
c) Interactive quiz on using monetary policy from reffonomics.com
                      a.With Graphs
                      b Without graphs
            
3. Dollar values on this page are representative of amounts prevalent during the late 1990's (billions of dollars).

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         E. Affecting the non-investment components of aggregate demand          
             1. Lower interest rates also increase C, G, and XN
                 a. Consumption increases as credit purchases become cheaper.
                 b. Refinancing existing debt at lower interest rates by individuals, businesses, and governments frees funds for spending.
                 c. Lower interest rates also decrease the international value of the dollar as investors buy (demand) other currencies to
                     earn more interest. The lower dollar increases XN as U.S. goods are less expensive and foreign goods more expensive.
             2. Higher interest rates have an opposite affect
         F. Federal reserve balance sheet. 
             1. Assets are held in securities and loans to commercial banks.
             2. Liabilities and net worth re the reserves of commercial banks, treasury deposits, federal reserve notes, and 
                 equity(accumulated profits).
        G. A Sokratic Dialogue: Liquidity Preference, Loanable Funds, European Hedge Funds that Fear the Collapse of U.S. Bond Prices
            Brad DeLong, This article is very complex and not for the faint of heart. 6/18/11
  III. Types of monetary policy
        A. Quantitative controls affect the money supply.
            
1. Required Reserve Ratio
                
a. Lowering the reserve ratio creates excess reserves which banks may loan as newly created money. This is expansionary.
                 b. Raising the reserve ratio eliminates excess reserve so banks can not renew loans removing money and causing
                    a contraction.
             2. Open-market operations
                 a. Buying and selling of U.S. government bonds by the Federal Reserve from banks or in the open market to change
                     excess reserves thus affecting the supply of M1 and interest rates is the primary tool.
                 b. Buying bonds is expansionary.
                     1) When buying from banks, the Federal Reserve pays with reserves providing excess reserves banks can loan as
                         demand deposits.
                     2) When buying in the open market, increased demand from the Federal Reserve pushes up prices sellers receive,
                         lowering the effective interest sellers pay.
                 c. Selling bonds contracts the economy.
                 d. Review of
Valuing bonds
                     1) Suppose you buy a twenty year, $10,000 bond paying 5% per year at face value of $10,000. Face value is called par value.
                         a) A few years go by and you need money and one choice is to sell the bond.
                         b) If interest rates on this type bond have gone down, people will be very anxious to buy, demand, will be
                             high pushing price up and your will receive more than $10,000.
                         c) If rate shave gone down, no one will give you $10,000, demand will be low, so if you need the money, you will sell for 
                             less, below par.
                         d) You can hold for twenty years and get par and get the money some where else.
                     2) Therefore, interest rates and bond values (prices) go in the opposite direction, if interest rates down, old bond price up
                         because they are at the old higher rate.
                     3) This is called the interest rate risk for bonds. Other risks have to do with issuer default and monetary inflation.
               e.
Federal Open Market Committee  minutes make interesting reading.
               f. It is the most powerful of the four tools.
           3. Discount rate
               a. This is the rate charged by the Federal Reserve for loans to member banks.  
               b. It strongly affects the prime interest rate paid by a bank's best customers.
                   1) Lower the rate to expand economy as interest rates decrease.
                   2) Raise the rate to contract economy as interest rates increase.
                   3) Another important interest rate is the federal funds rate which is the rate at which banks loan funds to 
                       each other.
           4. Term Auction Facility
 
               a. Initiated in 2007, it allows banks to add to their reserves at low rates.
                b Done to increase bank liquidity which was low because of a loss in reserve caused by a housing crisis.

         B. Other controls affect the actions of market participants.
             1. Moral suasion or jawboning  
             
   a. This social pressure by influential people to encourage specific people to act in the public interest.
                 b. It is used to influence public opinion and political attitudes.
                 c. An example is when the Chairman of Board of Governors makes his
Semiannual Report to Congress on the economy and
                     monetary policy
.
             2. Margin requirements, the down payment required on stocks which is now 50%, is seldom changed.
             3. Consumer credit controls, on items such as credit cards, work so well it is seldom used.
            
4. The Federal Funds Rate
                
a. Most controllable interest rate
                 b. Targeted by monetary policy
                 c. It is the overnight interest rate banks with excess fed reserve charge each banks short of fed reserve to keep the system
                     in balance.
                 d. By controlling reserves, the fed controls this rate.
                 e. This allows them some control over short-term rates.
                 f. For more information visit Federal funds rate - Wikipedia, the free encyclopedia
                g. Taylor rule affected by Fed's 
QE policies. 2/3/14
  IV. Effectiveness of monetary policy
       A. Strengths
           1. Speedy and flexible
           2. Somewhat isolated from political pressure
           3. Hard money, restrictive Federal Policy, has worked well recently. 
       B. Weaknesses
           1. Easy money has not worked well.
               a. In the early 1900's, it didn't stop a recession. 
               b. Low profit expectations by business and fears over possible 
                   employment loss by workers make lower interest rates ineffective.
               c. Interest rate cuts in 2001 were not able to stop a recession.
           2. Bank deregulation has made commercial banks a less important supplier
               of investment funds thus diminishing the effectiveness of monetary policy.
 
          3. Changes in money volocity may negate some of the effects of monetary policy.
      C. Additional Readings
           1.
Monetary Policy, James Tobin: The Concise Encyclopedia of Economics
           2
. Monetary Policy Myths:
     
     3. Learning tools from European Central Bank     
               a.
Monetary Policy Game from the
               b. Inflation Island another learning tool from ECB.
           4.
On the importance of sound money 6/16/13 Global Economic Intersection
           5.
On-definitions-of-money critiques modern monetary policy 11/01/13
           6. What Caused the Recession of 1937  Global Economic Intersection 8/212/13
        .      Editors note: After WWI much of Europe had severe inflation cause severe
               apprehension that existed today.  The U.S. is apprehensive concerning high
               persistent unemployment because of  the Great Depression of 1930's.
          7.
Monetary Policy will never be the same 12/16/13
         
8. For Econ majors  The Zero Interest-rate Bound and Optimal Monetary Policy
              and When Is the Government Spending Multiplier Large?  1/31/14
            
Source: seekingalpha
  V. With QE2, FED's keep money loose, for now

      
A. What is Fed's QE2
           1. Intended or Unintended consequences?
           2. For more read
Good Loosers from 5/7/11 Economist Magazine
       B
. European Monetary Policy 3/31/11
   
    C. The Case for ending QE2 early 4/12/11
   
    D. USB- US Monetary Policy Normalizing Near after helping Japan. 4/11
      
E. Buttonwood, Forty yeas on from 8/11 of Economist Magazine
      
F. The fed is not printing money Seeking Alpha 3/19/13
      
G. The fed isn-t stupid the market is understanding monetary policy
     
 H. Bond Vigilantes try to control federal borrowing
     
 I.  Paul Krugman changed his mind on bond vigilantes 2012-12
       J  Bondvigilantes.com
comments with video on Fed and QE2 6/17/13
      
K. Why 2014 could be ugly a look at the-fed

       L. Keynesian myths monetar -central planning and the triumph of the warfare state
VII. Review key points with
Seven Macro Videos from ACDC Leadership 6/19/13
VIII. Extra Reading Japan Reflation Update

 

Practice Quizzes amosweb practice test questions by specific topic
                                 money creation, answers provided         

                                 Monetary Policy
 
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from economist.com

 

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