Chapter 14: Monetary Policy and the Federal Reserve System

Relevant Textbook Solutions (some have been omitted)

Review Questions

1. The monetary base, or high-powered money, consists of the sum of currency held by the non-
bank public and banks’ reserves. In an all-currency economy, the money supply equals the
monetary base.

2. The money multiplier is the number of dollars of the money supply that can be created from
each dollar of monetary base. Changes in the desire by the public for holding currency affect the
currency-deposit ratio, thus changing the money multiplier. Similarly, changes in banks’ desire to
hold reserves affect the reserve-deposit ratio, thus changing the money multiplier. Increases in
either the currency-deposit ratio or the reserve-deposit ratio reduce the money multiplier. But
these effects do not mean that the central bank cannot control the money supply, because changes
in the money multiplier can be offset by changes in the monetary base to leave the money supply
unchanged.

3. An open-market purchase increases the monetary base. The increase in the monetary base leads
to an increase in the money supply through the multiple expansions of loans and deposits.

4. Monetary policy in the United States is determined by the Federal Reserve System. The
President appoints the seven members of the Board of Governors of the Federal Reserve System,
including the chairman, but otherwise has no direct influence on monetary policy.

5. Means of controlling the money supply other than open-market operations include:

(1) Reserve requirements. An increase in reserve requirements forces banks to hold more
reserves, increasing the reserve-deposit ratio, thus reducing the money multiplier. With a lower
money multiplier, the money supply is reduced for a given size of the monetary base.

(2) Discount window lending. A reduction in discount window lending, which may be caused by
the Fed increasing the discount rate or by the Fed refusing to lend, causes a reduction in banks’
reserves, decreasing the monetary base. Also, a higher discount rate may lead banks to choose a
higher reserve-deposit ratio, so the money multiplier declines. Both effects reduce the money
supply.

(3) Interest rate on reserves. The Fed can increase reserve holdings by banks by increasing the
interest rate on reserves, thus reducing the money multiplier and the money supply.

6. Intermediate targets are macroeconomic variables that the Fed cannot directly control, but can
influence fairly predictably, and that are related to the ultimate goals of monetary policy. The
ultimate goals of monetary policy are achieving price stability and promoting stable growth of
aggregate economic activity. Since the Fed can’t control its ultimate goals directly, it influences
its intermediate targets as a method for achieving those goals.
If the Fed targets the Fed funds rate, then it engages in monetary policy to peg a particular real
interest rate, thus allowing the LM curve to shift to whatever location is necessary to hit its target
for the real interest rate. Implicitly, then, the target for the real interest rate becomes a horizontal
LR curve, replacing the LM curve.

7. The three channels of monetary policy transmission are the interest rate channel, the exchange
rate channel, and the credit channel. The interest rate channel arises because tighter monetary
policy raises the real interest rate, which reduces aggregate demand, leading to lower output and
prices. The exchange rate channel comes about as tighter monetary policy raises the real
exchange rate, leading to lower net exports, which reduces aggregate demand and thus reduces
output and prices. The credit channel occurs when tighter monetary policy reduces the supply of
credit, as banks lend less, and the demand for credit, as firms and consumers borrow less. With
less borrowing and lending, consumption and investment decline, so aggregate demand falls,
leading to declines in output and prices.

8. The monetarist response to the argument that discretion is more flexible than following a rule is
to argue that (1) because of information lags, it is difficult for the central bank to tell what the
appropriate policy is at a particular time; (2) there are long and variable lags between monetary
policy actions and their economic results; and (3) the lags mean that by the time a policy change
has an effect, it may be destabilizing—moving the economy in the wrong direction. Further,
discretion allows political manipulation of the economy.

The more recent argument is that the central bank’s credibility can be enhanced by tying itself to
rules rather than relying on discretion. If people believe that the central bank is committed to a
rule, they will know that the Fed will not take advantage of them by using unexpected inflation to
increase output temporarily. As a result, inflation will be lower.

9. The Taylor rule sets the Fed funds rate target depending on recent inflation, the deviation of
output from the level of full-employment output, and the deviation of recent inflation from its
target of 2%. The rule has explained the movements of inflation fairly well in the past; when the
Fed has set interest rates below those called for by the Taylor rule, inflation has often increased
and when the Fed has followed the Taylor rule, inflation has been stable.

10. Inflation targeting may improve a central bank’s credibility because the public can easily
observe whether the central bank has achieved its goals. The main disadvantage is the long lag
between changes in monetary policy and changes in inflation, so that the Fed may not know
exactly how to change policy to hit its goals and the public may not know at any time if the Fed is
engaging in the best policy.

Numerical Problems

1. Omitted

2. Dollar amounts are in millions of dollars.

(a) DEP = MS − CU = 6 − 2 = 4. RES = res * DEP = 0.25 * 4 = 1. BASE = CU + RES = 2 +

1 = 3. Multiplier = MS / BASE = 6 / 3 = 2.

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(b) RES = vault cash + reserves at central bank = 1 + 4 = 5. CU = BASE − RES = 10 − 5 = 5.
MS = CU + DEP = 5 + 20 = 25. Multiplier = MS / BASE = 25 / 10 = 2.5.

3.
(a) res = 0.4 − 2(0.10) = 0.2. Multiplier = (cu + 1) / (cu + res) = (0.4 + 1) / (0.4 + 0.2) = 2 1/3.
MS = multiplier * BASE = 2 1/3 * 60 = 140. Setting MS / P = L(.) gives 140/1 = 0.5Y −
10(0.10), or 140 + 1 = 0.5Y, which has the solution Y = 282.

