Macroeconomics Chapter 15

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When Congress established the Federal Reserve in 1913, its main responsibility was

to make discount loans to banks suffering from large withdrawals by depositors

Congress broadened the Fed’s responsibility since

the 1930s as a result of the Great Depression.

Which one of the following is not one of the monetary policy goals of the Fed?

Reduce income inequality

Why is the Fed sometimes said to have a "dual mandate"?

maintaining price stability and high employment are the two most important goals of the Fed that are explicitly mentioned in the Employment Act of 1946

How can investment banks be subject to liquidity problems?

they often borrow short term, sometimes as short as overnight, and invest the funds in longer-term investments

What is a banking panic?

A situation in which many banks experience runs at the same time

Which of the following best explains how the Federal Reserve acts to help prevent banking panics?

The Fed acts as a lender of last resort, making loans to banks so that they can pay off depositors

An article in the Wall Street Journal quoted a Federal Reserve economist as referring to "the Fed’s existing dual mandate to achieve maximum sustainable employment in the context of price stability." "Maximum sustainable employment" means the economy is producing at its potential where

unemployment includes frictional and structural unemployment

"Price stability" means

a low and stable inflation rate

In the summer of 2015, many economists and policymakers expected that the Federal Reserve would increase its target for the federal funds rate by the end of the year. Some economists argued, though, that it would be better for the Fed to leave its target unchanged. At the time, the unemployment rate was 5.3 percent, close to full employment, but the inflation rate was below the Fed’s target of 2 percent. If it did not increase its target for the federal funds rate, the policy goal the Fed would be promoting is

economic growth, because maintaining lower interest rates would stimulate the economy and raise the price level

One of the goals of the Federal Reserve is price stability. For the Fed to achieve this goal

the rate of inflation should be low, such as 1% to 3%, and should be fairly consistent

Which of the following is not one of the monetary policy goals of the Federal Reserve ("the Fed")?

a high foreign exchange rate of the U.S. dollar relative to other currencies

Which of the following is a monetary policy target used by the Fed?

Interest Rate

The Fed uses policy targets of interest rate and/or money supply because

it can affect the interest rate and the money supply directly and these in turn can affect unemployment, GDP growth, and the price level

What do economists mean by the demand for money?

It is the amount of money- currency and checking accounts deposits – that an individual holds

What is the advantage of holding money?

Money can be used to buy goods, services, or financial assets

What is the disadvantage of holding money?

Money, in the form of currency or checking account deposits, earns either no interest or a very low rate of interest.

The federal funds rate is

The interest rate that banks charge each other for overnight loans

A former Federal Reserve official argued that at the Fed,
"the objectives of price stability and low long-term interest rates are essentially the same objective." This is true because?

stable prices make it easier to plan for the future, so expectations can be stable, which makes it less costly to make loans

Additionally, the federal funds rate is

very important for the​ Fed’s monetary policy because the Fed uses the federal funds rate as a monetary policy target since it can control the rate through open market operations

In the graph of the money market shown on the​ right, what could cause the money supply curve to shift from MS1 to MS2 ?

The Fed decreases the money supply by deciding to sell U.S. Treasury securities

In the graph of the money market shown on the​ right, what could cause the money demand curve to shift from MD1 to MD2

An increase in the price level and An increase in Real GDP

1. In​ 2015, one article in the Wall Street Journal discussed the possibility of​ "a September​ quarter-point increase in the​ Fed?s range for overnight target​ rates," while another article​ noted, "the U.S. central​ bank’s discount rate…has been set at​ 0.75% since February​ 2010." What is the name of the​ "target interest​ rate" mentioned in this​ article?

2.Who borrows money and who lends money at this​ "target interest​ rate"?

3.What is the discount​ rate?

1.The federal funds rate 2. Banks borrow and banks lend 3. The discount rate is the rate at which the Fed lends to banks

In response to problems in financial markets and a slowing​ economy, the Federal Open Market Committee​ (FOMC) began lowering its target for the federal funds rate from 5.25 percent in September 2007. Over the next​ year, the FOMC cut its federal funds rate target in a series of steps. Writing in the New York Times​,
economist Steven Levitt​ observed,
​"The Fed has been pouring more money into the banking system by cutting the target federal funds rate to 0 to 0.25 percent in December​ 2008."
1.What is the relationship between the federal funds rate falling and the money supply​ increasing?

2.How does lowering the target for the federal funds rate​ "pour money" into the banking​ system?

1.To decrease the federal funds rate, the Fed must increase the money supply 2. To increase the money​ supply, the Fed buys bonds on the open​ market, which increases bank reserves.

