C h a p t e r

13

MONETARY POLICY*

The major assets on the Fed’s balance sheet are gold and foreign exchange, U.S. government securities, and loans to banks. The major liabilities are Federal Reserve notes in circulation (currency) and banks’ deposits (reserves). The monetary base is the sum of Federal Reserve notes, coins, and banks’ deposits at the Fed.

Key Concepts „ The Federal Reserve System The Federal Reserve System (or the Fed) is the central bank for the United States. A central bank is a bank for banks and a public authority that regulates financial firms. The Fed is responsible for monetary policy, so it adjusts the quantity of money in circulation. Three key players in the Fed are: ♦ The Board of Governors — seven members appointed by the President and confirmed by the Senate for 14-year terms. This group oversees operations of the Fed. ♦ The Federal Reserve Banks —12 regional banks, each of which has a president. ♦ The Federal Open Market Committee (FOMC FOMC) FOMC — the Fed’s main policy-making group. Voting members are the Board of Governors, the president of the Federal Reserve Bank of New York and, on a rotating basis, presidents of four other regional Federal Reserve banks. The Fed has three policy tools: ♦ Required reserve ratio — the Fed sets the required reserve ratio, the minimum percentage that depository institutions must hold as reserves. ♦ Discount rate — the interest rate at which the Fed stands ready to lend reserves to commercial banks. ♦ Open market operation — the purchase or sale of government securities—U.S. Treasury bills and bonds—by the Fed.

„ Controlling the Quantity of Money To increase the quantity of money, the Fed’s three policy tools are used as follows: ♦ Changes in the required reserve ratio: A decrease in the required reserve ratio increases banks’ lending and so increases the quantity of money. ♦ Changes in the discount rate: A decrease in the discount rate raises banks’ borrowing from the Fed, thereby increasing their reserves and so increases the quantity of money. ♦ Open market operations: When the Fed buys government securities, banks’ reserves increase. (These reserves rise whether the Fed buys securities from a bank or from a member of the public.) The rise in banks’ reserves leads them to increase their lending and so increases the quantity of money. To decrease the quantity of money, the Fed reverses these policy actions, increasing the required reserve ratio, raising the discount rate, or selling government securities. The money multiplier is the amount by which a change in the monetary base is multiplied to determine the change in the quantity of money. The money multiplier is greater than 1.0. The larger the currency drain, the smaller the money multiplier.

* This is Chapter 28 in Economics. 193

194

CHAPTER 13 (28)

„ The Demand for Money

FIGURE 13.2

MS

9 8 7 6 5 4 3 2

MD

1

FIGURE 13.1

Money Demand Interest rate (percent per year)

The Equilibrium Interest Rate Interest rate (percent per year)

Four factors influence the demand for money: ♦ The price level — An increase in the price level increases the nominal demand for money. ♦ The interest rate — An increase in the interest rate raises the opportunity cost of holding money and decreases the quantity of real money demanded. ♦ Real GDP — An increase in real GDP increases the demand for money. ♦ Financial innovation — Innovations that lower the cost of switching between money and other assets decrease the demand for money.

2.8

2.9 3.0 3.1 3.2 Real money (trillions of 1996 dollars)

9

money.) The demand curve for money is MD, and the equilibrium interest rate is 5 percent. ♦ If the Fed increases the quantity of money, the supply of money curve shifts rightward and the equilibrium interest rate falls. ♦ If the Fed decreases the quantity of money, the supply of money curve shifts leftward and the equilibrium interest rate rises.

8 7 6 5 4 3 2

MD

1 2.8

2.9 3.0 3.1 3.2 Real money (trillions of 1996 dollars)

Figure 13.1 shows the demand for money curve (MD). The real quantity of money equals the nominal quantity divided by the price level. Changes in the interest rate create movements along the demand curve; changes in the other relevant factors change the demand and shift the demand curve. „ Interest Rate Determination An interest rate is the percentage yield on a financial security; other variables being the same, the higher the price of the security, the lower is the interest rate. The interest rate is determined by the equilibrium in the market for money, as illustrated in Figure 13.2. The real supply of money is $3.0 trillion, so the supply curve of money is MS. (The Fed sets the quantity of

