Explain two concepts of central bank independence. Is the Fed politically independent? Why do economists think central bank independence is important?

Answer) Instrument independence is a central bank's ability so that it could set its instruments, and on the other hand, goal independence is the central bank's ability so that it could set its goal. Both types of independence i.e. instrument independence and goal independence is being enjoyed by the Fed as Fed is not under the political pressure and it is largely independent because of its appointment conditions of its chairman and the board of directors, and earnings. Some kind of political pressure, however, can be applied to the fed through legislative enactment or threat that affect the Fed. Economists think that independence is important because lower rate of inflation is being pursued by the independent central banks without harming the economic performance of the country.

Make the case for and against an independent Federal Reserve

Answer) Case for: the economy can be shielded by the independent Federal Reserve form the business cycle involving politics and inflationary bias is less likely to occur to monetary policy. Moreover, money supply control is too important that it cannot be left to the politicians who are inexperienced.

The case against: Having the monetary policy of the state to be controlled by some autonomous individual sounds undemocratic as they will not be accountable. The freedom of Fed has not used wisely in the past and the independence of the Fed may encourage the own self-interest priority than then the interest of the public.

Who are the voting members of the Federal Open Market Committee and why is this committee important? Where does the power lie within this committee?

Answer) The monetary supply is determined by the FOMC in the United States of America through its strategies and decisions regarding operations of an open market. Reserve requirements and discount rate are also being effectively determined by the FOMC. The board of governors has seven members and voting happens on the rotating basis, along with the New York Fed’s president who is also involved in the voting process. The power is wielded by the board of governor’s chairman.

Lesson 9

How the Banking System Creates Money

Assume a simple banking world in which no banks hold excess reserves, and the public holds no currency. If a bank sells a $100 security to the Fed, explain the accounting process for the first two steps in the deposit expansion process, assuming a 10% reserve requirement. Now, separately assume that the deposit creation process has fully run its course. How much do deposits and loans increase for the banking system when the process is completed?

Answer) The security for the reserves will be changed first by the Bank A, and reserves will be lent to create the loans. $100 will be received by it in the reserves form the securities' sale. As all of the available reserves will be considered as the excess reserves and in checkable deposits, there will be no change, so all $100 will be loan out by the bank. Then this amount will be deposited eventually in the Bank B and Bank B would have the $100 change in its reserves, out of this $100, the excess reserve will be $90. This excess reserve will be loan out by the bank B that will be deposited ultimately in the Bank C. The reserves of the bank C will be increased by $90 and the amount of excess reserve will be $81. This excess reserve will be loan out by the bank C and this process will keep going till the time when no more excessive reserve will be left in the banking system. Both deposits and loans will be increased by $1000 for the banking system.

Explain two reasons why the Fed does not have complete control over the level of bank deposits and loans. Explain how a change in either factor affects the deposit expansion process.

Answer) The level of bank loans and bank deposits is not completely controlled by the Fed because excess reserve can be held by the banks and the currency holdings can be changed by the public. The change in any of the factors has the ability to the change the process of deposit expansion. The increase in excess reserve or currency has the ability to lower the number by which loans and deposits are increased.

Explain why the simple deposit multiplier overstates the true deposit multiplier.

Answer) Role banks is ignored by the simple model and creation process is being played by their customers. The customers of the bank are able to decide to hold the currency or not and the bank is able to decide to hold the excess reserve or not. Both banks and customers will restrict the ability of the banking system to create loans and deposits. Hence, the simple deposit multiplier's prediction is more than the true multiplier.

What factors determine a bank’s holdings of excess reserves? How does a change in each factor affect excess reserves, the money multiplier, and the money supply?

Answer) The increase in the market rate of interest lowers the excess reserves of the banks because increase lending will be profitable for the banks. On the other hand, the excess reserve will be increased by the increase in outflow of expected deposit. The excess reserves can be decreased due to the increase in the rate of interest, increasing the money supply as well as a multiplier. Excess reserves can be increased by the increase in expected outflows, reducing the money supply and multiplier.

