Activity 40 Monetary Policy

1. What is monetary policy?

1. What is monetary policy? Central bank activities to Promote growth Stabilize prices Maximize employment Moderate long-term interest rates Actions by the Fed to increase or decrease the money supply, to influence the economy

2. From 1998 to 2002, what was the dominant focus of monetary policy and why?

From 1998 to 2001, the Fed wanted to slow growth to prevent inflation 2. From 1998 to 2002, what was the dominant focus of monetary policy and why? From 1998 to 2001, the Fed wanted to slow growth to prevent inflation From 2001on the Fed wanted to stimulate growth without stimulating inflation

3. Explain why the money supply and short-term interest rates are inversely related.

3. Explain why the money supply and short-term interest rates are inversely related. Money supply is money supply, regardless of the interest rate; it is perfectly inelastic because it is controlled by the Fed. However changes in the money supply and short-term (nominal interest rates) are inversely related When the Fed buys securities (to increase the money supply) banks have more checkable deposits and therefore more reserves. Banks lower rates to entice more customers Easy money policy lowers the nominal interest rate When the Fed sells securities (to decrease the money supply) banks have fewer checkable deposits and therefore fewer reserves. Banks raise rates because they have fewer customers Tight money policy raises the nominal interest rate

4. What are some reasons for lags and imperfections in data used by central banks?

4. What are some reasons for lags and imperfections in data used by central banks? Financial institutions report at specified times (ie; quarterly to stockholders) and this may not be when the Fed may necessarily needs the information most. The central bank collects data from samples and extrapolates, errors can be in the data

5. Why do many economists believe that central banks have more control over the price level than over real output?

5. Why do many economists believe that central banks have more control over the price level than over real output? Many believe real output is determined by the level of capital stock and worker productivity Thus money affects price level more than output The P in PQ rather than the Q

6. What might cause velocity to change?

6. What might cause velocity to change? Changes in how money is transferred Changes in interest rates Higher interest rates tends to increase velocity Changes in price level Higher price level tends to increase velocity

7. If velocity were extremely volatile, why would this complicate the job of making monetary policy?

7. If velocity were extremely volatile, why would this complicate the job of making monetary policy? Change in Money supply affects price level in predictable ways if velocity is constant If velocity is volatile: a change in money supply may be too small (not helping) or too large (leading to inflation)

8. What role does the money multiplier (deposit expansion multiplier) play in enabling the Fed to conduct monetary policy?

8. What role does the money multiplier (deposit expansion multiplier) play in enabling the Fed to conduct monetary policy? The multiplier (the reciprocal of the reserve requirement) times excess reserves,yields changes in the money supply

9. What is the fed funds rate?

9. What is the fed funds rate? The interest rates banks (financial institutions) lend to other banks for short term borrowing (overnight loans from their excess reserves at their Fed account to another’s)

10. What happens to the fed funds rate if the Fed follows a contractionary (tight money) policy?

10. What happens to the fed funds rate if the Fed follows a contractionary (tight money) policy? The federal funds rate increases

11. What happens to the fed funds rate if the Fed follows a expansionary (easy money) policy?

11. What happens to the fed funds rate if the Fed follows a expansionary (easy money) policy? The federal funds rate decreases

12. Why do observers pay close attention to the federal funds rate?

12. Why do observers pay close attention to the federal funds rate? It is a leading indicator (early indicator) of monetary policy and a forecast of the direction for other interest rates and for Fed assessment of the direction of the economy