„ Monetary Policy, Real GDP, and the Price Level The Fed’s actions ripple through the economy. Higher interest rates: ♦ Decrease investment and consumption expenditure ♦ Increase the foreign exchange rate, which then decreases net exports ♦ A multiplier process then occurs If the Fed tightens to fight inflation, the quantity of money decreases, which raises the interest rate and thereby decreases investment. The decrease in investment leads to a multiplier effect that decreases aggregate demand, thereby lowering the price level and decreasing real GDP. If the Fed eases to fight a recession, the reverse results occur. The Fed in Action The data show that short-term interest rates generally move together. The data also show that interest rates

MONETARY POLICY

generally fall when the quantity of money increases and generally rise when the quantity of money decreases. Paul Volcker: In 1979, when Volcker became chairman of the Fed, the inflation rate was high. The Fed slowed the growth rate of the quantity of money, interest rates rose, the inflation rate fell, and the economy went into a recession. Alan Greenspan: Greenspan took over as chairman in 1987. From 1988 to 1990, the Fed slowed the monetary growth rate and forced interest rates higher. In 1990 a recession occurred; after that the Fed nudged along the expansion that started in 1992 until it ended in 2001. In 2001 the Fed cut the interest rate on eleven occasions because of concern about the recession.

195

2. DOES AN OPEN MARKET OPERATION INCREASE OR DECREASE THE QUANTITY OF MONEY ? Trying to keep track of whether an open market purchase of government securities by the Fed increases or decreases the quantity of money can be confusing. One way to remember their effects is to think of the following: “When the Fed buys government securities, it sells money; when the Fed sells government securities, it buys money.” By associating the purchase of securities with the sale of money and vice versa, keeping track of whether a purchase or sale of government securities increases the quantity of money becomes straightforward.

Questions Helpful Hints „ True/False and Explain 1. OPEN MARKET OPERATIONS : This activity is by far the Fed’s most important policy tool. Open market operations occur every business day. The term “open market operation” refers to the Fed’s purchase or sale of government securities. There is nothing mysterious about this process: All the Fed does is buy or sell government securities. However, even aside from the differences in scale, the economic impact of your purchase of a government security is different from that of the Fed’s purchase. In particular, when you pay for your purchase, you use money that already exists in the economy. The total amount of money in the economy does not change. But when the Fed pays for a purchase of $5,000 of securities, the Fed introduces new money into the economy. If the Fed buys $5,000 of securities from a broker, it gives the broker a check drawn on the Fed. The broker presents the check to his or her bank. The bank increases the broker’s account for $5,000 and then presents the check to the Fed. In turn, the Fed increases the bank’s checking account at the Fed for $5,000. Because funds kept in the bank’s checking account at the Fed are reserves for the bank, the bank gains reserves. You know that when banks gain reserves, they loan the excess reserves and the quantity of money expands by a multiple of the initial increase in reserves. So the Fed’s purchase of $5,000 of government securities will have a multiplier effect on the quantity of money.

The Federal Reserve System

11. The presidents of each of the Federal Reserve banks are nominated by the President of the United States and confirmed by the Senate. 12. As voting members, the FOMC comprises all the presidents of the Federal Reserve regional banks, the chairman of the Federal Reserve, and, on a rotating basis, four of the members of the Board of Governors. 13. The discount rate is the interest rate banks charge the Fed on the reserves the Fed borrows from banks. Controlling the Quantity of Money

14. If the Fed lowers the required reserve ratio, the quantity of money increases. 15. A purchase of government securities by the Fed reduces the quantity of money. 16. The higher the required reserve ratio, the larger the money multiplier. The Demand for Money

17. The price level is the opportunity cost of holding money. 18. An increase in real GDP increases the demand for money.

196

Interest Rate Determination

19. If the Fed buys government securities, it lowers the interest rate. 10. If both the supply and demand for money increase, the interest rate definitely rises.

CHAPTER 13 (28)

15. The monetary base equals the sum of a. checking accounts, coins, and currency. b. M1 plus savings accounts. c. banks’ reserves plus checking accounts. d. Federal Reserve notes, coins, and banks’ deposits at the Federal Reserve.

