Practice Questions 6 Answer Key

Money and Banking

Fall 2000

2) True/False/Uncertain

a) Uncertain: The Fed can control the discount rate, but the decision to go to the discount window and the amount requested is exogenous. However, the Fed is not obligated to provide a discount loan to a bank, in whole or in part.

b) False: It is very imprecise and very blunt.

c) False: Changing the discount rate is much more flexible and reversible, and has much more predictable effects than changing the reserve requirement.

d) False: The FOMC makes the decisions, but the trading desk at the NY Fed actually executes the transactions.

e) True: The Fed can add or remove liquidity to affect market rates, and thereby affect the Fed Funds rate. Moreover, the Fed can (and currently does) announce a target for the Fed Funds rate, which leads to fairly rapid convergence to this rate.

f) False: This has been proposed, however. You should understand the arguments.

g) False: The discount rate is a penalty rate.

h) False: The Fed is not obligated to provide a discount loan, in while or in part. However, if it desired, the Fed could loan as much as it wanted.

i) False: Changes in the reserve requirement causes liquidity problems, etc. so usually instigates discount window lending, etc. Open market operations are administratively the easiest.

j) False

k) False: Dynamic open market operations are what actually maintain price stability, etc.

l) True: The discount window reduces potential insolvency and thereby may lead banks to take on an excessive amount of risk, from the standpoint of taxpayers. If these assets go into default, the taxpayers may transfer funds to the bank. If, however, the assets pay out, the bank reaps any benefits.

m) False: Extended credit discount loans are long-term loans offered to banks that have experienced severe liquidity problems because of deposit outflows.

3) Short Response

a) How independent is the Fed? Very, though the Governors are appointed by Congress and Congress can change the laws dictating the operations of the Fed. Is this independence good? Pros: (1) no debt monetization, (2) greater price stability from independent central banks, historically, (3) no political business cycle. Cons: (1) “undemocratic”, (2) less coordination between fiscal and monetary policy.

b) MB = Reserves plus discount loans. Excess reserves can’t be controlled well by the Fed. The Fed can control required reserves, however sweep accounts and offshore banking have reduced the amount of required reserves. The Fed can affect discount loans, and can predict them moderately well. Money multplier components include C/D, ER/D, and the reserve requirement. The Fed can’t control C/D and really has no good idea how much currency is in circulation. The Fed can’t control ER/D. The Fed can control the reserve requirement perfectly, but not required reserves (given sweep accounts, etc.).

c) See the text for this answer.

d) Net free reserve (NFR) targeting is procyclical. In the Depression NFR increased so the Fed moved to decrease NFR, but this was contractionary. Why were NFR increasing? Banks worried about deposit outflows so held ER. Also, few good loans were available to be made (despite price deflation!) so banks kept cash as reserves. The Fed thought that high NFR corresponded to too much cash available to be loaned, so Fed was worried that economy was expanding too quickly. This was perfectly backwards.

e) Measurability: comparable, as it is real interest rates that matter, and this requires expected inflation. Controllability: Fed can affect the money supply, but can’t set real interest rates, as they can’t directly affect expected inflation. Predictable effect on goals: This is subject to much debate… provide an argument one way or another.

f) This tells you that the LM is more volatile than the IS, so a money supply target leads to bigger fluctuations in output than an interest rate target. Most of this is driven from the money supply side, partly due to technological innovation. The existence of sweep accounts has increased transactions velocity, and the proliferation of payment options and money transfer systems have increased both income and transactions velocity of money.