Deck 15: Monetary Theory and Policy

Question 1

Summarize the specific policies the Fed pursued during and after the Great Recession
(Great Recession) How did the Fed try to bring the economy back during and after the Great Recession? What specific policies did it pursue.

Answer 1

The Fed tried to bring the economy back during and after the Great Recession by pursuing following policies -
1. Bail out of AIG - Fed bailed out AIG by purchasing some of its troubled assets and thereby cleaning its balance sheet to some extent and prevented the AIG from busting.
This step of Fed prevented another wave of panic across financial markets as experienced by the bankruptcy of Lehman Brothers. Fed along with U.S. Treasury also made loans to AIG so that it has enough money to keep continue its operation in stable manner.
2. The Fed raised the capital requirement for banks so that they would be better equipped to stand bad economy. The Fed also tightened its supervisory role to see all its new requirements are meet by the banks in letter and spirit.
3. Fed also brought the non-banking financial institutions under its scope and control as mandated by Dodd-Frank Act. This leads to expanded oversight of Fed over the financial markets in general and large financial institution in particular.
4. Fed also framed rules with respect to steps that large financial institutions must take in case it fall into serious financial trouble so that orderly liquidation can be done without any serious collateral damage.
5. Fed undertook quantitative easing which means buying of long-term assets such as government bonds by the Fed.
This step enables the Fed to bring a decrease in long-term interest rate thereby making investment more profitable.
This quantitative easing by Fed specifically in terms of purchase of mortgage-backed securities leads to stabilization of financial market in general and housing market in particular.
It is the meltdown in housing market that has kicked-off the Great Recession.
Stabilization in this market paves the way for recovery.

Question 2

MONEY SUPPLY VERSUS INTEREST RATE TARGETS Assume that the economy's real GDP is growing.
a. What will happen to money demand over time?
b. If the Fed leaves the money supply unchanged, what will happen to the interest rate over time?
c. If the Fed changes the money supply to match the change in money demand, what will happen to the interest rate over time?
d. What would be the effect of the policy described in part (c) on the economy's stability over the business cycle?

Answer 2

a. Impact of increase in real GDP on money demand
An increase in economy's real GDP leads to an increase in the demand for money over time because more money will be needed to purchase enlarged basket of final goods and services.
b. Impact of increase in real GDP on interest rate when money supply is constant
Growth of an economy's real GDP means money demand will be more because people will need more money to purchase the bigger basket of final goods and services.
Increase in money demand must be offset by increase in money supply to attain equilibrium. But, if the money supply is kept constant by the central bank, then the increase in money demand will raise the market rate of interest.
c. Impact of increase in real GDP on interest rate when money supply is not constant
If the money supply is raised by the central bank to match the increase in money demand, then the equilibrium economy will attain equilibrium, and thereby the market rate of interest would not change.
d. Demand for money equals supply of money: economic stability
An economy can experience either expansion or contraction in its business cycle. In general, expansion is subject to the growth of real aggregate output. Similarly, contraction is the result of fall in real aggregate output.
If an economy is experiencing growth of real aggregate output, then the demand for money will increase. An increase in money supply by central bank to offset the increase in aggregate demand will reinforce the impact of expansion and thus the economic instability will also increase.
Similarly, during contraction, decrease in money supply to offset decrease in money demand will reinforce the impact of contraction, and thereby adding more economic instability.

Question 3

QUANTITATIVE EASING What's the difference between ordinary open-market purchases and quantitative easing?

Answer 3

Open market operations
Open market operations are the principal tools of monetary policy. Open market operation is the buying and selling of government securities in the open market to expand or contract the money supply in the economy.
The Federal Reserve through open market operation alters the federal funds rate - the rate at which banks borrow reserves from each other.
Quantitative easing
Quantitative easing is a monetary policy. Central bank purchases government securities and/or other securities to push down the market interest rates and to increase the money supply in the economy.
Quantitative easing is useful when short-term interest rates are at or approaching zero, and there is no printing of new currency notes by the central bank.
By purchasing assets of longer maturity, quantitative easing is used to stimulate the economy. Purchase of longer maturity assets will result in a fall in longer-term interest rates.
Quantitative easing also raises the prices of financial assets, and thereby, lowers their yield.

Question 4

Summarize the specific policies the Fed pursued during and after the Great Recession
(Quantitative Easing) Because of quantitative easing, the Fed purchased more than two trillion dollars of financial assets. Why did the Fed do this? How are these purchases reflected on the Fed's balance sheet? And why hasn't this increased the rate of inflation, at least not as of December 2013?

Question 5

MONEY DEMAND Suppose that you never carry cash. Your paycheck of $1,000 per month is deposited directly into your checking account, and you spend your money at a constant rate so that at the end of each month your checking account balance is zero.
a. What is your average money balance during the pay period?
b. How would each of the following changes affect your average monthly balance?
i. You are paid $500 twice monthly rather than $1,000 each month.
ii. You are uncertain about your total spending each month.
iii. You spend a lot at the beginning of the month (e.g., for rent) and little at the end of the month.
iv. Your monthly income increases.

Question 6

Explain how the demand and supply of money determine the market interest rate
(Market Interest Rate) With a diagram, show how the supply of money and the demand for money determine the rate of interest? Explain the shapes of the supply curve and the demand curve.

Question 7

MONEY AND AGGREGATE DEMAND Would each of the following increase, decrease, or have no impact on the ability of open-market operations to affect aggregate demand? Explain your answer.
a. Investment demand becomes less sensitive to changes in the interest rate.
b. The marginal propensity to consume rises.
c. The money multiplier rises.
d. Banks decide to hold additional excess reserves.
e. The demand for money becomes more sensitive to changes in the interest rate.

Question 8

MONETARY POLICY AND AGGREGATE SUPPLY Assume that the economy is initially in long-run equilibrium. Using an AD - AS diagram, illustrate and explain the short-run and long-run impacts of an increase in the money supply.

Question 9

MONETARY POLICY AND AN EXPANSIONARY GAP Suppose the Fed wishes to use monetary policy to close an expansionary gap.
a. Should the Fed increase or decrease the money supply?
b. If the Fed uses open-market operations, should it buy or sell government securities?
c. Determine whether each of the following increases, decreases, or remains unchanged in the short run: the market interest rate, the quantity of money demanded, investment spending, aggregate demand, potential output, the price level, and equilibrium real GDP.

Question 10

EQUATION OF EXCHANGE Calculate the velocity of money if real GDP is 3,000 units, the average price level is $4 per unit, and the quantity of money in the economy is $1,500. What happens to velocity if the average price level drops to $3 per unit? What happens to velocity if the average price level remains at $4 per unit but the money supply rises to $2,000? What happens to velocity if the average price level falls to $2 per unit, the money supply is $2,000, and real GDP is 4,000 units?

Question 11

QUANTITY THEORY OF MONEY What basic assumption about the velocity of money transforms the equation of exchange into the quantity theory of money? Also:
a. According to the quantity theory, what will happen to nominal GDP if the money supply increases by 5 percent and velocity does not change?
b. What will happen to nominal GDP if, instead, the money supply decreases by 8 percent and velocity does not change?
c. What will happen to nominal GDP if, instead, the money supply increases by 5 percent and velocity decreases by 5 percent?
d. What happens to the price level in the short run in each of these three situations?