Term
| Origins of the Federal Reserve |
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Definition
| The Federal Reserve began in 1913. Prior to that, there was too much hostility to give the central bank too much power. When a need for a central bank arose, they created the Federal Reserve, and split it into 12 regional banks to diffuse power |
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Term
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Definition
There are 12 banks that make up the Federal Reserve
-The most important one is the NYC one
-Their involvement in monetary policy is that they establish the discount rate, decide who gets Federal Reserve loans, and five of the 12 bank presidents vote in the FOMC |
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Term
| Why is NYC the most important Fed Reserve Bank? |
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Definition
-It is the largest, makes up 25% of reserves
-It is the only Fed Bank that is a member of the BIC, bank for international settlement
-Therefore, it is the only Fed bank in the foreign exchange market |
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Term
| Federal Reserve Bank's Involvement in Monetary Policy |
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Definition
-The 12 banks establish the discount rate (even though it is reviewed by the board of directors)
-Get to decide which banks get to borrow Federal Reserve Loans
-5/12 of the banks presidents are on the FOMC, or federal open market committee, who make open market decisions |
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Term
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Definition
This is a 7 member board of governors who reside in Washington DC
-They are all appointed by the president, and then confirmed by the Senate
They are involved in Monetary policy by
-they have all 7 members vote on the FOMC, so have majority
-set the reserve requirements
-Review, and thereby control, the discount rate set by the Fed banks
-Chairmen of the board advises the president on economic activity! |
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Term
| Board of Governors involvement in Monetary Policy |
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Definition
They are involved in Monetary policy by
-they have all 7 members vote on the FOMC, so have majority
-set the reserve requirements
-Review, and thereby control, the discount rate set by the Fed banks
-Chairmen of the board advises the president on economic activity! |
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Term
| Non Monetary Policy Duties of Board of Governors |
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Definition
-Set the salary for the president and all officers in the Federal Reserve
-Approves of bank mergers and bank applications
-Supervises foreign banks in the US |
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Term
| The Federal Open Market Committee (FOMC) and its duties |
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Definition
-It is made up of 5/12 of the Federal reserve banks (1 of which is always NYC), and all 7 board of governors, to make a team of 12
-Meets 8 times a year and makes OPEN MARKET DECISIONS
-Sets the Federal Funds Rate (interest rate on Overnight Loans from Federal Reserve)
-Commonly referred to the "Fed"
-Chairmen of Board of Governors = Chairmen of FOMC |
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Term
| Which part of Federal Reserve has the Most Power? |
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Definition
The FOMC!
-The FOMC controls the open market operations, the Fed's most powerful too for conducting Monetary Policy
-The FOMC advises the discount rate and reserve requirement. While they are set by the Banks/ board of governors respectively, can effect almost all policies! |
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Term
| The Chairmen of the FOMC's Power |
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Definition
-He is technically just 1/12 vote on the FOMC, but...
-He is the spokesperson, by addressing public and negotiating with congress/president
-Sets agenda for Board of Governors and FOMC meetings
-Influence over other board members, based on their personality |
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Term
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Definition
| This is one of the two types of bank independence the Fed has. It is the ability the central bank has to set its own monetary policy |
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Term
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Definition
| This is one of the types of bank independence the Fed has. It is the ability of the central bank to set its own monetary policy goals |
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Term
| Two types of Fed/Bank Independence |
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Definition
The Fed has both
-instrument independence (sets own policy)
-Goal independence (sets own goals) |
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Term
| Is the Fed Independent? Why? |
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Definition
Overall the Fed is very independent!
-Has both goal and instrument independence
-Each member has 4 year NON-Ousted term
-Cannot renew term, so no incentive to build political relations!
-Fed makes their own money through fed bank securities, doesnt rely on congress for $ |
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Term
| Case for Fed Being independent |
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Definition
-Best run without political influence
-Subjecting Fed to political influence would lead to bias
-Could lead to political business cycles, where there is expansionary policy before an election (lowering of interest rate), and contradictory policy right after one!
DONT WANT FED RUN BY POLITICS OR ELECTIONS |
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Term
| Case for Fed not being independent |
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Definition
-Considered undemocratic
-Makes Fed less accountable, they can "do whatever they want"
-makes it difficult to coordinate monetary policy
*EVEN STILL, Fed is considered very independent |
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Term
| Expansionary Monetary Policy |
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Definition
| Increasing the money supply (decreasing the interest rate) in order to stimulate the economy |
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Term
| Contracitonary Monetary Policy |
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Definition
| Decreasing the money supply (increasing the interest rate) in order to reduce inflation/ stimulate the economy |
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Term
| What dictates The Fed's/FOMC's behavior? |
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Definition
The Theory of Bureaucratic Behavior!
This states that bureaucracies/ the Fed behave like consumers, and do not "serve the public"
-Because of this, these bureaucracies behave to maximize their own profits/ welfare
*The Fed behaves like this (maximizes own welfare), but not to the extreme of ignoring public need |
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Term
| Theory of Bureaucratic Behavior |
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Definition
This is the idea that bureaucracies behave like consumers, seeking to maximize their own benefit, and do not "serve the public."