An article in the New York Times in 1993 stated the following about Fed Chairman Alan​ Greenspan’s decision to no longer announce targets for the​ money:
​"Since the late​ 1970’s, the Federal Reserve has made many of its most important decisions by setting a specific target for growth in the money supply … and often adjusted interest rates to meet​ them."
​Source: Steven​ Greenhouse, "Fed Abandons Policy Tied to Money​ Supply," New York Times​,
July​ 23, 1993.
1. If the Fed would no longer have a specific target for the money​ supply, it would be targeting the
2. The Fed gave up targeting the money supply because

1. federal funds rate 2. the relationship between money aggregates and other economic variables was becoming unreliable

In the figure to the​ right, which of the following events is most likely to cause a shift in the money demand​ (MD) curve from MD 1 to MD 2​(Point
A to Point ​C)​?

Increase in real GDP or increase in the price level

Which of these variables are the main monetary policy targets of the​ Fed?

the money supply and the interest rate

When interest rates on Treasury bills and other financial assets are​ low, the opportunity cost of holding money is​ _________, so the quantity of money demanded will be​ _________.

​low; high

If real GDP​ increases,

the money demand curve shifts to the right.

If the price level​ decreases,

the money demand curve shifts to the left

If the Federal Open Market Committee​ (FOMC) decides to increase the money​ supply, it orders the trading desk at the Federal Reserve Bank of New York to

buy U.S. Treasury securities.

If the FOMC orders the trading desk to sell Treasury​ securities,

the money supply curve will shift to the​ left, and the equilibrium interest rate will rise

Suppose that when the Fed decreases the money​ supply, households and firms initially hold less money than they want​ to, relative to other financial assets. As a​ result, households and firms will​ _________ Treasury bills and other financial​ assets, thereby​ _________ their​ prices, and​ _________ their interest rates.

sell; decreasing; increasing

When the Fed conducts monetary​ policy, the most relevant interest rate is the

​short-term nominal interest rate

To affect economic variables such as real GDP or the price​ level, the monetary policy target the Federal Reserve has generally focused on is the

federal funds rate

The interest rate that banks charge each other for overnight loans is called the

federal funds rate

Which of the following statements is​ correct?

The effect of a change in the federal funds rate on​ long-term interest rates is usually smaller than it is on​ short-term interest rates. A majority of economists support the​ Fed’s choice of the interest rate as its monetary policy​ target, but some economists believe the Fed should concentrate on the money supply instead. Changes in the federal funds rate usually will result in changes in both​ short-term and​ long-term interest rates on financial assets. ALL ARE CORRECT!!!!

An increase in interest rates affects aggregate demand by

shifting the aggregate demand curve to the​ left, reducing real GDP and lowering the price level.

As the interest rate​ increases,

consumption, investment, and net exports​ decrease; aggregate demand decreases

If the Fed believes the economy is about to fall into​ recession, it should

use an expansionary monetary policy to lower the interest rate and shift AD to the right

If the Fed believes the inflation rate is about to​ increase, it should

use a contractionary monetary policy to increase the interest rate and shift AD to the left

What is​ "quantitative easing"?
Quantitative easing involved the​ Fed’s

buying longer term Treasury securities that are not usually involved in open market operations

What is​ "Operation Twist"?
​"Operation Twist" refers to

the​ Fed’s program to purchase​ $400 billion in​ long-term Treasury securities while selling an equal amount of​ shorter-term Treasury securities

Which of the following was the​ Fed’s objective in using​ "quantitative easing" and​ "Operation Twist"?

A. To keep interest rates on mortgages low. B. To increase aggregate demand. C. To keep interest rates on​ 10-year Treasury notes low. D. All of the above. ALL THE ABOVE IS CORRECT

A student says the​ following:
​"I understand why the Fed uses expansionary policy but I​ don’t understand why it would ever use contractionary policy. Why would the government ever want the economy to​ contract?"
The government would want the economy to contract when real GDP is

above potential GDP and the price level is rising

According to an article in the New York Times​,
an official at the Bank of Japan had the following explanation of why monetary policy was not pulling the country out of​ recession ​"Despite recent major increases in the money​ supply, he​ said, the money stays in​ banks."
​Source: James​ Brooke, "Critics Say​ Koizumi’s Economic Medicine Is a Weak​ Tea," New York Times​,
February​ 27, 2002.
In the​ quote, when the official says​ "the money stays in​ banks," he is referring to 1.

an increase
a decrease

in the reserves in banks.

2. But the real problem was that banks were not

lending
properly accounting for

the reserves.