Monetary Policy, Real GDP, and the Price Level

11. Higher interest rates affect consumption expenditure, investment, and net exports. 12. To fight inflation, the Fed will decrease the quantity of money. 13. An increase in the quantity of money increases aggregate demand. The Fed in Action

14. The data show that an increase in the quantity of money lowers the interest rate. 15. When a recession occurred in 2001, the Fed responded by raising interest rates. „ Multiple Choice The Federal Reserve System

11. Which group makes decisions about the course of the nation’s monetary policy? a. The Fed’s Board of Governors b. The FOMC c. The presidents of the Fed’s regional banks d. The President and the Senate 12. The discount rate is the interest rate a. the Fed charges when it loans reserves to banks. b. banks charge their finest loan customers. c. banks pay on savings accounts. d. the Fed pays on reserves held by banks. 13. The purchase of $1 billion of government securities by the Fed is an example of a. the discount rate being affected. b. a multiple contraction of the quantity of money. c. an open market operation. d. a change in the required reserve ratio. 14. ____ is a liability of the Federal Reserve. a. Government securities b. Loans to banks c. Banks’ deposits at the Fed d. Foreign exchange

Controlling the Quantity of Money

16. ____ increases the quantity of money? a. A Fed purchase of government securities b. An increase in the discount rate c. An increase in the required reserve ratio d. None of the above 17. An increase in the required reserve ratio ____ the reserves that banks must hold and ____ the quantity of money. a. increases; increases b. increases; decreases c. decreases; increases d. decreases; decreases 18. The tool the Fed uses most often to change the quantity of money is a. changes in the discount rate. b. changes in the required reserve ratio. c. open market operations. d. changes in the demand for money. 19. An open market purchase of government securities by the Fed will a. increase the Fed’s assets, but not increase its liabilities. b. increase its assets and its liabilities by the same amount. c. increase both its assets and its liabilities, but increase the assets by more. d. increase both its assets and its liabilities, but increase the liabilities by more. 10. Which of the following changes the size of the monetary base? a. A bank withdraws currency from the deposits it keeps at the Fed. b. A bank uses some of its reserves to make a loan. c. The Fed buys government securities from a bank. d. A firm deposits currency in its checking account at its bank.

MONETARY POLICY

11. If the money multiplier is 2.5, a $10 billion increase in the monetary base raises the quantity of money by a. $25 billion. b. $10 billion. c. $4.0 billion. d. $2.5 billion. 12. Which of the following actions best describes the correct sequence of events following an expansionary open market operation? a. The Fed sells government securities, which lowers bank reserves, leading to a drop in lending, leading to a decrease in the quantity of money. b. The Fed sells government securities, which lowers bank reserves, leading to a drop in lending, leading to an increase in the quantity of money. c. The Fed sells government securities, which lowers bank reserves, leading to an increase in lending, leading to an increase in the quantity of money. d. The Fed buys government securities, which increases bank reserves, leading to an rise in lending, leading to an increase in the quantity of money. 13. The monetary expansion process from an open market operation continues until a. required reserves are eliminated. b. the Fed eliminates required reserves. c. the discount rate is lower than other interest rates. d. excess reserves are eliminated. The Demand for Money

14. An increase in ____ decreases the quantity of money people want to hold. a. the price level b. real GDP c. the interest rate d. the quantity of money 15. Which of the following does NOT directly shift the demand for money curve? a. A change in GDP. b. A change in the quantity of money. c. Financial innovation. d. None of the above because they all directly shift the demand for money curve.

197

16. Since 1976, in the United States the demand curve for M2 money has shifted a. rightward in almost all years. b. leftward in almost all years. c. rightward in most years until 1989 and then leftward in a few years and rightward in most. d. leftward in most years until 1989 and then rightward in some years and leftward in others. Interest Rate Determination

17. If the price of an asset rises and the amount paid on the asset does not change, what happens to the interest rate on the asset? a. It rises b. It does not change c. It falls d. The premise of the question is wrong because changes in the price of an asset have nothing to do with the interest rate paid on the asset. 18. Taken by itself, an increase in the quantity of money a. raises the interest rate. b. does not change the interest rate. c. lowers the interest rate. d. perhaps raises or perhaps lowers the interest rate, depending on whether the demand curve for money has a negative or a positive slope. 19. If real GDP increases, the demand for money curve will shift a. leftward and the interest rate will rise. b. leftward and the interest rate will fall. c. rightward and the interest rate will rise. d. rightward and the interest rate will fall. Monetary Policy, Real GDP, and the Price Level

20. If the Fed increases the interest rate, then a. investment and consumption expenditure decrease. b. the price of the dollar rises on the foreign exchange market and so net exports decrease. c. a multiplier process that affects aggregate demand occurs. d. All of the above answers are correct.