*The Fed behaves like this (maximizes own welfare), but not to the extreme of ignoring public need |
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Term
| European Central Bank (ECB) |
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Definition
This is the central bank for the countries in the European Union!
-It is patterned like the Fed, with a couple of differences!
Central bank of each country = Fed Reserve District Banks |
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Term
| Differences Between the ECB and the Fed |
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Definition
1) The Fed's budget is controlled by board of governors, while the budget for the ECB national banks is governed by their own, and the ECB's budget
2) ECD decisions aren't as centralized, because each country manages own budget
3)Fed oversees/ regulates the financial institutions, while the ECB lets own national banks handle that |
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Term
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Definition
YES! Most independent central bank in the world
-executive boards have long terms
-determines own budget with collection of national banks |
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Term
| Overall, the international trend is to make more central banks |
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Definition
| Independent from their country's government! |
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Term
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Definition
| The mechanism that determines the level of money supply |
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Term
| 3 players in the money supply process |
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Definition
1. The central bank - Fed oversees Money supply
2. The Banks/ Depository Institutions - Accepts deposits and makes loans
3. Depositors - Individual People |
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Term
| Who is the Most important Player in the Money Supply Process? |
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Definition
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Term
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Definition
| This is how the Fed balances the money supply. It is made up of the Feds Liabilities (currency in circulation, reserves) and Assets (Securities, loans to financial institutions) |
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Term
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Definition
The Fed's liabilities are made up of the currency that is in circulation (cash people have), and the reserves they have in banks
THE FEDS LIABILITIES ARE WHAT MAKE UP THE MONETARY BASE! |
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Term
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Definition
This is the amount of money that is considered a liability to the Federal Reserve. It is made up of:
-Currency in Circulation
-Reserves
MB = C + R |
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Term
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Definition
This is one of the Fed's 2 liabilities that make up the monetary base!
-It is the amount of currency held by the public
(Money held by banks is considered reserves) |
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Term
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Definition
This is one of the 2 types of Liabilities for the Fed that make up the monetary base.
-It is considered bank held money at the Federal reserve, and the money banks hold in their own vault
-AKA what banks have
NOTE: Reserves are assets for a bank, but liabilities for the FED |
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Term
| Why are reserves a Fed Liability |
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Definition
| When banks ask the Fed for payment on their reserves, the Fed MUST pay them for that. |
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Term
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Definition
| This the positive side of the Fed's Balance sheet. It is made up of Securities and Loans to Financial Institutions |
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Term
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Definition
This is one of the Fed's two assets.
The Fed holds US securities issued by the treasury.
-The Fed purchases these securities and then the banks take them as reserves
-This increase in reserves then increases the Monetary base and thus the Money supply! |
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Term
| Fed Loans to Financial Institutions |
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Definition
This is one of the two types of Fed Assets.
-The Fed makes loans to banks, which is called borrowing from the Fed or increasing "Borrowed Reserves"
-These appear as liabilities for banks, but Assets for the Federal Reserve!
*The interest rate on the Fed's loans is called the discount rate!
(The Fed gives out discount loans) |
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Term
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Definition
| This is a rate that is established by the Federal Reserve banks but reviewed by the board of governors and the FOMC. It is the interest rate in which banks can get borrowed reserves, or discount loans, from the Federal reserve |
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Term
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Definition
1. Required Reserves (Reserves the Fed makes a bank hold)
2. Excess Reserves (Reserves that a bank chooses to hold beyond the reserve required amount) |
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Term
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Definition
Fed Reserves that are required by banks to be held by the Fed
Usually a percentage of reserves much be held, dictated by the reserve ratio |
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Term
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Definition
| Reserves that a bank holds that is beyond the Fed's Required reserve ratio |
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Term
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Definition
| The fraction/percentage that must be held as reserves when a bank takes out Fed reserves |
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Term
| What is the primary way the Fed controls/ changes the monetary base? |
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Definition
Open Market Purchases!
-Bonds bought by the fed is a purchase, bonds sold by the fed is an open market sale |
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Term
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Definition
| It is a way to study open market operations. It is a T chart of a banks balance sheet |
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Term
| How does an open market purchase of bonds effect the amount of reserves? |
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Definition
It depends on what the seller of those bonds does with the sale!
