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EC140 Lecture Notes - Lecture 16: Overnight Rate, Inflation Targeting, Endogenous Money

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School
WLU
Department
Economics
Course
EC140
Professor
Ken Jackson

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EC140 Full Course Notes
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Document Summary

One solution ignore the money supply and target interest rates directly. Agree to pay interest or lend money at a set interest rate determine the market interest rate. Difficult to know the slope/position of the money demand curve. Difficult to know when the money demand curve will shift. Difficult to control the money supply - banks can change target reserve ratios. If the bank targets the money supply, the interest rate will fluctuate. If the bank wants to target the interest rate, it is easier to do so directly. Targets the overnight interest rate: rate charged on loans between commercial banks. Announces a bank rate, 0. 25 percentage points above the overnight rate: offers to end money to banks at this rate. Sets a deposit rate 0. 25 percentage points below the overnight rate: pays this rate on all deposits. Banks have an incentive to set their overnight rates close to the target.

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Related Questions

13. As we observed in this chapter, central banks, rather than purposefully setting the level of the money supply, usually set a target level for a short-term interest rate by standing ready to lend or borrow whatever money people wish to hold at that interest rate. (When people need more money for a reason other than a change in $4,010 $570.3 $641.0 CHAPTER 15 Money, Interest Rates, and Exchange Rates 383 the interest rate, the money supply therefore expands, and it contracts when they wish to hold less.) a. Describe the problems that might arise if a central bank sets monetary policy by holding the market interest rate constant. (First, consider the flexible-price case, and ask yourself if you can find a unique equilibrium price level when the central bank simply gives people all the money they wish to hold at the pegged interest rate. Then consider the sticky-price case.) b. Does the situation change if the central bank raises the interest rate when prices are high, according to a formula such as where a is a positive constant and a target price level? c. Suppose the central bank’s policy rule is where u is a random movement in the policy interest rate. In the overshooting model shown in Figure 15-12, describe how the economy would adjust to a permanent one-time unexpected fall in the random factor u, and say why. You can interpret the fall in u as an interest rate cut by the central bank, and therefore as an expansionary monetary action. Compare your story with the one depicted in Figure 15-13. Figure 15-12: http://gyazo.com/3d32377d42b5c9584e17b3c5e40aafaa

Figure 15-13: http://gyazo.com/1fa467e253e320f61da17532fa8d2b58

Question 1. (0.1 pt) According to the wealth effect, a higher price level will (decrease, increase)

the number of goods and services demanded. (Circle the correct answer for each.)

 

Question 2. (0.2 pt) If the central bank wants to expand aggregate demand, it can (decrease, increase)

the money supply, which would (decrease, increase) the interest rate.

(Circle the correct answer for each.)

 

Question 3. (0.2 pt) Monetary policy that contracts the money supply, will (decrease, increase) the

interest rate causing the aggregate demand curve to shift (in, out).

(Circle the correct answer for each.)

 

Question 4. (0.7 pt) The Federal Reserve contracts the money supply by 5 percent.

(Make sure to label your axes.)

 

a. ) Use the supply of money and the demand for money diagram to illustrate the impact of this policy on the interest rate.

b. ) Use the model of aggregate demand and aggregate supply to illustrate the impact of this change in the interest rate on output and the price level in the short run.

 

Question 5 . (0.8 pt) Explain how each of the following developments would affect the supply of money,

the demand for money, and the interest rate. Illustrate your answers with diagrams.

(Make sure to label your axes.)

 

a. ) The Fed's bond traders sell bonds in open-market operations.

 

b. ) An increase in credit-card availability reduces the cash people hold.

 

c. ) The Federal Reserve reduces banks' reserve requirements.

 

d. ) Households decide to hold more money to use for holiday shopping.

As we observed in this chapter, central banks, rather than purposefully setting the level of the money supply, usually set a target level for a short-term interest rate by standing ready to lend or borrow whatever money people wish to hold at that interest rate. (When people need more money for a reason other than a change in the interest rate, the money supply therefore expands, and it contracts when they wish to hold less.)

A. Describe the problems that might arise if a central bank sets monetary policy by holding the market interest rate constant. (First, consider the flexible-price case, and ask yourself if you can find a unique equilibrium price level when the central bank simply gives people all the money they wish to hold at the pegged interest rate. Then consider the sticky-price case.)

B. Does the situation change if the central bank raises the interest rate when prices are high, according to a formula such as R - R0= a(P - P0), where a is a positive constant and P0a target price level?

C.Suppose the central bank’s policy rule is R - R0= a(P - P0) + u, where u is a random movement in the policy interest rate. In the overshooting model shown in Figure 15-12, describe how the economy would adjust to a permanent one-time unexpected fall in the random factor u, and say why. You can interpret the fall in u as an interest rate cut by the central bank, and therefore as an expansionary monetary action.