(b) res = 0.4 − 2(0.05) = 0.3. Multiplier = (cu + 1) / (cu + res) = (0.4 + 1) / (0.4 + 0.3) = 2. MS
= multiplier * BASE = 2 * 60 = 120. Setting MS / P = L(.) gives 120/1 = 0.5Y − 10(0.05), or
120 + 0.5 = 0.5Y, which has the solution Y = 241.

(c) In this case the multiplier is unchanged from part (a) at 2 1/3, so the money supply is
unchanged at 140. Setting MS / P = L(.) gives 140/1 = 0.5Y − (10 ∗ 0.05), or 140 + 0.5 = 0.5Y,
which has the solution Y = 281.

(d) If the reserve-deposit ratio is unaffected by the real interest rate, the LM curve is steeper than
when it is affected by the real interest rate. To see why, consider the effect of a decline in the real
interest rate. If the reserve-deposit ratio is affected by the real interest rate, the fall in the real
interest rate causes banks to hold more reserves, since they are cheaper (they have a lower
opportunity cost). The increase in reserves reduces the money multiplier, reducing the nominal
money supply. At the same time, the fall in the real interest rate increases the real demand for
money. Since the price level is fixed in the short run, the decline in the nominal money supply
means that the real money supply has declined as well. Since the real money supply declines
while real money demand increases, something must adjust to restore equilibrium. Along an
LM curve, given a particular real interest rate, output adjusts to restore equilibrium. A decline in
output is necessary to reduce real money demand and restore equilibrium in the asset market.

If the reserve-deposit ratio is not affected by the fall in the real interest rate, then there is no effect
on money supply, just an increase in money demand. So it takes a smaller decline in output to
restore the asset market to equilibrium. Since output need not change as much, this means that
the LM curve is steeper.

4.
(a) The Taylor rule is i = π + 0.02 + 0.5y + 0.5 (π − 0.02). The inflation rate over the past year
is [(149.2 − 147.3) / 147.3] = 0.013. The percentage deviation of output from potential output is
(12,892.5 − 13,534.2) / 13,534.2 = −0.047. So the Taylor rule suggests a target Fed funds rate
equal to: i = π + 0.02 + 0.5y + 0.5 (π − 0.02) = 0.013 + 0.02 + [0.5 ∗ (−0.047)] + 0.5[0.013 −
0.02] = 0.006 = 0.6%.

(b) Omitted

Analytical Problems

1.
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(a) The increase in banks’ reserve-deposit ratio reduces the money multiplier, causing the money
supply to decline.

(b) The increased holding of cash raises the currency-deposit ratio, reducing the money multiplier
and causing the money supply to decline.

(c) The sale of gold to the public has the same effect as an open-market sale of government
securities—it reduces the monetary base, thus causing the money supply to decline.

(d) If the Fed pays a lower interest rate on reserves, banks are likely to decrease their reserve-
deposit ratio, thus increasing the money multiplier, causing the money supply to increase.

(e) As people sell their stocks and increase their deposits, the currency-deposit ratio will decline.
This causes the money multiplier to increase, which causes the money supply to increase.

(f) When the Fed monetizes the government debt, the monetary base increases, so the money
supply increases.

(g) When the Fed sells securities in exchange for yen, there is no change in the U.S. monetary
base or in the U.S. money supply. The Fed has simply changed the composition of its assets.

2. Omitted

3.
(a) The investment tax credit causes desired investment to rise, shifting the IS curve up and to the
right. The short-run equilibrium occurs at point B, with a higher level of output and an
unchanged real interest rate. In the long run (Figure 14.5), the equilibrium must occur at the
intersection of the FE line and the IS curve, so the existing real interest rate is not tenable; the
price level will increase, causing the LM curve to shift up and to the left, leading the LR curve to
shift up. Compared with the initial situation, output is unchanged, the price level is higher, and
the real interest rate is higher.

Figure 14.4

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 Figure 14.5

(b) If the Fed raises its target for the real interest rate to keep output stable in response to the shift
in the IS curve, it shifts the LR curve up to LR 2 (Figure 14.6). The short-run and long-run
equilibria both occur at the same point B, at which the real interest rate is higher but output and
the real interest rate are unchanged.

Figure 14.6

(c) The increase in the expected inflation rate causes the real interest rate to decline, if the Fed
keeps the nominal interest rate unchanged, causing the LR curve to shift down (Figure 14.7). The
short-run equilibrium occurs at point B, with a higher level of output and lower real interest rate.
In the long run (Figure 14.8), the equilibrium must occur at the intersection of the FE line and the
IS curve, so the existing real interest rate is not tenable; the price level will increase, causing the
LM curve to shift up and to the left, leading the LR curve to shift up, with the equilibrium again
occurring at point A. Compared with the initial situation, output is unchanged, the price level is
higher, and the real interest rate is unchanged.

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Figure 14.7 Figure 14.8

(d) If the Fed raises its target for the nominal interest rate to keep the real interest rate unchanged
in response to the increase in the expected inflation rate, then there is no shift in the LR curve
(Figure 14.9). The short-run and long-run equilibria both occur at the same point as the initial
equilibrium A, with no change in output, the real interest rate, or the price level.

Figure 14.9

4. Omitted