-It the sale goes into currency, it has no effect on reserves
-It if goes into deposits, reserves will increase by that amount |
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Term
| Do open market purchases effect reserves or Monetary Base more? |
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Definition
| Overall, open market purchases impact reserves more than monetary base |
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Term
| Buying securities (bonds) increases Fed assets, and where they put it dictates its liabilities, and thus the monetary base |
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Definition
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Term
| Other Factors on the Monetary Base besides Currency and Reserves |
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Definition
1. Floats - time between Fed increasing reserves and when it becomes available
2. Treasury Deposits - When the US treasury moves deposits from commercial banks to the Fed, decreasing monetary base |
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Term
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Definition
| This is one of the random factors of Monetary Base. It is The time between Fed increasing reserves and when it becomes available |
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Term
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Definition
| This is one of the random factors of monetary base. It is When the US treasury moves deposits from commercial banks to the Fed, decreasing monetary base |
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Term
| How much of the Monetary Base does the Fed Control |
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Definition
The Fed controls the monetary base that is not borrowed, or non borrowed reserves. Therefore
MBn = MB - BR
BR = borrowed reserves
MB = Monetary base
MBn = monetary base controlled by Fed |
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Term
| Multiple Deposit Creation/ Expansion theory |
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Definition
This is the concept of when the Fed gives the bank 1 dollar in loans/ reserves, the deposits created is a multiple of that, via a trickle down effect
THIS IS CAUSED BY:
The Fed giving out 100m in loans, which increases reserves by 100m. that bank then does the required reserve ratio, and the rest goes to loans of their own! The next bank does the same, and the same, etc.
This makes total deposits equal:
D = 1/rr x R
D = change in deposits
rr = reserve ratio
R = change in reserves
over and over until the loan from the Fed is expanded! |
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Term
| Critiques of the Multiple Deposit Expansion Theory |
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Definition
-Banks can turn their some of their excess reserves into cash, and holding money doesnt go through deposit expansion
-banks may not use all of it to filter through deposit expansion |
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Term
| Factors that Change Money Supply |
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Definition
-Non Borrowed Monetary Base
-Borrowed reserves
-Reserve ratio
-Currency Held
-Excess Reserves |
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Term
| Non Borrowed Monetary Base on Money Supply |
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Definition
| As MBn increases, the money supply increases |
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Term
| Borrowed Reserves on Money Supply |
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Definition
| As BR increases, the money supply increases |
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Term
| Reserve Ratio on Money Supply |
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Definition
| As the rr increases, MS decreases (less in checkable deposits!) |
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Term
| Currency Held on Money Supply |
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Definition
| As currency held increases, the MS decreases (currency doesn't expand like checkable deposits, reduces supply) |
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Term
| Excess reserves on Money Supply |
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Definition
| As excess reserves increases, the MS decreases (more excess reserves means less checkable deposits, which means less deposit expansion) |
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Term
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Definition
This is how much the money supply changes given a Monetary base. It is the relationship between MB and MS.
It is written as:
MS = m x MB
m = 1 + C/ (rr + e + c)
c = currency ratio (currency in circ/checkable deposits)
e = excess ratio = (excess reserves/ checkable deposits
rr = reserve ratio |
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Term
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Definition
MS = m x MB
OR
MS = (1 + C)/(rr + e + c) x MB
This shows how MS increases when Monetary Base MB increases
-It shows MS decreases when reserve ration rr increases
-It shows how MS decreases when currency held (currency ratio c) increases
- It shows how MS decreases when excess reserves (excess reserve ratio e) increases |
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Term
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Definition
This is denoted as required reserves PLUS excess reserves demanded
-It is written as a regular demand curve, until the federal funds rate hits the interest rate for reserves!
*The FF rate can NEVER be below the interest rate for reserves |
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Term
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Definition
It is denoted as borrowed reserves plus non borrowed reserves supplied
-it is written as a vertical curve, until the FF rate meets the discount rate, then it becomes horizontal.
*The FF rate can NEVER exceed the discount rate |
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Term
| Market for Reserves Graph |
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Definition
It is denoted with quantity reserves on the x axis, and the FF rate on the Y axis. The intersection between reserves demanded and reserves supplied is the reserves from the Fed.
NOTE: the restrictions on the graph are that the FF rate can never exceed the discount rate, which is why the supply curve goes horizontal at the top
-the FF rate can never be lower than the interest rate demanded for reserves, which is why the supply curve tails off |
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Term
| 3 ways to alter the FF rate |
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Definition
the three ways the FF rate can be altered is:
1) Open market operations
2) Reserve Requirements
3) Interest Paid on Reserves
All three involve shifts in the Reserve Market Graphs! |
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Term
| Open Market Purchases on the FF rate |
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Definition
| Open market purchases by the Fed and the FOMC increase reserves supplied, shifts the curve right, and then decrease the FF rate! (or keep it constant if its at the interest for reserves) |
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Term
| Open Market Sale on the FF rate |
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Definition
| An open market sale reduces the amount of reserves supplied, shifts the curve left, and increases the federal funds rate! |
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Term
| Reserve requirements on the FF rate |
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Definition
Increasing the reserve ratio increases the demand for reserves. This shifts the demand curve to the right, and increases the FF rate!
*Remember the bottom slides with the original part, that represents how the FF rate cannot be below the interest rate for reserves |
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Term
| Interest Paid on reserves |
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Definition
| When interest paid on reserves increases, the horizontal part of the reserve demand curve increases and shifts up, potentially increasing the FF rate! |
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Term
| Conventional Monetary Policy Tools Used by the Fed |
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Definition
-Open Market Operations
-Discount Loans
-Reserve Requiremnets |
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Term
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Definition
This is the most important conventional tool used by the Fed.
