ECON330 Money and Banking Discussion Handout 8

1 Midterm 2Time and venue: See professor’s emailCoverage: Chapter 9, 12 - 16Tips: Practice previous exams on my website!!!

Read the book materials that are not covered in class. Those may be tested as well.https://alanyangecon.weebly.com/econ330.html

2 Dictionary

BR - Borrowed Reserves

FOMC - Federal Open Market CommitteeFDIC - Federal Deposit Insurance Corporation

MB - Monetary Base (MBn+BR)MBn - Non-Borrowed Monetary Base

MS - Money SupplyMBS - Mortgage Backed SecuritiesOMO - Open Market OperationRRR - Required Reserve Ratio

QE - Quantitative Easing

3 Chapter 15 Tools of Monetary Policy

3.1 Reserves Market

Remarks:1. X-axis is reserves quantity and Y-axis is the “price of reserve” - the Fed Fund Rate2. Demand of reserves: Banks are the demander of reserve, quantity demanded increases as Fed Fund Rate becomelower (cheaper reserves). However, it will be capped below by ior, the interest rate paid on excess reserve by Fed.Otherwise banks can borrow reserves and put the money into Fed’s account to earn risk-free interest/profit3. Supply of reserves: Reserves are supplied by banks in the interbank lending borrowing market (Fed Fund Market).However, the ultimate reserves supplier (MBn+BR) is the Fed, who fully control and adjust reserves base on policyneed. Therefore the supply of reserves is inelastic to Fed Fund Rate, results in vertical supply. The supply is cappedabove by id, the discount loan rate, because banks will rather borrow from Fed with the discount loan rate thandoing interbank borrowing if Fed Fund Rate>id.

3.2 Fed’s Control of Reserve Market (Reasons for demand/supply shift)

Supply Shifter:1. Fed can buy (sell) T-bills to increase (decrease) reserves amount in the market. Increase (decrease) in reserveshift the supply to the right (left).2. Fed can increase (decrease) the discount loan rate - the rate it borrow reserve to the banks, to lift up (bringdown) upper cap of supply curve

Demand Shifter:1. Fed can increase (decrease) RRR to make shift reserves demand to the right (left). As higher (lower) RRR meansbanks are more (less) desparate to borrow to meet the reserve requirement2. Fed can increase (decrease) the ior , to lift up (push down) the lower cap of demand curve

ECON330 Money and Banking Discussion Handout 8

3.3 Summary of Monetary Policy Tools

Conventional Monetary Policy Tools

1. Open market purchase (buy and sell T-bills)2. Provide discount loans (act as lender of last resort) and adjust the discount loan rates3. Adjusting Reserve Requirement

Unconventional Monetary Policy Tools1. Liquidity Provision

• Discount window expansion

• Term Auction Facility

• New Lending Programs

2. Large-Scale Asset Purchase (LSAP)

• Quantitative Easing (QE) - Fed expands its balance by 3/4 QEs, purchasing T-bonds and MBS etc. (refer tolast week discussion)

3. Expectation management

• Announce to keep short-term rate at certain level for long time

• Change long run inflation target

• Fed provides Forward Guidance (e.g. QE3/4 will continue as long as “the unemployment rate remains above6.5 percent, inflation is projected to be no more than a half percentage point above our 2 percent longer-run goal”)

• Quote from Fed about Forward Guidance “Through ”forward guidance,” the Federal Open Market Committeeprovides an indication to households, businesses, and investors about the stance of monetary policy expected to prevail in the future. By providing information about how long the Committee expects to keep the target for the federal funds rate exceptionally low, the forward guidance language can put downward pressure on longer-term interest rates and thereby lower the cost of credit for households and businesses and also help improve broader financial conditions.”

• By setting Forward Guidance, the Fed wants to adjust household’s expectation (therefore affect behavior now)

Actions:

• Buy private sector debt

• QE

• Inflation targeting to price level targeting

• Change interest rate on excess reserves

4 Chapter 16 Conduct of Monetary Policy: Strategy and Tactics

4.1 Monetary Policy Goals

The Congress established the objectives for monetary policy in the Federal Reserve Act:1. Maximum employment2. Stable prices3. Moderate long-term interest rates

Achieving the first two at the same time are commonly called “dual mandate”

Other Goals:1. Output Stability2. Economic Growth3. Financial Markets Stability4. Interest-Rate Stability5. Foreign Exchange Markets Stability

- if unemployment rate < NAIRU => GDP growth > potential GDP => inflation increases - if unemployment rate > NAIRU => GDP growth < potential GDP => inflation decreases

ECON330 Money and Banking Discussion Handout 8

4.2 Taylor Rule & NAIRU

Fed can adjust nominal interest to affect economy in the short run. However, dual mandate is hard to achieve,employment (output) and prices seem to have inverse relationship. What is the suitable/optimal rate should theFed target?