3. The reason for this may have been a lack of

borrowers
reserves

1. an increase 2. lending 3. borrowers

1. An article in the Wall Street Journal discussing the Federal​ Reserve’s monetary policy included the following​ observation: "Fed officials have been signaling since last year that they expected to raise rates in 2015 … pushing up the value of the currency and contributing to the economic slowdown officials now​ confront."
​Source: Jon​ Hilsenrath, "Fed’s Rate Decisions Hang on​ Dollar, Growth​ Concerns," Wall Street Journal​,
April​ 22, 2015.
​"Pushing up the value of the​ currency" means

2. By increasing U.S. interest​ rates, the Fed would cause the value of the currency to increase because

3. An increase in the value of the currency would contribute to a slowdown in the growth of the U.S. economy because

1. increasing the exchange rate between the dollar and other currencies 2. international investors will demand more U.S. dollars to buy U.S. financial assets that now pay higher interest rates. 3. U.S. exports will fall and imports from other countries will​ rise, reducing net exports and aggregate demand.

1. According to an article in the Wall Street​ Journal,​ "Brazil’s economy grew just​ 2.3% in​ 2013, compared with​ 7.5% in 2010. The country also has struggled with persistently high​ inflation, which has forced its central bank to raise interest​ rates."
​Source: Emily Glazer and Luciana​ Magalhaes, "Brazil’s​ Debt-Laden Firms Try to Stay​ Afloat," Wall Street Journal​,
March​ 18, 2014.
The Brazilian central bank would have been​ "forced" to raise interest rates because of rising inflation

2. The increase in interest rates

1. if this was the only policy tool that could be used to reduce aggregate demand and the inflation rate 2. can be connected to the slowing rate of economic growth because it is a contractionary policy

1 William McChesney​ Martin, who was Federal Reserve chairman from 1951 to​ 1970, was once quoted as​ saying,
​"The role of the Federal Reserve is to remove the punchbowl just as the party gets​ going."
When he said​ "to remove the​ punchbowl," he meant to engage in

contractionary
expansionary

policy.

2. In terms of the​ economy, "just as the party gets​ going" refers to a situation in which real GDP

is greater than
is less than

potential​ GDP, which will result in

an increase in
a decrease in

the inflation rate.

1. contractionary 2. is greater than an increase in

1. An article in the Wall Street Journal in 2015 reported that the interest rate on​ five-year German government bonds had become​ negative: "The negative yield means investors are effectively paying the German state for holding its​ debt." The article quoted an investment analyst as​ saying: "The negative yield is not scaring investors​ away."
​Source: Emese Bartha and Ben​ Edwards, "Germany Sells​ Five-Year Debt at Negative Yield for First Time on​ Record," Wall Street Journal​,
February​ 25, 2015.
The interest rate on German government bonds became negative when

2. Investors were willing to buy bonds with a negative interest rate because

1. the inflation rate exceeded the nominal interest rate 2. they believed there was no chance that the government would default

​[Related to the Making the​ Connection] An article in the Wall Street Journal notes that before the financial crisis of 2007minus
​2009,
the Fed​ "managed just one​ short-term interest rate and expected that to be enough to meet its goals for inflation and​ unemployment"
​Source: Jon​ Hilsenrath, "Easy-Money Era a Long Game for​ Fed," March​ 17, 2013
The​ short-term interest rate the article is referring to is the

federal funds rate

The Fed expects that controlling that one interest rate would allow it to meet its goals for inflation and unemployment because lower​ short-term interest rates

encourage lending and stimulate economic activity

The article also notes that after the financial​ crisis, "the Fed is working through a broader spectrum of interest​ rates."
The reference to​ "a broader spectrum of interest​ rates" means that the Fed began to focus on

longer term Treasury rates and mortgage rates.

​[Related to the Making the Connection​]
Each​ year, the​ president’s Council of Economic Advisers prepares and sends to Congress The Economic Report of the President.
The report published in February 2008 contained the following summary of the economic​ situation: "Economic growth is expected to continue in 2008. Most market forecasts suggest a slower pace in the first half of​ 2008, followed by strengthened growth in the second half of the​ year."
​Source: Executive Office of the​ President, Economic Report of the​ President, 2008​,
​Washington, DC:​ USGPO, 2008, p. 17.
During​ 2008, real GDP

decreased

The difference between what was expected and what actually occurred illustrates that the formulation of economic policy

relies on economic forecasting that is subject to frequent revisions and errors

The following appears in a Federal Reserve​ publication:
​"In practice, monetary policymakers do not have​ up-to-the-minute, reliable information about the state of the economy and prices. Information is limited because of lags in the publication of data. ​ Also, policymakers have​ less-than-perfect understanding of the way the economy​ works, including the knowledge of when and to what extent policy actions will affect aggregate demand. The operation of the economy changes over​ time, and with it the response of the economy to policy measures. These limitations add to uncertainties in the policy process and make determining the appropriate setting of monetary policy…more​ difficult."
​Source: Board of Governors of the Federal Reserve​ System, The Federal Reserve​ System: Purposes and Functions​,
​Washington, DC, 1994.
If the Fed itself admits that there are many obstacles in the way of effective monetary​ policy, why does it still engage in active monetary policy rather than use a monetary growth​ rule, as suggested by Milton Friedman and his​ followers?
Policymakers at the Fed believe that

although it is not​ perfect, active monetary policy is still a stabilizing force in the economy