They are purchases or sales made by the Fed, intended on changing the levels of reserves and monetary base
2 types!
-Dynamic
-Defensive
Temporary ones are either done as:
-Repo
-Reverse Repo |
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Term
| 2 types of Open Market Operations |
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Definition
1) Dynamic Open Market Operations - purchases or sales by the Fed intended on changing reserves or Monetary Base
2) Defensive Open Market Operations - Purchases or Sales by the Fed, in response to Treasury Deposits or Float changes to offset them |
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Term
| Dynamic Open Market Operations |
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Definition
| This is one of the two types of Open Market Operations, the Feds most important tool. It is purchases or sales by the Fed intended on changing levels of reserves of MB |
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Term
| Defensive Open Market Operations |
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Definition
| This is one of the two types of Open Market Operations, the Fed's most important tool. It is purchases or sales by the Fed in response to random Float or Us Treasury deposit changes, and are done to offset them |
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Term
| 2 Types of temporary Open Market Operations |
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Definition
Temporary Open Market Operations are done by the Fed usually in order to help a bank or something in the short term. The types are:
1) repurchase agree (repo) - the Fed purcahses securites, agreeing to seller will buy them back shortly after
2) Mathced Sale-Purchase transaciton (reverse repo) - this is when the Fed sells securities (needs money) and agrees to buy them back in the future |
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Term
| Repurchase Agreement (Repo) |
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Definition
| This is one of the two types of temporary Fed Open Market operations. it is when the Fed buys securities from a bank, and the selling bank agrees to buy them back a short time later |
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Term
| Matched Sale Purchase Transaction (Reverse Repo) |
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Definition
| This is one of the two types of a temporary open market operation. It is when the Fed ironically needs money, so it sells securities to a bank, agreeing to buy them back in the future |
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Term
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Definition
| This is where banks can get discount loans/ borrowed reserves from the Fed |
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Term
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Definition
This is one of the 3 Conventional tools for monetary policy used by the Fed. It is broken up into 3 types
-primary
-secondary
-seasonal
and it essentially borrowing reserves from the Fed |
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Term
| 3 Types of Discount Loans |
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Definition
The different types of discount loans, a tool used by the Fed.
-Primary Credit
-Secondary Credit
-Seasonal Credit |
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Term
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Definition
This is one of the types of discount loans, a tool used by the Fed.
-It is the idea that a bank can borrow as much as they want, so long as they pay it back in a short amount of time. They are charged the discount rate
*This gives banks a safety net, so that the FF rate never exceeds the discount rate on reserves |
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Term
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Definition
This is one of the types of discount loans, a conventional tool used by the Fed.
-This is when banks are in great danger and liqudity problems, so they are given loans.
In this instance, they are charged 0.5 of the discount rate to repay |
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Term
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Definition
This is one of the types of discount loans, a conventional tool used by the Fed to dictate Monetary Base and Money Supply.
-This is when smaller banks recieve loans based on the season they are in
EX: receiving loans in the winter for agricultural areas |
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Term
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Definition
-The role the Fed plays to dole out money when no one else will, in order to prevent bank panics
-This is done by providing discounts and loans to stabilize economy
*FDIC can't cover too many bank failures, Fed must be careful to not use this too often |
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Term
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Definition
| This is one of the conventional tools used by the Fed in order to control Money Supply. By increasing the reserve ratio it effectively changes the money multiplier and reduces money supply. |
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Term
| 4 Advantages of Open Market Operations over the other Fed Monetary policy Tools (Discount Lending and Reserve Requirements) |
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Definition
1) Fed has complete control on the volume of open market operations
2) Flexible and precise (can be done at any time)
3) Easily reversed if a mistake occurs
4) Can be done quickly! No administrative delays |
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Term
| Non-conventional Fed Monetary Policy Tools |
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Definition
These are used during times of crisis! They are
1) Liquidity Provisions - when the Fed increases liqudity to banks, either by increasing the discount window (less of a discount rate), or borrowing using a team auction faciltity
2) Asset Purchase - This is when the Fed goes beyond buying government securities, and buys other ones such as Mortgage or Treasury Securities |
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Term
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Definition
| This is one of the non conventional monetary policy Fed tools. It is when the Fed increases liqudity to banks, either by increasing the discount window (less of a discount rate), or borrowing using a team auction faciltity |
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Term
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Definition
| This is one of the two non conventional Monetary Policy Tools used by the Fed. It is when the Fed goes beyond buying just government securities, and purchases other ones such as mortgage securities or US treasury securities |
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Term
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Definition
| This is levels of low and stable inflation. It is the primary goal of the Fed! |
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Term
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Definition
A nominal variable which is tied to the price level and used to attain price stability
-a variable used to attain economic goals in stable inflation/price level |
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Term
| Time Inconsistency Problem |
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Definition
The Problem with wasting time dedicated to a long term plan by focusing on short term problems.
