Self-Check Questions

When a central bank acts as a lender of last resort, it makes short-term loans available in situations of severe financial panic or stress. The failure of a single bank can be treated like any other business failure. Yet if many banks fail, it can reduce aggregate demand in a way that can bring on or deepen a recession. The combination of deposit insurance, bank supervision, and lender of last resort policies help to prevent weaknesses in the banking system from causing recessions.

15.3 How a Central Bank Executes Monetary Policy

In a limited reserves environment, the central bank has three traditional tools to conduct monetary policy: open market operations, which involves buying and selling government bonds with banks; reserve requirements, which determine what level of reserves a bank is legally required to hold; and discount rates, which is the interest rate charged by the central bank on the loans that it gives to other commercial banks. In a limited reserves environment, the most commonly used tool is open market operations. Since the financial crisis, the U.S. banking system is in an ample reserves environment. The FOMC has moved away from the traditional tools of a limited reserve environment and now uses changes in the interest rate on reserve balances (IORB) as its main monetary policy tool.

15.4 Monetary Policy and Economic Outcomes

An expansionary (or loose) monetary policy raises the quantity of money and credit above what it otherwise would have been and reduces interest rates, boosting aggregate demand, and thus countering recession. A contractionary monetary policy, also called a tight monetary policy, reduces the quantity of money and credit below what it otherwise would have been and raises interest rates, seeking to hold down inflation. During the 2008–2009 recession, central banks around the world also used quantitative easing to expand the supply of credit.

15.5 Pitfalls for Monetary Policy

Monetary policy is inevitably imprecise, for a number of reasons: (a) the effects occur only after long and variable lags; (b) if banks decide to hold excess reserves, monetary policy cannot force them to lend; and (c) velocity may shift in unpredictable ways. The basic quantity equation of money is MV = PQ, where M is the money supply, V is the velocity of money, P is the price level, and Q is the real output of the economy. Some central banks, like the European Central Bank, practice inflation targeting, which means that the only goal of the central bank is to keep inflation within a low target range. Other central banks, such as the U.S. Federal Reserve, are free to focus on either reducing inflation or stimulating an economy that is in recession, whichever goal seems most important at the time.

Self-Check Questions

1 . Why is it important for the members of the Board of Governors of the Federal Reserve to have longer terms in office than elected officials, like the President? 2 . Given the danger of bank runs, why do banks not keep the majority of deposits on hand to meet the demands of depositors? 3 . Bank runs are often described as “self-fulfilling prophecies.” Why is this phrase appropriate to bank runs? 4 . If the central bank sells $500 in bonds to a bank that has issued $10,000 in loans and is exactly meeting the reserve requirement of 10%, what will happen to the amount of loans and to the money supply in general? 5 . What would be the effect of increasing the banks' reserve requirements on the money supply? 6 . Why does contractionary monetary policy cause interest rates to rise? 7 . Why does expansionary monetary policy causes interest rates to drop? 8 . Why might banks want to hold excess reserves in time of recession? 9 . Why might the velocity of money change unexpectedly? 10 . Explain how to use the IORB to lower interest rates. 11 . Explain how to use the IORB to raise interest rates.

Review Questions

12 . How is a central bank different from a typical commercial bank? 13 . List the three traditional tools that a central bank has for controlling the money supply. 14 . How is bank regulation linked to the conduct of monetary policy? 15 . What is a bank run? 16 . In a program of deposit insurance as it is operated in the United States, what is being insured and who pays the insurance premiums? 17 . In government programs of bank supervision, what is being supervised? 18 . What is the lender of last resort? 19 . Name and briefly describe the responsibilities of each of the following agencies: FDIC, NCUA, and OCC. 20 . Explain how to use an open market operation to expand the money supply. 21 . Explain how to use the reserve requirement to expand the money supply. 22 . Explain how to use the discount rate to expand the money supply. 23 . How do the expansionary and contractionary monetary policy affect the quantity of money? 24 . How do tight and loose monetary policy affect interest rates? 25 . How do expansionary, tight, contractionary, and loose monetary policy affect aggregate demand? 26 . Which kind of monetary policy would you expect in response to high inflation: expansionary or contractionary? Why? 27 . Explain how to use quantitative easing to stimulate aggregate demand. 28 . Which kind of monetary policy would you expect in response to recession: expansionary or contractionary? Why? 29 . How might each of the following factors complicate the implementation of monetary policy: long and variable lags, excess reserves, and movements in velocity? 30 . Define the velocity of the money supply. 31 . What is the basic quantity equation of money? 32 . How does a monetary policy of inflation target work?

Critical Thinking Questions

33 . Why do presidents typically reappoint Chairs of the Federal Reserve Board even when they were originally appointed by a president of a different political party? 34 . In what ways might monetary policy be superior to fiscal policy? In what ways might it be inferior? 35 . The term “moral hazard” describes increases in risky behavior resulting from efforts to make that behavior safer. How does the concept of moral hazard apply to deposit insurance and other bank regulations?