198

21. In order to combat inflation, the Fed will ____ the quantity of money and ____ the interest rate. a. increase; raise b. increase; lower c. decrease; raise d. decrease; lower. 22. The Fed’s actions to fight a recession shift the a. aggregate demand curve rightward. b. aggregate demand curve leftward. c. short-run aggregate supply curve rightward. d. short-run aggregate supply curve leftward.

CHAPTER 13 (28)

2. How does a purchase of government securities from a bank by the Fed lead to an increase in the banks’ reserves? TABLE 13.1

Balance Sheet of the Federal Reserve Assets (billions of dollars) Gold and foreign exchange

$ 19

U.S. government securities

380

The Fed in Action

Loans to banks

23. The Federal Reserve directly controls which interest rate? a. The Federal Reserve directly controls the 3month Treasury bill rate. b. The Federal Reserve directly controls the 6month commercial bill rate. c. The Federal Reserve directly controls the discount rate. d. The Federal Reserve directly controls the federal funds rate.

Other assets

24. In general, a. short-term interest rates move together. b. different short-term interest rates go their own separate ways. c. changes in the federal funds interest rate are very different from changes in other short-term interest rates. d. the discount rate is the most crucial short-term interest rate. 25. In 1979, to reduce the inflation rate, Paul Volcker’s Fed ____ interest rates and ____ growth in the quantity of money. a. raised; increased b. raised; decreased c. lowered; decreased d. lowered; increased „ Short Answer Problems 1. a. How does an increase in the required reserve ratio affect banks’ excess reserves? The quantity of money? b. How does an increase in the discount rate affect banks’ excess reserves? The quantity of money?

Total assets

Liabilities (billions of dollars) Federal Reserve $380 notes Banks’ deposits

40

1 20 $420

Total

$420

3. The Federal Reserve System’s balance sheet is presented in Table 13.1. Suppose that the Fed buys $10 billion of government securities from a large bank and pays for the securities by increasing the bank’s deposits at the Fed. In Table 13.2, show the effect of the purchase on the Fed’s balance sheet. What is the change in the monetary base? If the money multiplier is 2.8, what is the resulting change in the quantity of money? TABLE 13.2

Short Answer Question 3 Assets (billions of dollars) Gold and foreign exchange

$ ___

U.S. government securities

___

Loans to banks

___

Other assets

___

Total assets

$ ___

Liabilities (billions of dollars) Federal Reserve $ ___ notes Banks’ deposits

Total

___

$ ___

4. Return to the original balance sheet in Table 13.1. Suppose that the Fed sells $10 billion of government securities to a large bank and takes payment by decreasing the bank’s deposit. Use Table 13.3 on the next page) to show the effect of the sale on the Fed’s balance sheet. What is the resulting change in the monetary base? If the money multiplier is 2.8, by how much does the quantity of money change?

MONETARY POLICY

199

FIGURE 13.3

Short Answer Question 4

Short Answer Problem 7

Assets (billions of dollars) Gold and foreign exchange

$ ___

U.S. government securities

___

Loans to banks

___

Other assets

___

Total assets

$ ___

Liabilities (billions of dollars) Federal Reserve $ ___ notes Banks’ deposits

Total

___

$ ___

Interest rate (percent per year)

TABLE 13.3

MS

9 8 7 6 5 4 3

MD

2

5. Return to the original balance sheet in Table 13.1. Suppose that a bank withdraws $10 billion in Federal Reserve notes from its deposits at the Fed. Use Table 13.4 to show the effects of this withdrawal on the Fed’s balance sheet. By how much does the monetary base change? If the money multiplier is 2.8, what is the change in the quantity of money?