Consider the following​ statement:
​"The Fed has an easy job. Say it wants to increase real GDP by​ $200 billion. All it has to do is increase the money supply by that​ amount."
The statement is

correct
incorrect

because an increase in the money supply

does
does not

affect real GDP directly.

incorrect does not

An investment blog said about Fed Chair Janet​ Yellen, "She is arguably the​ world’s most powerful​ woman, and perhaps the most powerful person in the world. Can you name anybody with more​ might"?
​Source: Barbara​ Friedberg, "Fed Chief Janet​ Yellen: The Most Powerful Woman in the​ World," log.personalcapital.com​,
September​ 17, 2014.
This assessment

is generally accepted by economists because of the influence the Fed chair has on monetary policy and the effect monetary policy has on​ inflation, employment, and financial stability

An article in BusinessWeek in 2013 reported that Fed Chairman Ben Bernanke testified to Congress​ that:
​"If we see continued improvement and we have confidence that that is going to be​ sustained, then we couldlong dash
in
the next few meetingslong dash
we
could take a step down in our pace of​ purchases." According to the​ article, Bernanke also told Congress that​ "’premature tightening’ could​ ‘carry a substantial risk of slowing or ending the economic​ recovery.’"
​Source: Nick​ Summers, "Confusion about the Fed Slowing Its​ $85 Billion in Monthly Bond Buying Is Roiling the​ Markets," Bloomberg BusinessWeek​,
June​ 10-16, 2013.
The purchases Fed Chairman Bernanke is referring to are

open market purchases of government securities.

A​ "premature tightening" of the​ "pace of​ purchases" would slow down the economic recovery because this action would be

​contractionary, reducing lending and economic activity.

The​ Fed’s strategy of increasing the money supply and lowering interest rates in order to increase real GDP is called

expansionary monetary policy.

Why would the Fed intentionally use contractionary monetary policy to reduce real​ GDP?

The Fed intends to reduce​ inflation, which occurs if real GDP is greater than potential GDP

If the Fed is too slow to react to a recession and applies an expansionary monetary policy only after the economy begins to​ recover, then

inflation will be higher than if the Fed had not acted

A countercyclical policy is one that

is used to attempt to stabilize the economy

A procyclical policy

increases the severity of a business cycle

For the Fed to succeed in reducing the severity of business​ cycles, it must act precisely when a recession or an acceleration of inflation can be seen in the economic data.

false

With an expansionary monetary​ policy, investment,​ consumption, and net exports all​ ________, which results in the aggregate demand curve shifting to the​ ________, increasing real GDP and the price level.

​increase; right

Which of the following is not a correct comparison between an expansionary monetary policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply​ model?

A. In the dynamic​ model, expansionary policy would be used when demand does not grow​ sufficiently; in the basic​ model, expansionary policy would be used when demand falls. B. The dynamic model assumes that potential GDP is constantly growing while the basic model assumes that it is static. C. If the economy is below full​ employment, expansionary monetary policy will cause an increase in the price level in both models. D. All of the above are correct statements about the two models. ALL ARE CORRECT

Which of the following is not a correct comparison between a contractionary monetary policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply​ model?

A. The static model assumes that potential GDP is constantly growing while the dynamic model assumes that it is static. B. In the dynamic​ model, contractionary policy would be used when demand grows too​ slowly; in the basic​ model, expansionary policy would be used when demand increases. C. If the economy is above full​ employment, contractionary monetary policy will cause a decrease in the price level in the static but not the dynamic model. D. All of the above are correct statements about the two models. E. None of the above are correct statements about the two models. NONE ARE CORRECT

Explain whether you agree with this​ argument:
If the Fed actually ever carried out a contractionary monetary​ policy, the price level would fall. Because the price level has not fallen in the United States over an entire year since the​ 1930s, we can conclude that the Fed has not carried out a contractionary policy since the 1930s.

The statement is false. A contractionary policy could result in a lower rate of inflation rather than a fall in the price level

If the Fed decides to carry out an expansionary monetary policy because it believes aggregate demand will not increase enough to keep the economy at potential​ GDP, the inflation rate will most likely be lower than it would have been without the policy.

false

During​ 2005, the FOMC was concerned that the inflation rate would begin to accelerate due to the continued boom in the housing​ market, so the Fed started decreasing the target for the federal funds rate.

false

Consider the following choices and determine the correct definition for the monetary rule.

