The Economics of Money, Banking, and Financial Markets - Assignment Example

Economic Questions DQ Discuss the functions of money. Money has three main uses in the economy. As a medium of exchange, money is used as paymentfor goods and services. It facilitates trade by lowering transaction costs which could hinder the smooth exchange of goods and services. As a unit of account, money provides a common and acceptable measure in valuing goods and services. Money is also used as a store of value, a repository of purchasing power over time. This means money can be used by the person anytime in availing of goods and services. However, money becomes an effective store of value only if there is price stability with high inflation not present to erode its value (Mishkin 49- 51). DQ 2: List and discuss the composition of M1, M2 and M3. M1 is the narrowest measure of money which includes currency, checking account deposits and travelers checks. The M2 includes the M1 plus other assets that have check-writing features such as small-denomination time deposits, savings deposits and money market accounts, and money market mutual fund shares (noninstitutional). The M3 monetary aggregate is composed of M2 plus large denomination time deposits, term repurchase agreements, term Eurodollars and institutional money market mutual fund shares (Mishkin 57- 59). DQ 3: What is the structure of the Federal Reserve System (Fed) and what are the functions performed by the 12 Federal Reserve banks The Fed consists of 12 regional Federal Reserve banks, around 3000 member commercial banks, the Board of Governors of the Fed, the Federal Open Market Committee, and the Federal Advisory Council. Each of the 12 Federal Reserve banks perform the following: a. clear checks; b. issue new currency; c. withdraw damaged currency from circulation; d. administer and make discount loans to banks in their districts; e. evaluate proposed mergers and applications for banks to expand their activities; f. act as intermediaries between the business community and the Fed; g. examine bank holding companies and state-chartered banks; h. collect data on local business conditions; i. use their staff of professional economist to research topics related to monetary policy (Mishkin 369- 370). DQ 4: What are the cases for and against Fed's independence Those in favor of an independent Fed argue that a less independent Fed would be subjected to political pressures. This would add inflationary bias to monetary policy leading to an expansionary monetary policy and political business cycles. However, those in favor of less independent Fed want more accountability, transparency and democratic decision- making which affects the entire economy (Mishkin 386-387). DQ 1: Discuss the four players and how they affect the money supply process. First is the central bank, the main government agency which oversees the banking system and is in control of monetary policy. Second are the banks which serve as financial intermediaries as they accept deposits and grant loans. Third are the depositors who hold accounts in banks. The last players are the borrowers from the banks (Mishkin391- 392). DQ 2: Discuss the deficiencies of the simple model of multiple deposit creation. First, the model fails to take into account the behavior of all four players which could affect the money supply, especially the role played by the central bank. Also, it fails to predict the smaller expansion of deposits once depositors decide to hold more currency or when banks decide to hold excess reserves (Mishkin 409-410). DQ 3: Compare and contrast the Keynesian and Monetarist views on the money supply. Both schools of thought see the money supply as an important component of the economy. They just differ on the policy to address the fluctuations resulting from the increasing money supply. Keynesian economists believe that central bank can manipulate the levels of money supply, either by increasing or raising it to prop up the economy. Monetarist believes that the central bank should avoid controlling the money supply since it will lead to further fluctuations. They propose instead, that the central bank should ensure the steady growth of the monetary base to adjust for velocity changes (Mishkin 688). DQ 4: Discuss what triggers shifts in the aggregate demand and the aggregate supply An increase in the money supply, government spending, net exports, consumer and business optimism shifts the aggregate demand (AD) curve to the right. The AD curve shift to the left if taxes increase. A negative supply shock, wage push, rise in expected price level or overproduction of output (output is more than the natural level of output) shifts the aggregate supply (AS) curve to the left. Positive supply shocks and an underproductive economy (output is less than the natural level of output) shifts the AS curve to the right (Mishkin 623-627). DQ 1: Define the money multiplier and list its determinants. The money multiplier is the ratio that relates the change in money supply to a given change in the determinants of the money multiplier. Its determinants include the changes in the required reserve ratio rD, changes in the currency ratio {C/D}, and changes in the excess reserves ratio {ER/D} (Mishkin 412, 416). DQ 2: Discuss how each determinant of the money multiplier affects the money supply An increase in the required reserve ratio rD, the currency ratio {C/D} or in the excess reserves ratio {ER/D} leads