-It is the idea that monetary policy is day to day, so focusing on a long term goal becomes difficult
-Shows the need for a nominal anchor |
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Term
| Why is Price Stability the Number one Goal of the Fed? |
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Definition
| In the long run, you do not sacrifice price stability with any other Fed goal stability (output, interest rate, unemployment, economic, etc) |
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Term
| 2 Ways to deal with Fed Goals (or mandates!), given that price stability involves tradeoffs with other economic goals in the short run |
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Definition
| The two mandates are the Hierarchical and the Dual Mandate. They are different ways to go about the tradeoffs between price stability and other goals of the Fed in the short run |
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Term
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Definition
| This is a way to solve the tradeoff of price stability and other goals in the short run. This is the idea that you must set an accomplish your primary goal (price/infation stability) first, once that is met, your then work on your other goals |
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Term
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Definition
| This is a way to solve the tradeoff of price stability and other monetary policy goals in the short run. When you view your primary Monetary Policy Goal as much as you another, and you strive for them equally |
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Term
| Results between the Hierarchical and Dual Mandate Debate |
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Definition
In the long run, price stability is seen as Hierarchical, being the most important compared to the other goals.
-In the short run, the mandate chosen does not matter, whether you pick hierarchical or dual. |
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Term
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Definition
This is announcing to the public that price stability is your number one goal, with inflation rate as the nominal anchor, to set an inflation goal. The steps are:
1)public announcement of media target inflation
2) Commitment to achieve that goal
3) Information inclusive approach, including all on the info gathered
4) increased transparency to the public on monetary policy
5) Increased accountability for the central bank for attaining objectives |
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Term
| Inflation Targeting Steps |
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Definition
1)public announcement of media target inflation
2) Commitment to achieve that goal
3) Information inclusive approach, including all on the info gathered
4) increased transparency to the public on monetary policy
5) Increased accountability for the central bank for attaining objectives |
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Term
| How Inflation Targeting has worked in other countries |
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Definition
-In New Zealand it has brought inflation down, growth is up, and unemployment down
-In UK inflation is at target, growth has surged, and unemployment is decreasing
OVERALL it has worked well |
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Term
| Advantages of Inflation Targeting |
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Definition
-Do not rely on one variable to attain goal (all focus on inflation goal)
-Easily understood
-Reduces the Time inconsistency problem, focuses monetary policy on the long term
-Makes Central Bank Accountable |
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Term
| Disadvantages of Inflation Targeting |
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Definition
-Delayed signaling: AKA inflation doesn't yield immediate results, won't know for a bit if its working
-Too much rigidity, or that it focuses too much on inflation goal
-Potential for output fluctuation in short run
-Low economic growth - during periods of delation, there is low economic growth! |
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Term
| Fed's Just Do it Strategy |
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Definition
-Fed would implicitly inflation target, using the inflation rate as their anchor, but never explicitly to the public stated plans.
-Close to inflation targeting but not transparent with public! |
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Term
| Advantages of Just Do it Approach |
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Definition
-It allows for looking into the future, not focused on present value of inflation taget
-not specific to one nominal anchor
-allows focusing on price stability without pressure from politicians for expansionary policy
-Increase interest rate with less fall back! |
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Term
| Disadvantages of Just Do it Approach |
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Definition
-Lack of Transparency, guessing on what Fed will do next
-Fed becomes less accountable for actions
-STRONG dependence on those who run the Fed and their decisions |
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Term
| Lessons From Global Financial Crisis |
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Definition
1) developments in financial sector have greater economic impact that we realized
2)Non conventional MP tools lead to economic uncertainty
3)Cost of cleaning up financial crisis is high
4) Price and output stability do not mean financial stability |
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Term
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Definition
When the price of an asset increases from fundamental values, eventually resulting in a burst and then a crisis!
(Housing bubble bursting caused global financial crisis) |
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Term
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Definition
This was a document stating that instead of trying to stop bubbles from happening, we should accept that they happen and focus on picking them up after they pop. It stated that because
1)It is impossible to identify asset price bubbles
2)Bubbles are not normal economic behavior, so normal tools will not work
3) Difficult to implement policies towards one asset
4) Lowering prices of asset has negative effects on rest of economy
5)If you respond quickly and aggressively you can handle a burst bubble
*This proved correct in 1987 and in 2000 during the stock market crashes |
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Term
| 2 Types of Market Bubbles |
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Definition
1) Credit Driven Bubbles
-When credit increases causing an asset price to rapidly increase. When bubble crashes, prices plummet, causing severe losses
2) Irrational Exuberance Bubble
-Bubbles that are driven only by optimistic expectations, and prices skyrocket due to consumer expectations.