Taylor Rule

Taylor proposed Taylor rule: Fed Fund Target Rate = inflation rate (CPI) + equilibrium real fed fund rate +1/2(Inflation gap)+1/2(output gap)

Idea: Fed Fund Target Rate should response to both inflation gap and output gap (1/2 and 1/2 means equallyweighted)

Non-accelerating Inflation Rate of Unemployment (NAIRU)A rate of unemployment that there is no tendency for inflation to change (natural rate of unemployment)

5 Exercises

(2016 Spring Midterm 2)

9) The discount rate is kept ________ the federal funds rate because the Fed prefers that ________.

A) above; banks borrow reserves from the Fed

B) below; banks borrow reserves from the Fed

C) below; banks borrow reserves from each other

D) above; banks borrow reserves from each other

12) In the market for reserves, if the federal funds rate is above the interest rate paid on excess

reserves, an open market sale ________ the supply of reserves causing the federal funds rate to

________, everything else held constant.

A) decreases; increase B) decreases; decrease

C) increases; increase D) increases; decrease

14) The goal for high employment should be a level of unemployment at which the demand for

labor equals the supply of labor. Economists call this level of unemployment the

A) frictional level of unemployment. B) structural level of unemployment.

C) natural rate level of unemployment. D) Keynesian rate level of unemployment.

20) Everything else held constant, in the market for reserves, when the supply for federal funds

intersects the reserve demand curve on the downward sloping section, decreasing the interest

rate paid on excess reserves

A) increases the federal funds rate.

B) lowers the federal funds rate.

C) has no effect on the federal funds rate.

D) has an indeterminate effect on the federal funds rate.

24) Everything else held constant, in the market for reserves, when the federal funds rate is 3%,

raising the discount rate from 5% to 6%

A) lowers the federal funds rate.

B) raises the federal funds rate.

C) has no effect on the federal funds rate.

D) has an indeterminate effect on the federal funds rate.

ECON330 Money and Banking Discussion Handout 8

(2014 Fall Midterm 2)

12) Using Taylor's rule, when the equilibrium real federal funds rate is 3 percent, the positive output

gap is 2 percent, the target inflation rate is 1 percent, and the actual inflation rate is 2 percent, the

nominal federal funds rate target should be

A) 5 percent. B) 5.5 percent. C) 6 percent. D) 6.5 percent.

18) The rate of inflation increases when

A) the unemployment rate exceeds the NAIRU.

B) the unemployment rate is less than the NAIRU.

C) the unemployment rate increases faster than the NAIRU increases.

D) the unemployment rate equals the NAIRU.

30) In the market for reserves, a lower discount rate

A) lengthens the vertical section of the supply curve of reserves.

B) decreases the supply of reserves.

C) increases the supply of reserves.

D) shortens the vertical section of the supply curve of reserves.

31) In the market for reserves, when the federal funds interest rate is below the discount rate, the

supply curve of reserves is

A) horizontal. B) negatively sloped.

C) positively sloped. D) vertical.

38) In the market for reserves, if the federal funds rate is between the discount rate and the interest

rate paid on excess reserves, a decline in the reserve requirement ________ the demand of

reserves, ________ the federal funds rate, everything else held constant.

A) decreases; raising B) decreases; lowering

C) increases; lowering D) increases; raising

45) If the Taylor Principle is not followed and nominal interest rates are increased by less than the

increase in the inflation rate, then real interest rates will ________ and monetary policy will be

too ________.

A) fall; tight B) fall; loose C) rise; tight D) rise; loose

48) Everything else held constant, in the market for reserves, when the federal funds rate is 3%,

lowering the interest rate paid on excess reserves rate from 2% to 1%

A) has an indeterminate effect on the federal funds rate.

B) has no effect on the federal funds rate.

C) raises the federal funds rate.

D) lowers the federal funds rate.

DACCC, DBDDBBB