A monetary rule is a plan for increasing the money supply at a constant rate regardless of the prevailing economic condition.

Milton Friedman would have liked the Fed to follow a monetary rule where the

money supply is increased every year by a percentage rate equal to the​ long-run growth rate of real GDP

Support for a monetary rule of the kind advocated by Friedman declined since 1980 because

the​ Fed’s performance since 1980 has been excellent even without a formal inflation target

For more than 20​ years, the Fed has used the federal funds rate as its monetary policy target. It has not targeted money supply at the same time because the

Fed cannot target both at the same​ time: It has to choose between targeting an interest rate and targeting the money supply.

What is the Taylor​ rule?

It is a rule that links the​ Fed’s target for the federal funds rate to the current inflation​ rate, real equilibrium federal funds​ rate, inflation gap and output gap.

What is the purpose of the Taylor​ rule?
The Taylor rule is used to

analyze and predict how the Fed targets the federal funds rate.

In an​ interview, Paul​ Volcker, Chairman of the Federal​ Reserve’s Board of Governors from 1979 to​ 1987, was asked about the​ Fed’s use of monetary policy to reduce the rate of inflation. Volcker​ replied:
The Federal Reserve had been attempting to deal with … inflation for some time. … By the time I became chairman … we adopted an approach of …​ saying, We’ll take the emphasis off of interest rates and put the emphasis on the growth in the money​ supply, which is at the root cause of inflation … we will stop the money supply from increasing as rapidly as it was … and interest rates went up a lot. …We said …​ we’ll take whatever consequences that means for the interest rate because that will enable us to get inflation under control.
​Source:​ "Paul Volcker​ Interview," ​http://www.pbs.org/fmc/interviews/volcker.htm.
While Paul Volcker was​ chairman, the Fed did not target both the rate of inflation and interest rates because

if the Fed targets interest​ rates, they have to accept that inflation will fluctuate​ significantly, and​ Volker’s goal was to reduce inflation.

In discussing the Taylor​ rule, John Taylor​ wrote:
​"I realize that there are differences of opinion about what is the best rule to guide policy and that some at the Fed​ (including Janet​ Yellen) now prefer a rule with a higher coefficient​ [on the output​ gap]."
​Source: John​ Taylor, "Cross Checking​ ‘Checking in on the Taylor​ Rule’," www.economicsone.com, July​ 16, 2013.
If the Taylor rule was changed to have a higher coefficient on the output​ gap, then during a recession the federal funds rate would be

​lower, because more weight would be given to the output gap

Economists
and policymakers might disagree over the best rule to guide monetary policy because

of differing views about the significance of inflation and unemployment.

Two economists at the Federal Reserve Bank of Cleveland note that​ "estimates of potential GDP are very​ fluid, [which] suggests there is considerable error in our current​ measure." They conclude that​ "this lack of precision should be recognized when policy recommendations are made using a​ Taylor-type rule."
​Source: Charles Carlstrom and Timothy​ Stehulak, "Mutable Economic Laws and Calculating Unemployment and Output​ Gaps-An Application to Taylor​ Rules," Federal Reserve Bank of​ Cleveland, June​ 5, 2015.
The Federal Reserve Bank of Cleveland economists made this argument based on

the likelihood that potential output or the natural rate of unemployment cannot be accurately measured.

While serving as the president of the Federal Reserve Bank of St.​ Louis, William Poole​ stated,
​"Although my own preference is for zero inflation properly​ managed, I believe that a central bank consensus on some other numerical goal of reasonably low inflation is more important than the exact​ number."
​Source: William​ Poole,"Understanding the​ Fed," Federal Reserve Bank of St. Louis Review​,
Vol.​ 89, No.​ 1, January/February​ 2007, p. 4.
Which of the following are benefits that the economy might gain from an explicit inflation target
LOADING…

even if the target chosen is not a zero rate of​ inflation?

A. Better communication between the Fed and the public B. Improved accountability for the Fed C. More accurate expectations of future inflation D. All of the above ALL ARE CORRECT

October 2015 was the​ forty-second consecutive month that the rate of inflation as measured by the personal consumption expenditures​ (PCE) price index was below the Federal​ Reserve’s target of 2 percent.
​Source: Josh​ Mitchell, "Inflation Misses Fed​ 2% Target for 38th Straight​ Month," Wall Street Journal​,
August​ 3, 2015.
The consumer price index​ (CPI) might yield a rate of inflation different from that found using the PCE price index because

the PCE does not measure food and energy​ prices, which are measured by the CPI.

