ECON 202 - PRINCIPLES OF ECONOMICS:

MACROECONOMICS
Phil Martinez

Updated: June 27, 2011

This study guide is not intended to comprehensively cover all of the material which may be tested on Exam 3. Rather it is an aid offered to help students organize their preparation for the exam.  The outline presented here is primarily follows the material covered in the  lectures. There is additional material in the Chapters 13, 14, and 15 that does not appear here but is required material for this exam.

 EXAM 3  -  STUDY GUIDE
MONETARY THEORY

MONEY AND BANKS

Definitions: 

Money; functions of money; forms of money; prices of money;
transaction accounts, demand deposits, reserve accounts, required reserve ratio; liquidity, liquidity trap.

Concepts/Processes:

"Money Creation":  The role of private banking in the money supply.

The private banking system creates money automatically via new deposits & new loans, i.e. transfers of funds into transaction accounts from reserves.

The money multiplier (i.e. the deposit expansion multiplier).
Limitations to "money creation".


Money Supply: the role of Monetary authority and regulation.

       The primary authority used to manage the money supply is the Federal Reserve Bank ("the FED"). The FED is a
quasi-governmental, private bank (see below).

The FED increases the money supply primarily by using open market transactions to transfer funds from the FED's Reserves into transaction accounts of private banks and institutions.

The FED decreases the money supply primarily by using open market transactions to transfer funds from the transaction accounts of private banks and institutions into FED's Reserves.

Other specific tools and mechanisms available to the FED are outlined below.


Money Demand

Transactions Demand for Money
Speculative Demand for Money
Precautionary Demand for Money

The quantity of money demanded is inverse to the real interest rate.


The Graphical Model of the Money Market
1.   The money supply is modelled as if it were entirely determined or fixed by government (i.e. the FED's) policy. Therefore it is drawn as a vertical line on the Money Market graph.

2.   The quantity of money demanded is inverse to the real interest rate. Thus, money demand is drawn as a negatively-sloped line intersecting the vertical money supply line.

3.   The real rate of interest is determined by the intersection of the money supply and money demand lines.


THE FEDERAL RESERVE BANK & MONETARY POLICY

Definitions:

Reserve accouts: actual reserves, required reserves, excess reserves; the required reserve ratio; Discount Rate; Federal Funds Rate; Prime Rate.


Concepts/Processes:

The 4 responsibilities of the Federal Reserve Bank. (See text.)
The quasi-governmental authority of the Fed.
The private nature of the Fed.
The independence of the Fed. and of the Federal Reserve Chair.
The structure of the Fed.: the Chairman, the Board of Governors, the Federal Open Market Committee, the 12 Regional Federal Reserve banks.

Managing the Money Supply

1.    Open Market Transcations:

Expansionary Monetary Policy
    Fed buys bonds => funds transfered from Reserves into Trans. Acc'ts. =>
        money supply rises => r falls => I rises => E rises => AD rises => (Q,P) rise.

Contractionary Monetary Policy
    Fed sells bonds => funds transfered from Trans. Acc'ts. into Reserves =>
        money supply falls => et cetera...

2.      Adjusting Interest Rates

Expansionary and Contractionary Policy

a) Discount Rate
b) Federal Funds Rate
c) Prime Rate

3.     Changing the Required Reseve Ratio

Expansionary and Contractionary Policy


Monetarism
Claims of Monetarist Theory:

1. All fiscal policy is ineffective and should never be used to manage the business cycle.

a) Fiscal policy only has a short-term influence on output. In the long-run a fiscal stimulus only results in inflation.

b) Discretionary fiscal policy has a lag-time that is too long, and risks destabilizing the natural adjustment process of the business cycle.

c) All fiscal policy, being discretionary and involving spending and taxation, is open to manipulation for political and personal benefit.

2.  Expansionary monetary policy is ineffective and should never be used to manage the business cycle. In the long run it only results in inflation. It only has temporary impacts on:

a) Unemployment.
b) Output
c) Interest rates and investment

3)  Discretionary monetary policy should never be used. Although the Fed. is formally independent of the governmental "chain of command" it is still susceptile to lobbying and political pressure. Additionally, its independence  does not ensure a balanced approach to the managing the money supply.

4) Monetarist policy does not have goals of maintaining Q, UN, nor I high. It does not targt adjustment of the level of interest rates.  Rather it argues that the market self-adjusts adequately via the pricing mechanisms, and that the government, i.e. the Fed, can promote the greatest economic stability simply by maintaining the money supply stable.

5)  The only governmental policy that should ever be used is Contractionary Monetary Policy governed by a "fixed rule" (i.e. calculation).  The "rule" should calculate out the  level of the money supply needrd to allow for the growth rate of GDP to be no more than 3% per year. The role of the Chair of the Fed should be only to ensure the implemention of the "rule"

6)  The primary concerns of Monetarism is controlling the inflation level and restricting government policy from affecting the business cycle. Monetarist policy is focused solely on measuring the Money Supply and the inflation rate. The goal for inflation is to maintain it at 0.0%.

Other less rigid Monetaristsargue for a target of 1.0% inflation or even 3.0% or less, which has been relatively successfully maintained by the Fed for the last several decades (especially under the Chairmanship of Alan Greenspan).

By contrast, Keynesian policy advisors would argue that the most effective policy for stabilizing the business cycle is to seek a balance of low inflation at or near full employment, with growing investment. Thus, many Keynesians argue that the money supply should be more "loosely" managed, allowing inflation to well over 3% if necessary to push the economy toward full employment.


A few Loose Ends to Consider:
The Effectiveness of Monetary Policy in an Open Economy.
The Fed's Effectiveness in Fighting Inflation and Recession.


SHORT ANSWER ESSAY QUESTIONS

* Questions 5 and 6 will not be used as Short Answer Essay questions be may appear as Multiple Choice format questions.

1.        Explain how the private banking system creates money.

2.        Explain the (3) limitations to the banking system creating money.

3.        What is the money multiplier? How does it work?

4.        In what ways is the Federal Reserve Bank a quasi-governmental, private bank.

*5.         a)  What is the most important job of the Federal Reserve Bank? 
            b)  What are the tools that it can use use to accomplish this job? 
            c)  What are the other primary jobs of the Federal Reserve?

*6.         What is the Equation of Exchange? What is the Velocity of Money? Explain how the monetarist view uses the equation of exchange and the velocity of money to argue that expansionary monetary policy only results in inflation.

7.        Explain the Monetarist proposal for monetary policy.

8.        Explain current Fed policy.  What is the Fed trying to achieve?