1 2.8

2.9 3.0 3.1 3.2 Real money (trillions of 1996 dollars)

TABLE 13.5

The Demand For Money

TABLE 13.4

Short Answer Question 5 Assets (billions of dollars) Gold and foreign exchange

$ ___

U.S. government securities

___

Loans to banks

___

Other assets

___

Total assets

$ ___

Interest rate (percent per year)

Quantity of money demanded (billions of dollars)

Liabilities (billions of dollars)

3

$600

4

500

Federal Reserve $ ___ notes

5

400

6

300

Banks’ deposits

Total

___

$ ___

6. According to your answers to problems 3, 4, and 5, which had the larger effect on the quantity of money: The actions of the Federal Reserve or the actions of commercial banks? What does your answer imply for the ability of the Federal Reserve to control the nation’s quantity of money? 7. Initially, the market for money is in equilibrium, as illustrated in Figure 13.3. Then, the Fed increases the quantity of money by $100 billion. a. Draw this increase in Figure 13.3. b. What was the initial equilibrium interest rate? What happens to the equilibrium interest rate? c. Explain, in general, the adjustment process to the new equilibrium interest rate.

8. Table 13.5 gives data on the demand for money. a. Suppose that the equilibrium interest rate is 6 percent. What is the quantity of money? b. Suppose that the Fed wants to lower the interest rate to 4 percent. By how much must it change the quantity of money? If the money multiplier is 2.5, what magnitude of open market operation is necessary to lower the interest rate as desired? Is it an open market purchase or sale of government securities? „ You’re the Teacher 1. Your friend is talking: “Whenever the government runs a deficit and has to sell government securities, it automatically increases the quantity of money, right?” You realize that this comment actually is not “right”; in fact, it is wrong! Explain to your friend why it is wrong.

200

2. Your friend has one last question about the Fed: “I can see a lot of what you’re talking about. But there’s one last thing that puzzles me. Let’s see if I can lay it out. Now, the Fed buys a lot of government securities, and these securities all pay interest to the Fed. The Fed pays for them by printing Federal Reserve notes and increasing banks’ reserves. But neither Federal Reserve notes nor banks’ reserves pay any interest. So the Fed gets a lot of in-

CHAPTER 13 (28)

terest income and has no interest expense. It seems to me that this would be very profitable. Is it? And, if it is, what does the Fed do with the profit?” These are interesting questions; perhaps your friend thinks that the Fed spends its profits on the “mother of all parties” and would like to be invited. Tell your friend to forget about the party by explaining the profits and what happens to them.

MONETARY POLICY

201

„ True/False Answers

12. T By decreasing the quantity of money, aggregate demand decreases which lowers the price level. 13. T Changing aggregate demand is part of the ripple effect of monetary policy.

The Federal Reserve System

The Fed in Action

11. F The members of the Board of Governors are nominated by the President and confirmed by the Senate. 12. F As voting members, the FOMC comprises all the members of the Board of Governors, the president of the New York Federal Reserve Bank and, on a rotating basis, the presidents of four other regional Federal Reserve banks. 13. F The discount rate is the interest rate the Fed charges banks for the reserves that banks borrow from the Fed.

14. T This fact is in accord with the theory. 15. F When the recession occurred, the Fed responded by lowering the interest rate eleven times.

Answers

Controlling the Quantity of Money 14. T When the Fed lowers the required reserve ratio,

banks have more excess reserves, which, through the process of loaning (and loaning again), increases the quantity of money. 15. F When the Fed purchases government securities, it pays for the purchases by increasing banks’ reserves, which leads to an increase in the quantity of money. 16. F The higher the required reserve ratio, the less banks are able to loan from each deposit and so the smaller is the money multiplier. The Demand for Money

17. F The interest rate is the opportunity cost of holding money. 18. T An increase in real GDP means more transactions occur and increases the demand for money. Interest Rate Determination

19. T When the Fed buys government securities, the quantity of money increases and the interest rate falls. 10. F If the increase in the demand for money is larger than the increase in the supply, the interest rate rises. But if the increase in the supply exceeds the increase in demand, the interest rate falls. Monetary Policy, Real GDP, and the Price Level