to a decrease in the money multiplier and the money supply. The opposite movements of the three determinants will lead to higher money multiplier and money supply (Mishkin 417-418). DQ 3: Discuss Keyne's liquidity preference theory Keyne's liquidity preference theory views the transactions and precautionary component of money demand as proportional to income. Higher income will lead to higher transaction and precautionary demand for money. According to the theory, velocity is unstable and can never be a constant. Interest rates and expectations of its future movement affect the demand for money (Mishkin 543-546). DQ 4: Discuss Friedman's quantity theory of money Milton Friedman's quantity theory of money creation states that money is the primary determinant of aggregate spending with a predictable velocity. Demand for money is affected by the expected returns on other assets relative to the expected return on money and permanent income. Individuals will hold other assets if expected return on these assets are higher than when holding money. Demand for money is stable and is not greatly affected by interest rate movements (Mishkin 552-555). DQ 1: What are the monetary policy tools The monetary policy tools refer to the policy tools of the central bank used to affect the money supply and interest rates. First are the open market operations which affect the quantity of reserves and monetary base. Second are changes in the discount rates which influence the quantity of discount loans. Third are the changes in the reserve requirements which affect the money multiplier (Mishkin 435). DQ 2: Discuss how the Fed would use the monetary policy tools under expansionary and /or contractionary policy. Under an expansionary policy, the central bank must increase the money supply and lower the short- term interest rates. The Fed can engage in the following: a. open market purchase which expands reserves and monetary base; b. lower the discount rate which encourages borrowing by banks; or c. lower the reserve requirements among banks. All options lead to higher money supply and lower federal funds rate. Under a contractionary policy, the Fed needs to lower the money supply level and raise short- term interest rates. To do so, the Fed can: a. raise the discount rates which discourages bank borrowings; b. open market sale which tightens reserves and monetary base; c. raise the reserve requirement among banks which shrinks the available funds for banks to grant as loans to borrowers (Mishkin 439- 451). DQ 3: Briefly discuss the goals of monetary policy The goals of monetary policy are the following: a. high level of employment; b. economic growth; c. price stability; d. interest- rate setting; e. stability of financial markets; f. stability in foreign exchange markets (Mishkin 454) DQ 4: What is the Phillips curve and what does it depict The Phillips curve depicts the relationship between the state of the economy relative to its productive capacity and changes in inflation. Once unemployment rate surpasses the non-accelerating inflation rate of unemployment (NAIRU) with output above the potential, inflation will start to decrease. But if it is below NAIRU with potential output, then inflation will start to rise (Mishkin 475). DQ 1: What do the IS and LM curves depict Discuss the factors that would cause the IS and he LM curves to shift The IS curve shows the combinations of interest rates and the aggregate output for which the goods market is in equilibrium, while the LM curve gives out combinations for which the money market is in equilibrium. Increases in government spending, consumer expenditure, investment, and net exports will shift the IS curve rightward. An increase in money supply will shift the LM curve rightward. An increase in money demanded will shift the LM curve leftward (Mishkin 598). DQ 2: Discuss the effectiveness of monetary versus fiscal policy When demand for money is unaffected by interest rate movements, monetary policy will be more effective in increasing output than fiscal policy. Any increase in government spending (a fiscal policy) will raise interest rates, causing private investment and net exports to fall. This is known as the crowding out effect. If the central bank makes use of an expansionary monetary policy (either by raising money supply levels or lowering interest rates), the demand for money will increase and consequently the total output. (Mishkin 599- 601). DQ 3: Compare and contrast the Keynesian with the monetarist views on inflation Both Keynesians and Monetarists believe that high inflation can happen if only there is a high rate of money supply growth. Since fiscal policy is unsustainable, it cannot drive high inflation for a period of time. However, Keynesians believe that budget deficits can lead to high inflation on one condition. Excessive government spending financed through the printing of money leads not just to inflation but hyperinflation. Such scenario negatively affects the economy by destroying the credibility of the domestic currency (Mishkin 672-677). DQ 4: Define demand-pull and cost-push inflation, and explain when they occur. Demand-pull inflation refers to inflation caused by the policies that shift the aggregate demand to the right. Cost-push inflation occurs due to negative supply shocks or a push by workers to get higher wages. These inflations occur as government use activist stabilization policy to promote high employment. Through an