The
choice of the price index the Federal Reserve uses to measure inflation can affect monetary policy because

one goal of monetary policy is price stability​ and, if the price index used to measure inflation is consistently​ wrong, monetary policies based on that information will be wrong.

If the economy moves into​ recession, monetarists argue that the Fed should

keep the money supply growing at a constant rate

Which of the following statements is true about the​ Fed’s monetary policy​ targets?

The Fed is forced to choose between the interest rate and the money supply as its monetary policy target

The Taylor rule for federal funds rate targeting does which of the​ following?

It links the​ Fed’s target for the federal funds rate to economic variables.

According to the Taylor​ Rule, if the Fed reduces its target for the inflation​ rate, the result will be

a higher target federal funds rate.

When the central bank commits to conducting policy in a manner that achieves the goal of holding inflation to a publicly announced​ level, it is using

inflation targeting.

Which of the following were important developments in the mortgage market that took place during the​ 1970s?

A. Fannie Mae and Freddie Mac began to act as intermediaries between investors and home buyers. B. Banks began to resell mortgages on the secondary market rather than holding them in their portfolios. C. Lending standards greatly loosened credit​ standards, enabling more borrowers to obtain mortgages. D. All of the above. E. A and B only. A AND B ONLY

Beginning in​ 2008, the Federal Reserve and the U.S. Treasury Department responded to the financial crisis by intervening in financial markets in unprecedented ways.
Which of the following is one of the unprecedented actions of the​ Fed?

Making loans to primary dealers and holders of mortgage-backed securities

A newspaper article in the fall of 2007 reported stated​ that:
​"The luxury-home builder Hovnanian Enterprises reported its fourth consecutive quarterly loss on​ Thursday, citing continuing problems of credit availability and high​ inventory."
​Source: "New Loss for Home​ Builder," Associated​ Press, September​ 7, 2007.
Hovnanian was suffering losses because

the economy was slowing down and about to head into a severe recession.

When the article refers to​ "credit availability," it means the ability of

people to obtain credit.

Problems of credit availability would affect a homebuilder such as Hovnanian Enterprises because

most potential homeowners need mortgages to buy homes.

An article in a Federal Reserve publication observes that
​"20 or 30 years​ ago, local financial institutions were the only option for some borrowers.​ Today, borrowers have access to national​ (and even​ international) sources of mortgage​ finance."
​Source: Daniel J.McDonald and Daniel L.​ Thornton, "A Primer on the Mortgage Market and Mortgage​ Finance," Federal Reserve Bank of St. Louis Review​,
​January/February 2008.
What caused this change in the sources of mortgage​ finance? What would be the likely consequence of this change for the interest rates borrowers have to pay on​ mortgages?
The primary reason for this change in the sources of mortgage finance was​ _____; the consequence of this change was also​ _____ in mortgage rates.

the development of a secondary mortgage market; a decrease

The Federal Reserve releases transcripts of its Federal Open Market Committee​ (FOMC) meetings only after a​ five-year lag in order to preserve the confidentiality of the discussions. When the transcripts of the​ FOMC’s 2008 meetings were​ released, one member of the Board of Governors was quoted as saying in an April 2008​ meeting, "I think it is very possible that we will look back and​ say, particularly after the Bear Stearns​ episode, that we have turned the corner in terms of the financial​ disruption."
​Source: Jon​ Hilsenrath, "New View into​ Fed’s Response to​ Crisis," Wall Street Journal​,
February​ 21, 2014.
This​ member’s analysis turned out to be

incorrect. The economic situation worsened throughout 2008.

The​ member’s prediction may have seemed reasonable at the time because

there was a crisis atmosphere in April​ 2008, and once the crisis was​ resolved, it was reasonable to expect things to improve.

In late​ 2012, the U.S. Treasury sold the last of the stock it purchased in the insurance company AIG. The Treasury earned a profit on the​ $22.7 billion it had invested in AIG in 2008. An article in Wall Street Journal noted​ that:
​"This step in​ AIG’s turnaround, which essentially closes the book on one of the most controversial bailouts of the financial​ crisis, seemed nearly unattainable in​ 2008, when the​ insurer’s imminent collapse sent shockwaves through the global​ economy."
.
​Source: Jeffrey Sparshott and Erik​ Holm, "End of a​ Bailout: U.S. Sells Last AIG​ Shares," New York Times​,
December​ 11, 2012.
The federal government bailed out AIG because

it was the largest insurance company in the nation and the government feared the repercussions of a failure of AIG.

The government bailout was controversial because

it was​ expensive, and other companies suffered through bankruptcy and failure.

Even though the
federal government earned a profit on its investment in​ AIG, economists and policymakers who opposed the bailout were

not necessarily​ wrong, because it was an expensive and risky solution.