11. T Higher interest rates ripple through the economy, affecting many sectors.

„ Multiple Choice Answers The Federal Reserve System

11. b The FOMC is an important committee because it makes decisions about the nation’s monetary policy. 12. a The discount rate is the interest rate that banks must pay when they borrow reserves from the Fed. 13. c An open market operation occurs whenever the Fed buys or sells government securities. 14. c Banks’ deposits are a Fed liability because banks own the deposits, and the Fed must return the funds to a bank that wants to make a withdrawal from its deposit. 15. d Answer (d) defines the monetary base. Controlling the Quantity of Money

16. a When the Fed buys government securities, the quantity of money increases; the other actions mentioned reduce the quantity of money. 17. b Because banks must hold more reserves, the increase in the required reserve ratio decreases the loans that banks make, which decreases the quantity of money. 18. c Open market operations are conducted every business day. 19. b An open market purchase of government securities increases the amount of government securities the Fed owns (a Fed asset) and also increases by the same amount either Federal Reserve notes or, more likely, banks’ deposits at the Fed (both Fed liabilities). 10. c When buying a government security, the Fed pays for it either by increasing banks’ deposits at the Fed or by issuing new Federal Reserve notes. Both forms of payment increase the monetary base.

202

11. a The change in the quantity of money equals the money multiplier multiplied by the change in the monetary base or, in this case, (2.5)($10 billion) = $25 billion. 12. d Answers (a), (b), and (c) are incorrect because a Fed sale of government securities decreases the quantity of money. Answer (d) describes how the Fed’s purchase of government securities increases the quantity of money. 13. d As long as banks have excess reserves, they increase their loans and hence increase the quantity of money. The Demand for Money

14. c The interest rate is the opportunity cost of holding money, so an increase in the interest rate reduces the quantity of money demanded. 15. b Changes in the quantity of money create movements along the demand for money curve; they do not shift the curve. 16. c Until about 1989, growth in real GDP generally increased the demand for M2. Since 1989, innovation has decreased the demand for M2 while GDP growth has increased it. Interest Rate Determination

17. c There is an inverse relationship between the price of an asset and the interest rate paid on the asset. 18. c An increase in the quantity of money creates a surplus of money at the initial interest rate and, as people buy financial assets to be rid of the surplus, the price of financial assets rises, which drives down their interest rates. 19. c An increase in GDP increases the demand for money and, as the demand curve shifts rightward, the equilibrium interest rate rises. Monetary Policy, Real GDP, and the Price Level

20. d Each of the answers describes one of the ripples from the Fed’s policy. 21. c By decreasing the quantity of money and raising the interest rate, the Fed decreases aggregate demand. 22. a By shifting the aggregate demand curve rightward, the Fed increases real GDP, thereby offsetting the recession.

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The Fed in Action

23. c The Federal Reserve directly sets the discount rate, the interest rate banks pay when they borrow reserves from the Fed. 24. a Because short-term interest rates tend to move together, by affecting one short-term interest rate — the federal funds rate — the Fed can influence all short-term interest rates. 25. b These policies decreased aggregate demand, and thereby lowered the inflation rate though they also lead to a recession. „ Answers to Short Answer Problems 1. a. An increase in the required reserve ratio means that for every dollar of deposits banks must keep more reserves either in their vault or at the Federal Reserve. As a result, banks’ excess reserves — the reserves over and above the required reserves — fall because the total amount of required reserves increases. Because banks need to keep more reserves on hand for each dollar of deposits, they can make fewer loans. Then, with fewer loans, the quantity of money decreases. b. An increase in the discount rate makes borrowing reserves from the Fed more expensive for banks. They respond by reducing the amount of reserves they borrow. As a result, their excess reserves decline. Then, similar to the answer in part (a), the decrease in banks’ excess reserves leads to a decrease in the quantity of money. 2. An open market purchase of government securities by the Fed increases reserves by increasing one of its components, banks’ deposits with the Federal Reserve. The process is direct: the Fed pays for the securities by increasing the bank’s deposit at the Federal Reserve, which directly increases banks’ reserves. Reserves expand by the amount of the open market purchase. (If the purchase is from the nonbank public, the Fed pays by writing checks on itself, which the sellers of the securities deposit in their banks. The banks increase the sellers’ deposits at the bank, and, in turn, present the checks to the Federal Reserve. The Fed then increases the banks’ deposits at the Fed.)