*Irrational Expectation bubbles are much less dangerous |
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Term
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Definition
| One of the types of Market Bubbles. It is When credit increases causing an asset price to rapidly increase. When bubble crashes, prices plummet, causing severe losses |
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Term
| Irrational Exuberance Bubbles |
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Definition
| This is one of the two types of market bubbles. It is when Bubbles that are driven only by optimistic expectations, and prices skyrocket due to consumer expectations. |
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Term
| Eliminate Credit Bubble Approach |
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Definition
This is the opposite of the Greenspan Doctrine, believing that monetary policy to try to stop bubbles from occurring. Utilizing macroprudential policy, or implementing regulatory policy to affect the credit market and reduce risk. Therefore, you should conduct monetary policy so that you prevent these credit boom risks
*THIS Does not work, because the greenspan doctrine is valid, and macroprudential strategies of overseeing are very biased politically |
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Term
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Definition
This is a variable that responds to one of the Fed's Monetary Policy Tools (OMO, Reserve Requirements, Discount rate/loans) and indicates how well it is working! (how tight the policy is)
There are 2 types!
-Reserve aggregates (how much reserve is left over
-Interest rates based on MP (like FF rate)
-You can also use intermediate targets, or links between policy instruments and goals on monetary policy (not affected directly by goals)
*THE Fed Uses Interest rates as their policy instrument |
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Term
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Definition
This is how the Federal Funds Rate is Calculated. It is that the Federal funds rate target should be the inflation rate, plus the equilibrium FF rate, plus the average of the output and inflation gap!
*It is a rule to calculate the FF rate |
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Term
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Definition
| It is the idea that you should raise the nominal interest rate higher than the inflation rate, so the real interest rate is always higher than the inflation rate |
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Term
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Definition
The quantity theory of money is
M x V = P x Y
*where aggregate income and money velocity are constant, therefore price is related to the Money supply!
Can be changed to:
P = (M x V)/Y |
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Term
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Definition
Periods of extremely high inflation, or more that 50% increases a month!
-Zimbabwe increased their money supply to those heights, go insanely high price levels |
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Term
| Government Budget Constraint |
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Definition
The govt budget deficit is equal to its expenditure minus its Tax revenue, or the change in Monetary Base plus the change in bonds held by the public
G = G-T = MB + B |
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Term
| Keynesian Theory Of Money Demand |
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Definition
Keynes felt that the demand for money was the same as the Liqidity Preference Theory, and that we have 3 motives for wanting money. Those 3 motives are:
1) transactions motive - People hold money as a medium exchange/ way to pay for things. (the more ways to pay for something, the less demand for money there is)
2) Precautionary Motive - the idea that we hold money just in case something we want to buy comes up or an emergency arises
3) Speculative Motive - People hold onto money to store their wealth, hold it for a specific value
Keynes felt money velocity was NOT constant, and therefore overall, money demand was dictated by income positively and the nominal interest rate negtively |
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Term
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Definition
| This is one of the 3 motives in the Keynesian theory of money demand. It states that we hold onto money because it is a medium of exchange, or a means to buy something |
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Term
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Definition
| This is one of the 3 motives for the Keynesian Theory of Money Demand. It is the idea that people hold onto money incase something comes up, either they can to buy something or they have an emergency |
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Term
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Definition
| This is one of the 3 motives in the Keynesian Theory of Money. It states that people hold onto money to store their own wealth/ value |
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Term
| 2 Factors of Money Demand in the Keynesian Theory of Money |
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Definition
Income increases, Money demand increases
Nominal Interest Rate increases, money demand increases |
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Term
| Portfolio Theory of Money |
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Definition
Expanded on the Keynesian Theory of money demand, saying there were other factors that influenced it! Including:
-interest rate
-income
-payment technology
-wealth
-Risk
-Liqudity of Other Assets |
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Term
| Determinants of Money Demand |
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Definition
-Interest Rate
-Income
-Payment Technology
-Wealth
-Risk
-Liquidity of Other Assets |
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Term
| Interest Rate of Demand for Money |
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Definition
| Interest rate increases, MD decreases |
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Term
| Income on Demand for Money |
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Definition
| Income increases, MD increases |
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Term
| Payment Technology on Demand for Money |
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Definition
| Payment Technology increases, MD decreases |
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Term
| Wealth on Demand for Money |
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Definition
| Wealth increases, MD increases |
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Term
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Definition
| Risk increases, MD decreases |
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Term
| Liquidity for other assets on Demand for Money |
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Definition
| Liquidity for others increases, MD decreases |
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Term
| Interest Rate Sensitivity on Money Demand |
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Definition
The more sensitive money is to the interest rate, the less likely predicting money demand is!
-Less Sensitive = more likely velocity to be constant
-Therefore, the less sensitive to the interest rate, the better predicted the quantity of money demanded will be (using the quantity theory of money) |
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Term
| How does the Fed tighten or loosen their monetary policy? |
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Definition
They do so by adjusting the rate, and therefore adjusting the real interest rate!
Tighten = raise FF rate = Raise real interest rate
Loosen = Decrease FF rate = Decrease Real interest rate |
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Term
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Definition
The MP curve is a relationship between the inflation rate and the real interest rate. The curve is Upward sloping!