Recall that​ "securitization" is the process of turning a​ loan, such as a​ mortgage, into a bond that can be bought and sold in secondary markets. An article in the Economist ​notes:
That securitization caused more subprime mortgages to be written is not in doubt. By offering access to a much deeper pool of​ capital, securitization helped to bring down the cost of mortgages and made​ home-ownership more affordable for borrowers with poor credit histories.
​Source: "Ruptured​ Credit," Economist​,
May​ 15, 2008.
What is a​ "subprime mortgage," and would a subprime borrower be likely to pay a higher or a lower interest rate than a borrower with a better credit​ history?

Loans granted to borrowers with flawed credit​ histories; a higher interest rate

Why would securitization give mortgage borrowers access to a deeper pool of​ capital?

Since banks could resell mortgages to​ investors, they had access to more funds than just their own deposits

In​ 2015, Richard​ Fuld, the last CEO of Lehman​ Brothers, gave a talk in which according to an article in the Wall Street​ Journal,​ "He outlined what he called the​ ‘perfect storm’ of events that led to the financial​ crisis, saying​ ‘it all started with the​ government’ and policies that subsidized cheap loans for people to buy homes in order to help them chase the American​ dream."
​Source: Maureen​ Farrell, "Lehman’s Fuld Says It​ Wasn’t His​ Fault," Wall Street Journal​,
May​ 28, 2015.
The events that led to the financial crisis include

a burst in a housing bubble in 2006 which led to mortgage​ defaults, and a disruption of the financial system resulting from the creation of complex packagings of mortgages.

Government policies that could have been said to have been subsidizing cheap loans included

the creation of a secondary mortgage market through Fannie Mae and Freddie​ Mac, and the low interest rates following the 2001 recession.

During the expansion and deflation of the housing​ bubble, housing prices rose by

60 percent between January 2000 and July 2005 and then fell by 80 percent between July 2005 and May 2010.

At the beginning of​ 2005, Robert​ Toll, CEO of Toll​ Brothers, argued that the United States was not experiencing a housing bubble.​ Instead, he argued that higher house prices reflected restrictions imposed by local governments on building new houses. He argued that the restrictions resulted from ​"NIMBY"long dash
​"Not
in My Back ​Yard"long dash
politics.
Many existing homeowners are reluctant to see nearby farms and undeveloped land turned into new housing developments. As a​ result, according to​ Toll, "Towns​ don’t want anything​ built."Why would the factors mentioned by Robert Toll cause housing prices to​ rise?

It would keep the supply of housing from increasing.

It would be possible to decide whether these factors or a bubble was the cause of rising housing prices by looking at the number of new home units sold. If the number of new home units sold rose noticeably over​ time, then the evidence supports the bubble argument.

true

Which of the following events was an important cause of the 2007dash
2009
​recession?

the collapse of a housing bubble

Two ​government-sponsored enterprises that stand between investors and banks that grant mortgages are the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation.

true

The decline in housing prices that began in 2006 led to rising defaults among which​ borrowers?

A. borrowers with​ adjustable-rate mortgages B. ​alt-A and subprime borrowers C. borrowers who had made only small down payments D. All of the above. ALL OF THE ABOVE

Which of the following is a monetary policy response to the economic recession of 2007dash
2009
and the accompanying financial​ crisis?

A. The Fed purchased large amounts of​ mortgage-backed securities. B. The Fed provided loans directly to corporations by purchasing commercial paper. C. The Fed expanded the eligibility for discount loans to firms other than commercial banks. D. All of the above were responses. ALL OF THE ABOVE

Which of the following is NOT a monetary policy goal of the Federal Reserve bank​ (the Fed)?

low prices

When the Federal Open Market Committee​ (FOMC) decides to increase the money​ supply, it

buys
sells

U.S. Treasury securities. If the FOMC wishes to decrease the money​ supply, it

buys
sells

U.S. Treasury securities.

buys sells

As the figure to the right​ indicates, the Fed can affect both the money supply and interest rates.​ However, in recent​ years, the Fed targets interest rates in monetary policy more often than it does the money supply. Which interest rate does the Fed​ target?

the federal funds rate

The federal funds rate

is the rate that banks charge each other for​ short-term loans of excess reserves

In the figure to the​ right, when the money supply increased from MS 1

to MS 2

the equilibrium interest rate fell from​ 4% to​ 3%. Why?

A. Increased demand for Treasury securities drives down their interest rate. B. Increased demand for Treasury securities drives up their prices. C. ​Initially, firms hold more money than they want relative to other financial assets. D. All of the above. ALL OF THE ABOVE

The

long-term real interest rate
short-term nominal interest rate

is considered the most relevant interest rate when conducting monetary policy.

short-term nominal interest rate

In the figure to the​ right, the opportunity costof holding money

increases
decreases
remains the same

when moving from Point A to Point B on the money demand curve.

decreases

In the figure to the​ right, which of the following events is most likely to cause a shift in the money demand​ (MD) curve from MD 1

to MD 2

​(Point
A to Point ​C)​?

