Deck 14: Monetary Policy

Question 1

Why do people hold bonds rather than larger savings-account or checking-account balances? Under what circumstances might they change their portfolios, moving their funds out of bonds into bank accounts?

Answer 1

Reason for Preference of bonds over savings-account or checking-account
In general, people place their funds in those investments which provide them the highest returns. These returns, or sources of additional income, may take the form of interest, dividends or capital appreciation (i.e., higher stock prices).
Among the three investment possibilities i.e. bonds, savings-account and checking-accounts, bonds pay the highest returns.
Checking-accounts do not pay any interest; whereas interest on saving-account is lesser than the returns obtained from bonds.
Thus, people prefer to hold funds in bonds over savings-account or checking accounts.
Situation under which moving of funds from bond to bank accounts is possible
The open-market operations of the Federal Reserve (Fed) determine whether people will deposit funds in bank accounts or hold bonds.
People will move out of bonds if the Fed will make bonds less attractive as an investment option. This is done by offering a high price for bonds, which will induce people to sell them and deposit their money in bank accounts.

Question 2

Suppose the Federal Reserve decided to purchase $10 billion worth of government securities in the open market.
( a ) How will M1 be affected initially?
( b ) How will the lending capacity of the banking system be affected if the reserve requirement iS₁ 0 percent?
( c ) How will banks induce investors to utilize this expanded lending capacity?

Answer 2

Supposition: Fed decides to purchase
worth of government securities in the
open market.
Find: (a) Initial impact on
(b) Impact on lending capacity if reserve requirement is
(c) The process by which banks will induce investors to utilize the extended capacity.
(a) Impact on
of an open market purchase :
The open market purchase by the Fed increases the money supply
. This can be explained as follows:
An open market purchase makes public offload their bond holdings (i.e., the public sells them) in exchange for check written on the Fed's name.
The Fed check used to buy securities gets deposited in a private bank.
The bank returns the check to the Fed, thereby obtaining additional reserves and hence the lending capacity.
Thus,
Bank deposits
Cash held by public …… (1)
Or,
…… (2)
Now, due to open market purchase,
Whereas
And,
(b) Impact on lending capacity
The purchase of
billion worth of government securities raises the bank reserves by
billion as discussed in (a) above.
Thus, total reserves increase by
Since reserve requirement equals
,
Required reserves
As required reserves
Bank deposits
Reserve requirement …… (1)
Then excess reserves
Total reserves
required reserves …… (2)
Available lending capacity
Excess reserves
money multiplier …… (3)
Where,
Money multiplier
…… (4)
Thus, available lending capacity
Thus, available lending capacity will increase by
billion if
billion worth of government securities is purchased by the Fed.
(c) Utilization of increased lending capacity
The open market purchase operation increases the bending capacity of banks, as seen in (a) and (b) above.
The banks, in turn, will try to use that expanded capacity to make more loans. To do so, they may offer lower interest rates or easier approval terms in order to encourage people to borrow (and consequently, spend more).

Question 3

If the Federal Reserve banks mailed everyone a brand-new $100 bill, what would happen to prices, output, and income? Illustrate with aggregate demand and supply curves.

Answer 3

Impact of increase in money supply by Federal Reserve on prices, output and income can be explained through expansionary policy which occurs due to shift in aggregate supply (AS) curve.
Impact of an expansionary monetary policy :
A change in money supply directly affects aggregate demand. Increase in the money supply shifts the aggregate demand curve rightward; decrease in money supply shifts it to the left.
However, the impact of monetary policy on macro-economic outcomes depends on the slope of the aggregate supply curve (
curve).
If
curve is horizontal , then monetary policy is ideal and if the economy is in a recession, expansionary policy increases output and income but not price. However, if the economy is in an inflationary phase, restrictive policy reduces prices but not output.
If the
curve is vertical , expansively monetary policy only causes inflation; the rate of output is unaffected.
If the
curve is upward sloping , expansionary policy causes some inflation and increase in output and income as well.
Thus, when the Fed mails a
billion to everyone, it pursues on expansionary monetary policy. This monetary policy will increase output and not prices if the
curve is horizontal.
However, the expansionary monetary policy will lead to some inflation as well as an increase in output and income if
curve is upward sloping. In case of a vertical
curve, expansionary monetary policy will only cause inflation with no change in output and income. This is illustrated in figure 1 below:

Question 4

Suppose the economy is initially in equilibrium at an output level of 100 and price level of 100. The Fed then manages to shift aggregate demand rightward by 20.
( a ) Illustrate the initial equilibrium ( E 1 ) and the shift of AD.
( b ) Show what happens to output and prices if the aggregate supply curve is (i) horizontal, (ii) vertical, and (iii) upward-sloping.

Question 5

How does an increase in the money supply get into the hands of consumers? What do they do with it?

Question 6

Illustrate the effects on bank reserves of an open-market sale (see Figure 14.5).

Question 7

Is a reduction in interest rates likely to affect spending on pizza? What kinds of spending are sensitive to interest-rate fluctuations?

Question 8

How did the money multiplier for large banks change when China increased its reserve requirement (Headline, p. 293)?

Question 9

If banks and credit card companies charged zero interest, would people spend and invest more? What would inhibit business or consumer borrowing?

Question 10

Which aggregate supply curve in Figure 14.6 does the Fed chairman fear the most? Why?

Question 11

Like all human institutions, the Fed makes occasional errors in altering the money supply. Would a constant (fixed) rate of money-supply growth eliminate errors?

Question 12

Congress sometimes demands more control of monetary policy. Is this a good idea? Why is fiscal policy, but not monetary policy, entrusted to elected politicians?

Question 13

Would you advocate monetary restraint or stimulus for today's economy? Who would disagree with you?

Question 14

Suppose the following data apply:
( a ) How large is the money supply?
( b ) How much excess reserves is there?
( c ) What is the money multiplier?
( d ) What is the available lending capacity?

Question 15

Why do banks want to maintain as little excess reserves as possible? Under what circumstances might banks desire to hold excess reserves? ( Hint: see Figure 14.3.)

Question 16

Assume that the following data describe the condition of the commercial banking system:
( a ) How large is the money supply (M1)?
( b ) Are the banks fully utilizing their lending capacity? Explain.
( c ) What would happen to the money supply initially if the public deposited another $20 billion in cash in transactions accounts? Explain.
( d ) What would the lending capacity of the banking system be after such a portfolio switch?
( e ) How large would the money supply be if the banks fully utilized their lending capacity?
( f ) What three steps could the Fed take to offset that potential growth in M1?