-Real interest rate and inflation rate are positively related! |
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Term
| Taylor Principle Written out, if it wasn't Followed! |
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Definition
The taylor principle states that you must raise nominal interest rates above inflation, so that real interest rates are always above inflation. Therefore, you must RAISE interest rates when inflation increases, to sustain normal levels of output.
Written out when not followed, it creates a cycle:
inflation increases, interest rate decreases, income increases, which then raises inflation more, which means you must reduce interest rate more, which means output rises even more!
MUST increase interest rate to reduce inflation! |
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Term
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Definition
There are 2 types, automatic and autonomous
1. automatic - this is when you move ALONG the MP curve, due to the taylor principle (stabilizing inflation by increasing interest rate)
2. Autonomous - tightening or easing, when you SHIFT the MP curve up or down by raising the real interest rate for all levels of inflation |
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Term
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Definition
The relationship between the inflation rate and aggregate demand when the market is in equilibrium
It is denoted as
Y = C + I + (G-T) + NX |
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Term
| Factors for shifts in the AD Curve |
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Definition
-Consumption
-investment
-government expenditure
-taxes
-net exports
-financial frictions
*Autonomous tightening/loosening of Monetary Supply! |
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Term
| Autonomous Tightening of MP on AD curve |
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Definition
| Tightening raises the real interest rate, which decreases investment spending, and in turn shifts the AD curve to the left |
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Term
| Autonomous Loosening of MP of AD Curve |
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Definition
| Loosening lowers the real interest rate, which increases investment spending, and then shifts the AD curve to the right |
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Term
| Long Run Aggregate Supply |
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Definition
The economy behaves at the natural rate of unemployment in the long run! AKA demand for labor = supply for labor, approx 5%
-Therefore the LRAS curve is vertical, performing at the output potential Yp |
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Term
| Consumption on the AD curve |
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Definition
| Consumption increases, AD shifts right |
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Term
| Investment on the AD curve |
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Definition
| Investment increases, AD curve shifts right |
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Term
| Net exports on the AD curve |
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Definition
| NX increases, AD curve shifts right |
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Term
| Government Expenditure on AD Curve |
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Definition
| G increases, AD shifts right |
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Term
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Definition
| T increases, AD shifts left |
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Term
| Financial Friction on the AD curve |
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Definition
| f increases, AD shifts left |
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Term
| 3 Factors on Short Run Aggregate Supply |
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Definition
1. Expectations of Inflation (increase, makes inflation also increase)
2. Output gap (increases, makes inflation increase
3. Price (supply) shocks, makes inflation increase/ decrease |
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Term
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Definition
-Total capital in economy
-Labor in economy
-Available technology
-Natural employment level |
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Term
| Total Capital in Economy on LRAS |
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Definition
| Total capital increases, LRAS moves right |
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Term
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Definition
| Total Labor increases, LRAS moves right |
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Term
| Available Technology on LRAS |
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Definition
| Technology increases, LRAS moves right |
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Term
| Natural Rate of Unemployment on LRAS |
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Definition
| Natural Rate of Unemployment increases, LRAS shifts to the left |
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Term
| Expected inflation on SRAS |
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Definition
| Expected inflation increases, SRAS shifts right |
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Term
| Positive price shock on SRAS |
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Definition
| A positive price shock will shift the SRAS to the right |
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Term
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Definition
| An increase in the output gap will shift the SRAS to the right |
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Term
| Self Correcting Mechanism |
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Definition
This is the concept of how over time the economy eventually produced output at the natural level, based on the natural level of unemployment. So when there is a SRAS shift, so that AD and SRAS are not intersecting with LRAS, eventually it will move back to that equilibrium point
*HOW Fast this occurs depends on price stickiness, or how resistant prices are to changes! |
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Term
| 2 ways to respond to an aggregate Demand Shock |
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Definition
1) no response - allowing for the self correcting mechanism to eventually bring the AS curve to a natural intersection point with the AD curve, back on the LRAS curve. With this method however, it takes a lot of time, AND there is a change in inflation! (Down if demand decreases, up if demand increases)
2) Policy to fix demand - you can set policies, AKA tighten/loosen monetary policy via the FF rate, to set AD back to its original point after a shock!
*There is no tradeoff between price stability policy and economic policy when responding to a demand shock! In other words, implementing policy to stabilize inflation DOES NOT CHANGE Output in response to a demand shock |
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Term
| 2 Ways to Respond to A permanent Supply Shock |
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Definition
1) Do nothing. A permanent supply shock will have the economy eventually adjust itself back to a natural level of unemployment. The demand would remain the same, and eventually the SRAS would intersect at the new LRAS supply. However, this can lead to changed in inflation, and takes a while!
2) implement inflation stabilizing policy
-implement a policy that would shift the AD curve along with the LRAS curve. This would bring inflation back down to the original target point, but at the new natural rate of output
**there is no tradeoff between price stabilizing policy and economic stability, because the economy is performing at the new natural rate of unemployment |
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Term
| 3 ways to respond to a temporary supply shock |
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Definition
1) not respond
-The SRAS curve may move to the left/right, but over time, it will return to the natural rate of unemployment, and shift BACK to where it once was. However, it takes a long time and the economy hurts during those times
2)Policy to stabilize inflation
-You can tighten monetary policy to bring the AD curve left and stabilize the target inflation level during a negative supply shock, however doing so actually decreases the output even further! Additionally, when the supply goes back to the LRAS at natural unemployment, you must reverse the policy
3) Stabilize economic activity.