Explain two developments in recent years that have led to the decreasing importance of reserve requirements in determining the money multiplier and the money supply.

Answer) The first one is known as the sweep account, it means that two different accounts are tied together. The sweeps account usually consists of the money market fund account and the checking account. At each business day's end, in the checking account, the balance over some specific amount are swept into the account of MMF. This process has caused the lower balance of checking accounts and minimum required reserve, as only checkable deposit accounts are applicable by the reserve requirements.

The second one is the ATMs' increasing availability. It was found by the banks that more cash is needed to be supplied to the banks increased the ATMs all over the world. Thus, the mean of this increased vault cash is that more excess reserves are being held by the banks. The behaviour of banks will not be altered by the change in reserve requirement, as long as extra vault cash that the bank is holding is more than the change in reserve requirements.

Lesson 10

How the Fed Conducts Policy/Operations of a Central Bank

Explain the Fed’s three tools of monetary policy and how each is used to change the money supply. Does each tool affect the monetary base or the money multiplier?

Answer) There are three tools for the monetary policy that are bank rates, reverses, and open market operations. Each tool can change the money supply as when reserves increase supply goes towards decrease. Increase in the open market operations regulates the money supply in the most effective manner as government and federal make policies for money supply according to the open market operations requirements and outcomes. While increase or decrease in the bank rates as the discount rate and interest rates also affect the decision towards the money supply. Reserve has the direct impact on the money multiplier. But discount rate and open market operations have the influence on the monetary base.

Explain dynamic and defensive open market operations. What is the purpose of each type? Describe two situations when defensive open market operations are used. How defensive open market operations are typically conducted?

Answer) Dynamic open market operations are used to change the monetary base as well as money supply permanently. On the other hand, defensive open market operations temporary offset the changes in the monetary base as well as money supply. Defensive open market operations are useful to offset shifts, float in Treasury balances out of the Fed or into the fed, and temporary currency changes. Typically, defensive purchases are conducted through repurchase agreements, while defensive open market sales are conducted through matched sale-purchase transactions or reverse repos.

Graphically illustrate the market for reserves for two cases:

An increase in the discount rate.

Rate of interest

Explain and demonstrate graphically how targeting the federal funds rate can result in fluctuations in non-borrowed reserves.

Answer) When non-borrowed reserves are constant, demand for reserve increase will cause the increase in federal funds rate while a decrease in the non-borrowed reserve demand will cause the decrease in federal funds rate. Since demand fluctuation does not cause the actions of monetary policy, this will cause the fluctuations in the federal funds rate. It can be seen in the following figures as well.

Figure 1:

Explain the Taylor rule, including the formula for setting the federal funds rate target, and the components of the formula. If the Fed were to use this rule, how many goals would it use to set monetary policy?

Answer) The Taylor rule has specified that the target rate of federal funds should be equal to the equilibrium of real federal fund rate plus on half time an output gap, plus the inflation rate for a Fisher effect, plus one-half times the gap of inflation. Following formula explains the Taylor rule:

 Target of federal funds rate = equilibrium real federal fund rate + ½ (output gap) + inflation rate + ½ inflation gap

The output gap represents the real GDP’s percentage deviation from the potential full-employment real GDP. The inflation gap represents the difference between the target rate of inflation of the central bank and the actual inflation. The equilibrium real federal fund rate represents the real rate that is consistent with the full level of employment in the long run. The federal funds rate is set by the Taylor rule recognizing the goals of full employment and low inflation or long-run economic growth equilibrium.

Exam 3

Explain the Fed’s three tools of monetary policy and how each is used to change the money supply. Does each tool affect the monetary base or the money multiplier?