expansionary monetary policy, the central bank can lower interest rates leading to higher money growth and money supply (Mishkin 673-675). DQ 1: Discuss the advantages and disadvantages of the Structural Model evidence and of the Reduced-Form Model Evidence. The main advantage of the structural model is that it explains how the economy works and of the relationship between output and money. However, an incorrectly specified structure could ignore important monetary transmission mechanisms, underestimating the effects of monetary policy. The Reduced-Form Model evidence could explain the full effects of monetary policy. This is because it leaves some room for monetary policy to affect the economy. Possible reverse causation or an ignored outside driving force could lead to confusing conclusions about the importance of money in the economy (Mishkin 635-639). DQ 2: Discuss the lessons for monetary policy. First, expanding or contracting monetary policy should never be associated with the fall or rise in short-term nominal interest rates. Instead, the public should focus on the changes in real interest rates which is a more effective channel of monetary policy. Second, asset prices other than interest rates on short-term debt paper have major effects on aggregate demand, and therefore on monetary policy. Land prices, stock prices and the value of the local currency could possibly indicate what monetary policy is at work. Third, monetary policy can be highly effective in reviving a weak economy despite short-term interest rates at near zero. Fourth, price stability is the primary goal of monetary policy. This requires the use of monetary policy to help avoid unanticipated fluctuations in the price level (Mishkin 659- 661) DQ 3: Discuss the two problems resulting from asymmetric information. There are two problems resulting from asymmetric information. First is the adverse selection problem which occurs before the transaction happens. It is encountered when parties who are most likely to produce an undesirable output are the ones most likely to engage in the transaction. The moral hazard problem arises after the transaction occurs. This is manifested by the "not moral" behavior of drivers who begin to drive recklessly after paying for car insurance. In the viewpoint of the insurance companies, the driver is engaging in an "immoral" behavior (Mishkin186-187). DQ 4: Describe the principal-agent problem and provide an example. The principal-agent problem is a type of moral hazard problem found in corporations. This arises due to the different interest of the stockholder (the principal) who owns the corporation and of the managers (the agent) who manages the corporations for the stockholders. The managers have less incentive to maximize profits than the stockholders since ownership, therefore a large part of the profits, reverts back to the stockholders. It may be in the interest of the managers to make it appear the corporation is profiting. The managers can avail of rewards from the stockholders like higher salaries or travel allowance. In case of bankruptcy, the stockholders suffer more through less value for their shares compared to the managers who are fired for mismanagement (Mishkin 193). DQ 1: What is a nominal anchor and what purpose does it serve A nominal anchor is a nominal variable that monetary policymakers use to tie down the price level such as the inflation rate, an exchange rate, or the money supply. This is used as an intermediate target to achieve the objective of price stability. It helps conduct monetary policy by limiting thr time-inconsistency problems that could possibly lead to long- run outcomes (Mishkin 506- 507). DQ 2: What are the main advantages and disadvantages of monetary targeting Monetary targeting has two main advantages. First, it enables the central bank to adjust its monetary policy on the domestic situations. Second, the effects of monetary policy are known almost immediately. However, such policy requires a stable relationship between monetary aggregates and inflation which has been unreliable as recent data show (Mishkin521). DQ 3: Briefly discuss the advantages and disadvantages of inflation targeting. Inflation targeting has four main advantages. First, it allows monetary policy to focus on domestic considerations. Second, it is easily understood by the public. Third, it increases the accountability of the central bank. Lastly, it could be used to cushion inflationary pressures. Some of its disadvantages are the ff: a. inflation is not easily controlled by monetary authorities, b. impose a rigid rule on policymakers leaving little room for flexibility, c. lead to larger output fluctuations (Mishkin 524- 529). DQ 4: What are the advantages and disadvantages of the Fed Reserve having an implicit and not explicit nominal anchor By having an implicit concern (like low inflation in the long run), the Fed allows monetary policy to work on domestic considerations. It doesn't rely on a stable money- inflation relationship and has had some success. However, such policy depends on the credibility of the policymakers of the central bank. Such policy lacks a level of transparency and accountability in decision making which is counter to the ideals of any democratic country (Mishkin 530- 533). Works Cited Mishkin, Frederic. The Economics of Money, Banking, and Financial Markets. Addison-Wesley, 2004 (7th ed.) 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