MONETARY POLICY

203

TABLE 13.6

Short Answer Question 3 Assets (billions of dollars) Gold and foreign exchange

$ 19

U.S. government securities

390

Loans to banks Other assets Total assets

Liabilities (billions of dollars) Federal Reserve $380 notes Banks’ deposits

50

1

TABLE 13.8

20 $430

Total

Short Answer Question 5 $430

3. Table 13.6 shows the effect of the Fed’s purchase of $10 billion of government securities. Compared to the initial amounts shown in Table 13.1, government securities owned by the Fed have increased by $10 billion (from $380 to $390 billion) and the amount of banks’ deposits at the Fed also has increased by $10 billion (from $40 to $50 billion). The monetary base equals the sum of Federal Reserve notes plus banks’ deposits. Hence the monetary base has increased by $10 billion, from $420 billion initially to $430 billion after the purchase of government securities. If the money multiplier is 2.8, the quantity of money will increase by 2.8 times the change in the monetary base, or (2.8)($10 billion) = $28 billion. TABLE 13.7

Short Answer Question 4 Assets (billions of dollars) Gold and foreign exchange

$ 19

U.S. government securities

370

Loans to banks Other assets Total assets

Liabilities (billions of dollars) Federal Reserve $380 notes Banks’ deposits

30

1 20 $410

lion, to $30 billion. The monetary base, which equals the sum of Federal Reserve notes plus banks’ deposits, falls from $420 to $410 billion, a decrease of $10 billion. Finally, the change in the quantity of money equals the money multiplier, 2.8, times the change in the monetary base, –$10 billion, or (2.8)(–$10 billion) = –$28 billion; that is, the quantity of money declines by $28 billion.

Total

$410

4. Table 13.7 shows the effect of the sale of $10 billion of government securities. The amount of government securities decreases by $10 billion, to $370 billion. As the bank pays for this purchase, the amount of its deposit — and hence the total amount of banks’ deposits — decreases by $10 bil-

Assets (billions of dollars) Gold and foreign exchange

$ 19

U.S. government securities

380

Loans to banks Other assets Total assets

Liabilities (billions of dollars) Federal Reserve $390 notes Banks’ deposits

30

1 20 $420

Total

$420

5. The effect of the banks’ withdrawal of $10 billion from their deposits is presented in Table 13.8. The only effects are on the liability side of the balance sheet. The amount of Federal Reserve notes increases by $10 billion to $390 billion, and the amount of banks’ deposits decreases by $10 billion to $30 billion. The monetary base equals the sum of Federal Reserve notes and banks’ deposits. The key result in this question is that the effect on the monetary base is nil because the two changes offset each other. So neither the monetary base nor the quantity of money change. 6. Banks’ withdrawals of currency from their deposits at the Fed has no effect on the quantity of money. (Similarly, their deposit of Federal Reserve notes in their deposits at the Fed have no effect on the quantity of money.) In general, setting aside when banks borrow reserves from the Fed (which is a relatively tiny amount of reserves), the quantity of money changes in reaction to the Federal Reserve’s actions. Because the quantity of money changes whenever the Fed buys or sells government securities, the Fed can use the purchase or sale of government securities — which are open market operations — to control the nation’s quantity of money.

204

CHAPTER 13 (28)

the money multiplier is 2.5, the monetary base must expand by $80 billion. (An additional $80 billion in the monetary base supply will lead to a (2.5)($80 billion) = $200 billion increase in the quantity of money.) In order to increase the monetary base by $80 billion, the Fed must purchase $80 billion of government securities.