Answer) There are three tools for the monetary policy that are bank rates, reverses, and open market operations. Each tool can change the money supply as when reserves increase supply goes towards decrease. Increase in the open market operations regulates the money supply in the most effective manner as government and federal make policies for money supply according to the open market operations requirements and outcomes. While increase or decrease in the bank rates as the discount rate and interest rates also affect the decision towards the money supply. Reserve has the direct impact on the money multiplier. But discount rate and open market operations have the influence on the monetary base.

Explain inflation targeting. What are the advantages and disadvantages of this type of monetary policy strategy?

Answer) Following are the five elements of inflation targeting:

Medium term target’s public announcement for the rate of inflation

The price stability commitment as the policy's long-term primary goal

Use of various variables in decision making regarding policy moves

Transparency increase about the strategy of policy with the public

Accountability increase by the central bank for attaining the policy goals.

The inflation targeting advantages include the clarity and simplicity of the numerical inflation rate target; there is increased central bank accountability; reduces the inflationary shocks’ effects.

The inflation targeting’s disadvantages: there is the delayed signal about the target’s achievement; the rigid rule could be led where the only and major focus is the inflation rate; if the inflation rate is the sole focus, larger fluctuations in output can occur.

Explain and demonstrate graphically how targeting the federal funds rate can result in fluctuations in non-borrowed reserves.

Answer) When non-borrowed reserves are constant, demand for reserve increase will cause the increase in federal funds rate while a decrease in the non-borrowed reserve demand will cause the decrease in federal funds rate. Since demand fluctuation does not cause the actions of monetary policy, this will cause the fluctuations in the federal funds rate. It can be seen in the following figures as well.

Explain the Taylor rule, including the formula for setting the federal funds rate target, and the components of the formula. If the Fed were to use this rule, how many goals would it use to set monetary policy?

Answer) The Taylor rule has specified that the target rate of federal funds should be equal to the equilibrium of real federal fund rate plus on half time an output gap, plus the inflation rate for a Fisher effect, plus one-half times the gap of inflation. Following formula explains the Taylor rule:

 Target of federal funds rate = equilibrium real federal fund rate + ½ (output gap) + inflation rate + ½ inflation gap

The output gap represents the real GDP’s percentage deviation from the potential full-employment real GDP. The inflation gap represents the difference between the target rate of inflation of the central bank and the actual inflation. The equilibrium real federal fund rate represents the real rate that is consistent with the full level of employment in the long run. The federal funds rate is set by the Taylor rule recognizing the goals of full employment and low inflation or long-run economic growth equilibrium.

Make the case for and against an independent Federal Reserve.

Answer) Case for: the economy can be shielded by the independent Federal Reserve form the business cycle involving politics and inflationary bias is less likely to occur to monetary policy. Moreover, money supply control is too important that it cannot be left to the politicians who are inexperienced.

The case against having the monetary policy of the state to be controlled by some autonomous individual sounds undemocratic as they will not be accountable. The freedom of Fed has not used wisely in the past and the independence of the Fed may encourage the own self-interest priority than then the interest of the public.

Outline and summarize the assigned reading: “Understanding the Persistence of Poverty.” 2006 Annual Report, Federal Reserve Bank of Cleveland.

Answer) In this reading, the issue and persistence of poverty are highlighted that with one of the most productive and wealthiest nations around the globe, millions of the citizens are still living in poverty. The poverty rate in the United States has remained among the highest as compare of other developed companies as well as stalled for the previous 30 years. This reading has discussed the issues of people living in poverty that they tend to earn less money, acquire fewer job skills, and experience worse health as well as financial issues than the people who are comparatively better off. Moreover, this reading has highlighted the gaps created by the poverty that how it saps the strengths of people and communities. The research function of this reading is among the various areas of bank contributing to advance the leadership’s strategic objective in deed and thought external focus, and operational excellence in 2006. The reading has discussed the ongoing research efforts of the bank to better understand the role played by innovation, education, and human capital in driving the economic growth for the long term.