ECON 2035 : Review Exam 3 Spring 2012 - Complete
ECON 2035 Spring 2012
Review Questions for Exam 3 (chapters: Central Banks & the Federal Reserve System, the
Money Supply Process, and only part of Tools of Monetary Policy—just the Conventional
Monetary Policy Tools section)
Exam 3: WEDNESDAY APRIL 25
30 Multiple choice questions
1. What is a central bank?
The government authorities in charge of monetary policy. Central banks actions affect
interest rates, the amount of credit, and the money supply, all which have direct impacts not
only on financial markets, but also on aggregate output and inflation.
2. In 1900 there were about 18 central banks in the world, but today there are about 160
central banks in the world. Why are there more central banks today than in 1900? (two
reasons)
From reading it seems to be from new countries that want to create an image of economic
independence and also as a tool to speed monetary growth in these developing countries.
3. Is the statement “The functions of central banks have remained unchanged over time.”
true or false? Thoroughly explain why you indicated the statement was true or false. If
you think the statement is true, you should explain the timeless functions. If you thing the
statement is false, you should explain the functions in the past and the functions now.
I think recently the structure of the central banks have changed most notably in its function
as a lender of last resort helping out a plethora of failing businesses and banks that it
normally would not have been accountable for. Another change in the function is the way
they act. The central banking system has moved away from certain methodologies and have
moved to focusing on different, newer methods of controlling the money supply. In the end,
it’s function of keeping the economy on track and preventing high inflation has remained
pretty much the same, but the methods in which they achieve these goals are different over
the evolution of time.
4. Distinguish between microprudential and macroprudential regulation of the banking system.
he term macroprudential regulation characterizes the approach to financial regulation
aimed to mitigate the risk of the financial system as a whole (or "systemic risk").
Following Borio (2003)[4], the macro and microprudential perspectives differ in terms of
their objectives and understanding on the nature of risk. Traditional microprudential
regulation seeks to enhance the safety and soundness of individual financial institutions,
as opposed to the macroprudential view which focuses on welfare of the financial system
as a whole. Further, risk is taken as exogenous under the microprudential perspective, in
the sense of assuming that any potential shock triggering a financial crisis has its origin
beyond the behavior of the financial system. The macroprudential approach, on the other
hand, recognizes that risk factors may configure endogenously, i.e. as a systemic
phenomenon. In line with this reasoning, macroprudential policy addresses the
interconectedness of individual financial institutions and markets, as well as their
common exposure to economic risk factors. It also focuses on the procyclical behavior of
the financial system in the effort to foster its stability.
5. The trend in the world is to more independence for central banks.
a. Are central banks typically free to choose their own goals? Explain briefly.
Yes, because they are not as tied down politically.
b. What is meant by instrument independence?
Instrument independence refers only to the central bank’s ability to freely adjust
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its policy tools in pursuit of the goals of monetary policy. The Bank of England, while
lacking goal independence, has instrument independence; given its inflation mandate set
by the government, it is able to sets its instruments without influence from the
government. Similarly, the inflation target range for the Reserve Bank of New Zealand is
set in its Policy Targets Agreement (PTA) with the government, but given the PTA, the
Reserve Bank has the authority to sets its instruments without interference. The Federal
Reserve and the ECB have complete instrument independence.
Goal independence
refers to the central bank’s ability to determine the goals of policy without the direct
influence of the fiscal authority. In the U.K., the Bank of England lacks goal
independence since the inflation target is set by the government. In the U.S., the Federal
Reserve’s goals are set in its legal charter, but these goals are described in vague terms
(e.g., maximum employment), leaving it to the Fed to translate these into operational
goals. Thus, the Fed has a high level of goal independence. Price stability is mandated as
3the goal of the European Central Bank (ECB), but the ECB can choose how to interpret
this goal in terms of a specific price index and definition of price stability
c. What are arguments for more independence for central banks? What are the arguments
against?
Independence – if it were under political influence there would be inflationary bias;
politicians would attempt to monetize the debt more frequently and drive up inflation. there
would be a political cycle coinciding with elections of higher inflation during the election
season while politicians attempted to “reduce the debt” by creating money (called a political
business cycle, though it can be argued that this already exists today). Another reason for
independence is that politicians cannot be trusted to make hard decisions on the economy.
The independent fed can be preferred by politicians to be used as a scapegoat when things
go awry. They can pursue unpopular solutions that are in the public interest although not in
politicians interest.
