14 Monetary Policy and Bank Regulation
12.1 The federal reserve banking system and central banks
Review Activities
Practice Problems
No practice problems for this section.
External Resources
No external resources for this section.
12.2 Bank Regulation
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No practice problems for this section.
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No external resources for this section.
12.3 How a Central bank executes monetary policy
Review Activities
Practice Problems
Problem 12.3.1: Suppose that Widget Financial is currently holding $300 million in deposits. The reserve requirement is 10%. They plan on keeping no excess reserves. Outside of the reserves, they have issued $170 million in loans, and $100 million in USGS. The Fed wants to engage in expansionary monetary policy, so the FOMC buys bonds from banks (including Widget). Suppose that the Fed buys $50 million worth of bonds from Widget and that they want to keep no excess reserves. Show the process of the purchase and then the restoration of the reserve requirement.
Answer: See video for solution.
Problem 12.3.2: Suppose that Erie Federal Credit Union is currently holding $50 million in deposits. The reserve requirement is 10%. They plan on keeping no excess reserves. Outside of the reserves, they have issued $30 million in loans, and $15 million in USGS. The Fed wants to engage in restrictive monetary policy, so the FOMC sells bonds to banks (including EFCU). Suppose that the Fed sells $5 million worth of bonds from EFCU and that they want to keep no excess reserves. Show the process of the purchase and then the restoration of the reserve requirement.
Answer: See video for solution.
Problem 12.3.3: For each of the following, determine whether the given policy impacts the money supply. If it does, determine whether the policy increases or decreases the money supply.
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The FOMC purchases bonds.
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The Fed increases the reserve requirement.
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The federal government increases the income tax rate.
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The Fed begins to pay more interest on required reserves.
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The Fed increases the discount rate.
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The government decreases its overall spending level.
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The Fed decreases the amount of interest it pays on excess reserves.
Answers: Yes, increase; Yes, decrease; No; No; Yes, decrease; No; Yes, increase
External Resources
Khan Academy: Open-Market Operations
Khan Academy: Quantitative Easing
12.4 Monetary policy and economic outcomes
Review Activities
Practice Problems
Problem 12.4.1: Suppose that the FOMC buys bonds. Show the impact of this action on BOTH the market for loanable funds and the subsequent impact on the aggregate market. Be sure that everything is labeled and that you fully explain the mechanism that connects the loanable funds market for the aggregate market.
Answer: When the FOMC buys bonds, they exchange bonds with cash. This means that they take bonds away from the banks (which cannot be loaned out) and give them cash (which can be loaned out). This means that the supply of loanable funds has increased (since banks have more money to loan out). This causes a surplus of loanable funds (see the relevant problems in chapter 11 about shifts in the supply of loanable funds) pushing the real interest rate downward. When the real interest rate falls, consumption will increase (less people saving, more people borrowing, therefore spending) and investment will increase (cheaper to borrow, so firms borrow more for large projects). Since consumption and investment are both increasing, aggregate demand increases as well.
Problem 12.4.2: Suppose that the Fed increases the reserve requirement. Show the impact of this action on BOTH the market for loanable funds and the subsequent impact on the aggregate market. Be sure that everything is labeled and that you fully explain the mechanism that connects the loanable funds market for the aggregate market.
Answer: When the Fed increases the reserve requirement, they are forcing banks to hold on to more of their money which means they can lend less of it out. This means that the supply of loanable funds has decreased (since banks have less money to loan out). This causes a shortage of loanable funds (see the relevant problems in chapter 11 about shifts in the supply of loanable funds) pushing the real interest rate upward. When the real interest rate increases, consumption will decrease (more people saving, less people borrowing, therefore less spending) and investment will decrease (more expensive to borrow, so firms borrow less as they are taking on less large projects). Since consumption and investment are both decreasing, aggregate demand decreases as well.
External Resources
Khan Academy: Monetary Policy Tools
12.5 pitfalls for monetary policy
Review Activities
Practice Problems
No practice problems for this section.
External Resources
No external resources for this section.