-During a negative supply shock, you can choose to increase demand by loosening the monetary policy and reducing the interest rate, which will shift the AD curve up, and back to a point where natural output is. However, to do so, you increase inflation!
*There IS a tradeoff between economic stability (output) and price stability (inflation) in the short run supply shock response |
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Term
| Nonactivist View to Shocks |
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Definition
This is the view that you should not implement policies, because prices are flexible, and the economy will use the self correcting mechanism after a shock!
*AKA prices changes easily, so inflation will correct itself in the long run, must allow economy to do so |
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Term
| Activist/ Keynesian View of Shocks |
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Definition
These economist feel that prices are sticky, or that they are resistant to change. Therefore, in response to shocks, you must implement policy to help stabilize the economy/ prices.
Keynes famously said, "in the long run, we are all dead" meaning that we cannot wait for the stabilization process |
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Term
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Definition
These are time constraints for implementing policies in response to shocks. The amount of lag works in favor of the non activist approach. The types of lag are
-data lag
-recognition lag
-legislative lag
-implementation lag
-effectiveness lag |
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Term
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Definition
| this is the time is takes for policy makers to obtain data on whats going on in economy |
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Term
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Definition
| This is the time it takes policy makers to decide what the data means/ is signaling |
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Term
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Definition
| This is the time it takes to pass legislation to implement a policy change |
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Term
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Definition
this is the time it takes to change a policy tool, ex change the interest rate, once a policy has gone through legislation
(this lag doesn't take very long for monetary policy, Fed can just adjust FF rate) |
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Term
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Definition
| This is the time it takes for the new policy tool to be effective on the economy |
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Term
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Definition
| The relationship between inflation and unemployment. It shows how there is no tradeoff between the two in the long run, but there is in the short run |
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Term
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Definition
| This is the negative relationship between the output and unemployment gaps. The more you produce, the less unemployment there is |
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Term
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Definition
| The result of the Fed targeting unemployment as a goal, trying to stabilize it at the natural rate. Short run aggregate supply is shifted left due to workers demand higher wages, due to expected inflation or more for their productivity. This demand for higher wages causes the AS curve to shift left, and to compensate the Demand curve shifts right. This keeps the Y level the same on the LRAS, but inflation increases. Workers will continue to do this seeing the success, shifting the AS left and forcing the Fed to shift AD right. The constant rise in inflation is called COST PUSH inflation |
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Term
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Definition
| This occurs when the Fed puts unemployment as its goal, but the target unemployment is too low, or the target output is too high. The Fed will implement monetary policy to increase demand, and the supply will shift due to the self correcting mechanism. Seeing output decrease again, the Fed will again increase AD, causes AS to shift left once more. This causes a rise in inflation, called demand pull inflation. |
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Term
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Definition
| Binding plans for how to respond (or not respond) in a given situation |
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Term
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Definition
| When policymakers don't commit to a specific plan in the future, but instead go for monetary policy in a case by case basis |
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Term
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Definition
2 types
1. Non Activist Rules
-These are rules that do not react to economic activity and are implemented no matter what
2. Activist Rules
-Specifying how monetary policy should be changed, given changes in economic activity |
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Term
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Definition
One of the types of rules.
These are rules that do not react to economic activity and are implemented no matter what
EX: Constant money growth rate rule = money supply needs to keep growing regardless of economy |
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Term
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Definition
This is one of the types of rules.
Specifying how monetary policy should be changed, given changes in economic activity
EX: The taylor rule: calculation the FF rate, based off of the output and inflation gap |
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Term
| Case for Having Rules in Monetary Policy |
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Definition
-Rules reduce the time inconsistency problem, by eliminating focusing on short run inflation-unemployment tradeoff and focusing on goals established in rules
-eliminates politicians, cant be influenced if "must follow rules" |
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Term
| Case for Having Discretion in Monetary Policy |
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Definition
-Rules are too rigid, do not apply to every case
-economic model could be wrong when rules written
-if economic model is right, does not mean economy wouldn't change, making it incorrect
-economists need to be able to adjust, deal with wide range of info |
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Term
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Definition
A method of Monetary policy that implements BOTH rules, and discretion
-It is by picking a NOMINAL ANCHOR
-and then ensuring that anchor is credible |
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Term
| Approaches to achieving a credible nominal anchor/ monetary policy |
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Definition
1) Inflation targeting
-being explicit that inflation is your goal, target an inflation level, and make the Fed accountable by announcing to the public
2. Appointing a conservative Chairmen
-putting people who are inflation averse, public expects conservatives less likely to pursue expansionary policy, and will keep inflation under control |
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