Increase in real GDP or increase in the price level

The Fed uses monetary policy to offset the effects of a recession​ (high unemployment and falling prices when actual real GDP falls short of potential​ GDP) and the effects of a rapid expansion​ (high prices and​ wages).
Can the​ Fed, therefore, eliminate​ recessions?

The Fed can only soften the magnitude of​ recessions, not eliminate them.

Changes in interest rates affect aggregate demand.
Which of the following is affected by changes in interest rates​ and, as a​ result, impacts aggregate​ demand? ​(Mark all that​ apply.)

The value of the dollar Consumption of durable goods Business investment projects

Suppose the economy is in equilibrium in the first period at point A. In the second​ period, the economy reaches point B. What policy would the Fed likely pursue in order to move AD 2

to AD Subscript 2 comma policy

and reach equilibrium​ (point C) in the second​ period? ​ (What policy will increase the price level and increase actual real​ GDP?)

Open market purchase of government securities

If the Federal Reserve is late to recognize a recession and implements an expansionary policy too​ late, the result could be an increase in inflation during the beginning of the next phase. Even though the goal had been to reduce the severity of the​ recession, the poor timing caused another​ problem: inflation. This is an example of what type of​ policy?

Procyclical policy

The figure to the right illustrates the economy using the Dynamic Aggregate Demand and Aggregate Supply Model
If actual real GDP in 2006 occurs at point B and potential GDP occurs at LRAS 06
we would expect the Federal Reserve Bank to pursue

an expansionary
a contractionary

monetary policy.

contractionary

The figure to the right illustrates the economy using the Dynamic Aggregate Demand and Aggregate Supply Model
LOADING…
If actual real GDP in 2006 occurs at point B and potential GDP occurs at LRAS 06
​,
we would expect the Federal Reserve Bank to pursue
a contractionary

monetary policy.
If the​ Fed’s policy is​ successful, what is the effect of the policy on the following macroeconomic​ indicators?
Actual real GDP

increases
decreases
does not change

Potential real GDP

increases
decreases
does not change

Price level

increases
decreases
does not change

Unemployment

increases
decreases
does not change
.

Actual real GDP decreases Potential real GDP does not change Price level decreases Unemployment increases .

The figure to the right illustrates a dynamic AD-AS model
LOADING…Suppose the economy is in equilibrium in the first period at point A. In the second​ period, the economy reaches point B.
We would expect the Fed to pursue what type of policy in order to move AD 2 to AD Subscript 2 comma policy
and reach equilibrium​ (point C) in the second​ period?

Expansionary fiscal policy
Expansionary monetary policy
Contractionary fiscal policy
Contractionary monetary policy
.

expansionary monetary policy

If the Federal Reserve​ Bank’s policy is​ successful, what is the effect on the following macroeconomic​ indicators?

actua; real GDP increases potential real GDP does not change price level increases unemployment decreases

The figure to the right illustrates a dynamic AD-AS model
Suppose the economy is in equilibrium in the first period at point A. In the second​ period, the economy reaches point B. What policy would the Fed likely pursue in order to move AD 2

to AD Subscript 2 comma policy

and reach equilibrium​ (point C) in the second​ period?

open market purchases of government securities

What is inflation​ targeting?

Committing the central bank to achieve an announced level of inflation.

Nobel laureate Milton Friedman and his followers belong to a school of thought known as monetarism. What do the monetarists argue the Fed should​ target?

The Fed should target the money​ supply, not the interest​ rate, and that it should adopt the monetary growth rule.

Consider the figure to the right. Can the Fed achieve a​ $900 billion money supply​ (MS) AND a​ 5% interest rate​ (point C)?

No. The Fed cannot target both the money supply and the interest rate simultaneously.

According to the Taylor rule what is the federal funds target rate under the following​ conditions?
follows
Equilibrium
real federal funds rate equals 3​% follows Target rate of inflation equals 3​%
follows Current inflation rate equals 2%
follows Real GDP is 2​%
below potential real GDP

3.5%

What two institutions did Congress create in order to increase the availability of mortgages in a secondary​ market?

"Fannie Mae" and​ "Freddie Mac"

How do investment banks differ from commercial​ banks? ​(Mark all that​ apply.)

Investment banks generally do not lend to households. Investment banks do not take deposits.

Why did the Fed help JP Morgan Chase buy Bear​ Stearns?

Failure of Bear Stearns would lead to a larger investment bank failure. Commercial banks would be reluctant to lend to investment banks.

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