Against – undemocratic to have monetary policy controlled by an elitre group that is
responsible to no one. becomes a slippery slope: if monetary policy is better off being
decided by elites, other functions of our government should be done the same way. It would
allow monetary policy and fiscal policy to be determined by the same group (politicians)
and prevent cross-purposed programs. Independent central banks do not always use their
freedom successfully. It is also not completely immune from political pressure.
d. Is the inflation rate higher or lower for more independent central banks than less independent
central banks? Are output fluctuations higher for more independent central banks than less
independent central banks? Do your answers support or oppose the movement to more
independence for central banks?
Inflation performance is better in countries with more independent central banks,
statistically. They are no more likely to have greater output fluctuations. Therefore, it
supports a move to more independent central banking systems.
6. What is a lender of last resort and why is a lender of last resort important to a banking system?
to prevent bank failures from spinning out of control, it was to provide reserves to banks
when no one else would, thereby preventing bank and financial panics. discounting is a
particularly effective way to provide reserves to the banking system during a banking crisis
because reserves are immediately channeled to the banks that need them most.
using the discount tool to avoid financial panics by performing the role of lender of last
resort is an extremely important requirement of successful monetary policymaking. bank
panics in the thirties were the cause of the sharpest decline in the money supply in history
which economists see as the driving force behind the great depression. financial panics can
also severely damage the economy because they interfere with the ability of financial
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intermediaries and markets to move funds to people with productive investment
opportunities
7. In terms of the banking system and a central bank, how can the period from 1836-1913 in the
U.S. be characterized?
because there was no lender of last resort that could provide reserves to the banking system
to avert a bank panic, in the ninteteeth and early twentieth centuries, nationwide bank
panics became a regular event, occurring every twenty years or so, culminating in the panic
of 1907. the panic resulted in such widespread bank failures and such substantial losses to
depositors that the public was finally convinced that a central bank was needed to prevent
future panics.
8. What event lead to the establishment of a true central bank in the U.S.? When was the Federal
Reserve created? When did operations begin?
See previous answer.
Congress wrote an elaborate system of checks and balances into the Federal Reserve Act of
1913, which created the Federal Reserve System with its twelve regional Federal Reserve
banks.
9. Why was the Federal Reserve set up with 12 regional Federal Reserve banks rather than just
one centralized bank as was typically the case for many European countries?
Decided to set up a decentralized system with twelve Fed Reserve banks spread throughout
the country to make sure that all regions of the country were represented in monetary
policy deliberations.
The hostility of the American public to banks and centralized authority created great
opposition to the establishment of a single central bank like the bank of England. fear was
rampant that the money interests on wall street would be able to manipulate such an
institution to gain control over the economy and that federal operation of the central bank
might result in too much government intervention in the affairs of private banks.
10. How did the Banking Acts of the 1930s affect the Federal Reserve? How did the Monetary
Control Act of 1980 affect the Federal Reserve? How did the Dodd-Frank Act of 2010 affect the
Federal Reserve?
Later that year Congress passed the 1933 Banking Act. The Federal Reserve Board was
given tighter control of the investment practices of banks and the Federal Deposit Insurance
Corporation was set up to insure all deposits in banks up to $5,000.
1980: All depository institutions became subject ot the same requirements to keep deposits
at the Fed, so member and nonmember banks would be on an equal footing in terms of
reserve requirements. In addition, all depository institutions were given access to the Fed
facilities, such as the discount window and Fed check clearing on equal basis. These
provisions ended the decline in Fed membership and reduced the distinction between
member and nonmember banks. It essentially gave the Fed more power since it had control
over all banks, not just member banks.
Dodd Frank: The legislation explicitly expands the goals for the Fed to include financial
stability in addition to the traditional goals of price stability and full employment.
Consequently, the central bank will have enhanced responsibility for systemic risk
assessment and regulation, and it will house and fund a new Consumer Financial Protection
Document Summary
Review questions for exam 3 (chapters: central banks & the federal reserve system, the. Money supply process, and only part of tools of monetary policy just the conventional. The government authorities in charge of monetary policy. Why are there more central banks today than in 1900? (two reasons) Thoroughly explain why you indicated the statement was true or false. If you think the statement is true, you should explain the timeless functions. If you thing the statement is false, you should explain the functions in the past and the functions now. Another change in the function is the way they act. The central banking system has moved away from certain methodologies and have moved to focusing on different, newer methods of controlling the money supply. Following borio (2003)[4], the macro and microprudential perspectives differ in terms of their objectives and understanding on the nature of risk.
