Econ 330 – Kelly

Fall 2000

Midterm #3 Answer Key (ID’s & T/F/U)

ID’s:

1. Non-borrowed monetary base:
• The monetary base, less discount loans. Equals currency plus reserves.
• Is perfectly controllably by the Fed, via open market operations.
2. Lender of last resort:
• A role of many central banks, generally, and the Fed in particular. The Fed through the operation of the discount window may provide liquidity to financial institutions in times of need.
• This role may instigate morally hazardous behavior by banks, etc.
3. Political business cycle:
• Business cycle associated with election cycles, particularly for chief executives and legislators. There is a tendency to institute expansionary fiscal policies prior to an election, so as to make (re)election more palatable to a nation’s citizens. This expansion is often followed by a contraction, which offsets some of the detrimental effects of the former.
• One of the major arguments for central bank independence. Central bankers should have long-term policy horizons that are independent of political considerations.
4. Float:
• Cash items in the process of collection minus deferred-availability cash items.
• Is essentially equivalent to temporary privately created Federal Reserve notes, and as such is the target of defensive open market operations.
• Mitigated by ACH and electronic check truncation, as well as rules on daylight overdrafts (which have to do with Repos, mostly).

Short Responses:

1. False:
1. Discount borrowing is exogenous to the Fed… raising or lowering the discount rate can only discourage or encourage it.
2. Fed can refuse to lend at the discount window… discount loans are a privilege not a right.
3. Fed engages in moral suasion to effect discount borrowing.
4. An increase in market rates will tend to increase discount borrowing, ceteris paribus. The Fed can use assorted policy tools to raise market interest rates.
2. Uncertain:
1. Nominal interest rates are easy to find, but there are a lot of them… it’s not clear which one to look at.
2. More relevantly, the real interest rate is the one that matters. To determine a real interest rate, one must know expected inflation. There is no easy way to determine expected inflation, and moreover, any action taken by the Fed to assess expected inflation will most likely change expected inflation.
3. Expected inflation is not controllable by the Fed, so interest rates are shaky on the controllability criterion.
4. Monetary aggregates are very volatile and not easy to either measure or target. Interest rates and monetary aggregates are probably comparable in controllability.
5. The predictability of changes in interest rates and monetary aggregates on goals is the subject of much debate.
3. False:
1. An increase in the reserve requirement will probably reduce the money supply, as the money multiplier most likely decreases. If, however, the increase in the reserve requirement is less than or equals the typical ER/D ratio, and excess reserves are simply ‘relabeled’ required reserves, this may not be true.
2. Assume the money supply decreases. Then the interest rate increases. An increase in the interest rate means that there is a higher opportunity cost of holding excess reserves. Consequently, the ER/D ratio will decrease.
4. False:
1. An OMO changes the monetary base by exactly the sale or purchase amount, regardless of the counterparties in the OMO or their preferences for currency vs. reserves. The MB equals currency plus reserves… an OMO changes one or both.
2. If the counterparties in an open market purchase, say, hold some or all of their proceeds in the form of currency, then reserves change by less than the amount of the purchase.
5. True:
1. When the economy is expanding, money demand increases. This increases market interest rates.
2. When market interest rates increase, the opportunity cost of excess reserves increases, so ER/D generally decreases. This increases the multiplier, which increases the money supply.
3. Also, when market rates increase, discount loans become relatively less costly, so the volume of these loans increases. This increases the monetary base, and hence the money supply.
6. False:
1. A purchase of Euros by the Fed is an OMO purchase. As such, the monetary base increases by the amount of the purchase. The money supply increases by no less than the amount of the purchase, and may increase by as much as the money multiplier times the amount of the purchase.
2. This assumes that the intervention is non-sterilized. A sterilized intervention would, of course, result in no change in the monetary base.

ESSAYS

1.

The Fed has three tools that it uses for monetary policy purposes:

OMO’s: Selling or Buying of government securities by the Fed in the market.

Flexibility: very high

Reversibility: very high

Effectiveness: very effective

Speed of implementation: easy to implement and of a very rapid impact

Required Reserve Requirement: Determination of the liquidity in the form of deposits in the Federal Reserve that the Fed ask the banks to have in proportion of their deposits.

Flexibility: very low

Reversibility: very low

Effectiveness: effective but difficult to control because it affects a wide array of different matters.

Administrative Cost: High.

Speed of implementation: Very low.

Discount Rate: Rate that is charged by the Fed to banks which come for funds at its discount window.

Flexibility: not very high, but difficult to set in the “right” level due to uncertainties associated with the functioning of financial markets.

Reversibility: easy to move, but the effects on the money supply are quite unpredictable.

Effectiveness: Difficult to assess beforehand.

Administrative Ease: not as easy as the OMO’s

Speed of Implementation: quite high.

2.

The fiscal deficit is just the difference between public expenditure and taxes. If it is positive the government is in need of extra funds. There are three ways to finance the public sector deficit, provided the public expenditure remains fixed: an increase in taxation which does not have an impact on the monetary base, an pure increase in the public sector debt, (with no simultaneous participation of the Fed), which does not increase the monetary base and the third one, the placement of new bonds and the simultaneous buy open market operation by the Fed. In this last case, if the increase is at no expense of other assets of the Fed, -like international reserves- the monetary base does increase.

3.

There are three main problems related with the existence of a discount window, problems associated with the function of the Fed as a lender of last resort, problems associated with the announcements effects and problems associated with the lack of controllability of the window.

The basic problem associated with the lender of last resort function is of moral hazardous behavior from part of the banks.

The basic problem associated the announcement effect is that people form expectations according to the setting of the discount rate by the Fed.

The basic problem associated with the lack of controllability is with banks going to the discount window too often. To avoid this problem it has been suggested to peg the discount rate to the rate in the market plus a premium; this kind of policy will also have a positive effect in eliminating the announcement effect even though it would mean that the Fed is resigning one of its monetary policy tools, and also, the moral hazard would not be reduced with such a policy.

4.

Results are:

Iff: 3%

R=1400

ER=280

RR=1120

D=14000

C=6000

MB=7400

c=C/D

m=M/MB