FIGURE 13.4

Interest rate (percent per year)

Short Answer Problem 7 MS0

9

MS1

8 7

„ You’re the Teacher

6 5 4 3

MD

2 1 2.8

2.9 3.0 3.1 3.2 Real money (trillions of 1996 dollars)

7. a. Figure 13.4 shows the $100 billion increase in the quantity of money as the rightward shift from MS 0 to MS1. b. The initial interest rate was 6 percent; after the increase in the quantity of money, the equilibrium interest rate fell, to 4 percent. c. An increase in the quantity of money means that, at the initial interest rate (6 percent), the quantity of money supplied is greater than the quantity of money demanded. Money holders want to reduce their money holdings and do so by buying financial assets. The increase in the demand for financial assets raises the price of financial assets and thus lowers their interest rate. As interest rates fall, the quantity of money demanded increases, which reduces the excess supply of money. This process continues until the interest rate has fallen sufficiently so that the quantity of money demanded is the same as the quantity of money supplied. The interest rate that sets the new quantity of money supplied equal to the quantity of money demanded is the (new) equilibrium interest rate. 8. a. When the interest rate is 6 percent, the quantity of money demanded is $300 billion. Hence the quantity supplied also must be $300 billion. b. In order to reduce the interest rate to 4 percent, the Fed must increase the quantity of money supplied to $500 billion. So the quantity of money must increase by $200 billion. Because

1. “Well, you’re close but not quite right. Look, the deal is that you have to be careful to distinguish between the Fed and other branches of the government. So when the federal government runs a deficit, it’s not the Fed that sells the government securities necessary to cover the deficit but the U.S. Treasury. And the Treasury sells the securities to anyone who will buy them, that is, to you, me, an insurance company, or whomever. “Since it was founded in 1913, the Federal Reserve has bought more than $450 billion of U.S. government securities. So, the Fed has a lot that it can sell if it wants. But, if you and I have bought some government securities in the past, we could sell them just like the Fed could sell the securities it holds. Of course, we probably can’t sell as much as the Fed can.... “However, the amount isn’t the key thing; it is that the Fed’s securities are like ours in that they aren’t newly issued securities. That is, unlike the Treasury selling new securities to finance the deficit, when the Fed sells its securities and when we sell ours, we aren’t helping finance a new deficit. So when the federal government runs a deficit, it’s the U.S. Treasury that sells securities to finance the deficit, not the Fed and not us!” 2. “This is another great set of questions. Here are a couple of great answers! Sure, the Fed makes a lot of ‘profit’ and for exactly the reasons you stated: It earns a lot of interest income on its government securities and it pays no interest expense. But the Fed doesn’t do anything wild and crazy with its profit: There’s not a party to die for. Instead, the Fed pays its costs with its revenue. However, the amount of revenue easily covers those costs, so what happens to the extra? The Fed gives it back to the Treasury. That’s right, the Fed sends the extra profit back to the U.S. Treasury so the Treasury can use it as revenue to help pay for the government’s expenditures.”

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Chapter Quiz 11. The U.S. central bank is the a. Federal Central Bank. b. Federal Open Market Committee. c. Federal Reserve System. d. U.S. Treasury. 12. Open market operations are a policy tool of the Fed. Changing the tax rate imposed on interest paid by bonds is a policy tool of the Fed. a. Both sentences are true. b. The first sentence is true and the second sentence is false. c. The first sentence is false and the second sentence is true. d. Both sentences are false. 13. When the Fed changes the interest rate it charges banks for loans of reserves, the Fed has a. changed the required reserve ratio. b. changed the discount rate. c. changed the Treasury bill rate. d. conducted an open market operation. 14. The largest asset on the Fed’s balance sheet is a. gold. b. loans to banks. c. government securities. d. None of the above. 15. When the Fed buys a government security, the monetary base ____ and the quantity of money ____. a. increases; increases b. increases; decreases c. decreases; increases d. decreases; decreases

16. An increase in the interest rate a. shifts the demand for money curve rightward. b. shifts the supply of money curve rightward. c. does not shift the demand for money curve. d. shifts the demand for money curve leftward. 17. If the demand for money increases by the same amount as the quantity of money increases, the interest rate ____. a. rises b. does not change. c. falls d. probably changes, but without more information it is not possible to determine if it rises, falls, or does not change 18. If the Fed raises the required reserve ratio, the a. demand for money increases. b. demand for money decreases. c. quantity of money increases. d. quantity of money decreases. 19. If the Fed raises the required reserve ratio, the interest rate ____. a. rises b. does not change. c. falls d. probably changes, but without more information it is not possible to determine if it rises, falls, or does not change 10. If bond prices fall, a. interest rates rise. b. interest rates fall. c. banks’ reserves increase. d. households increase the quantity of money they demand.

The answers for this Chapter Quiz are on page 310

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