TEST 4 MACROECONOMICS Federal Funds Rate Interbank overnight lending rate of at least 1 million dollars Discount Rate The rate at which the FED lends to banks Prime Rate The rate that banks charge their preferred customers T Bill Rate The rate that the treasury pays for lending to the treasury our national debt Mortgage Rate Interest rate on houses List and briefly explain the advantages that money has over barter and both Money is convenient Easy to carry With barter items get cumbersome annoying Always know the worth Everything can be valued in money With barter parties must agree on the value of the items and the value will change depending on the parties involved Debit Credit Creates a system where debit and credit can be used and expand to provide for more spending and transactions What backs our money What is important about that Money is backed by the word of the government It s value comes from the goods and services that it can purchase so it is essentially backed by the goods and services in the economy This is important because you used to be able to redeem a dollar for lawful money because money was backed by gold and silver but now you cannot It is simply legal tender With relative scarcity of money compared to goods and services the money has more purchasing power Why is the supply of money in an economy so important The supply of money in an economy determines price level and inflation in the long run and the current direction of the economy in the short run Keeping money relatively scarce maintains its purchasing power and by reducing the volatility of the money supply we reduce the volatility of consumption and are able to have a smooth running economy List and briefly describe 4 functions of the FED Setting reserve requirements determines what the minimum amount of banks deposits need to be held in their vaults Lending to banks the Fed lends to banks charging them interest discount rate Issuing Federal Reserve Notes issuing money into the economy Monetary Policy They control the money supply through monetary policy and ensures that the economy expands stably What are the components of M1 and how large is M1 currently M1 is both currency and checkable deposits It is the most liquid measure of money Currency accounts for 51 of M1 and checkable deposits accounts for 49 of M1 2575 9 billion is the amount of M1 as of September 2013 according to www federalreserve gov Describe how banks create money VERY IMPORTANT To create money banks make loans from deposits They set up accounts for clients and each time the client writes a check for the loan money it creates a deposit in another bank Then the other bank can make even more money by making more loans Negative relationship between banks reserves and their lending capacity Positive relationship between banks lending capacity and money supply What two features of our banking system are needed for banks to create money Fractional Reserve System Banks are only required to keep a fraction of checkable deposits in cash This enables banks to make more money by lending money that they do not actually have on hand The fact that demand deposits are included in our definition of money Since demand deposits count as money the money supply goes up when loans are made and checks are written and deposited How is the money multiplier calculated and what is its importance It is important because it tells you how much the money supply would increase with one dollar increase in deposits Money Multiplier 1 required reserve ratio 1 R What is the Federal Funds Market and what role does that market play in the banking system The federal funds market where banks give money to each other in order to meet their reserve requirements This makes it so that banks with more than they need can help banks with less than they need They are very quick overnight loans which have very low interest rates List and briefly describe the 6 ways that the Fed has to control the money supply 1 Open Market Operations To increase reserves the Fed buys sells bonds with checks When people deposit the checks their bank s reserves rise so that they can make new loans Buying bonds increases the money supply selling them decreases 2 Reserve Ratio Requirement To increase excess reserves the Fed can lower the reserve ratio decreasing the amount of reserves that a bank is required to hold and making them give out more loans Lower RRR increased money supply 3 Discount Rate To increase excess reserves the Fed can decrease the discount rate interest rate that Fed charges banks making borrowing reserves easier and expanding excess reserves Lower interest rates increases money supply higher interest rates decreases money supply 4 Term Auction Facility The Fed holds two auctions each month where banks bid to borrow reserves This changes the money supply depending on how much reserves the Fed decides to auction More auctioning increases money supply 5 Paying Interest on Reserves Held at Fed To increase banks reserves the Fed can pay low interest rates on excess reserves giving the banks less incentive to hold excess reserves Lower interest rates increases money supply higher interest rates decreases money supply 6 Quantitative Easing Like Open Market Operations except the Fed purchases sells long term government bonds instead of other bonds Buying bonds increases the money supply selling them decreases Write out the Taylor Rule and identify each of the 4 terms In the late 70s early 80s the economy was in inflation in fact in 1978 the inflation was near 15 and the Fed wanted to bring the inflation rate down If the value for the inflation rate is 15 the historical FFR average is 2 the inflation target is 2 the RGDP is 5 1 trillion and the full employment GDP is 4 8 trillion what would the target FFR rate be Does your answer make sense Explain FFR FFR ave P 1 2 P P 1 2 RGDPt RGDP RGDP FFR 0 02 0 15 1 2 15 0 02 1 2 4 8 5 1 5 1 FFR 0 17 0 065 0 029 FFR 0 264 FFR Target Short Term Federal Funds Rate FFR ave Average Federal Funds Rate P P Inflationary Gap RGDPt RGDP RGDP Gap P Inflation My answer makes sense because during times of increase inflation the government wants to increase the short term federal funds rate in order to lower spending decrease inflation and decrease RGDP For Inflation explain how the FFR target should change Does this make sense For Inflation the FFR target should be higher The Average Federal Funds Rate remains the same the Inflation Rate is positive