Key Concepts in Monetary Policy and Macroeconomics
Federal Open Market Committee
The Federal Open Market Committee (FOMC) is a committee within the Federal Reserve System (the Fed). Under United States law, it is charged with overseeing the nation’s open market operations.
Open Market Operations
Open Market Operations refer to the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system.
Money Creation by Commercial Banks
Money creation by commercial banks: In a fractional reserve banking system, commercial banks are permitted to create money by allowing multiple claims to assets on deposit. Banks create credit that did not previously exist when they make loans. This is sometimes called the money multiplier effect.
Federal Funds Rate
The federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis.
Real Exchange Rate
The real exchange rate indicates how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign country.
Balance of Payments Gap
The balance of payments (BOP) gap occurs when the central bank intervenes in the foreign exchange market. The BOP gap will be equal to the change in official reserves.
Spot Exchange Rate
The spot exchange rate is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date.
Forward Exchange Rate
The forward exchange rate is the exchange rate at which a bank agrees to exchange one currency for another at a future date when it enters into a forward contract with an investor.
Theory of Unbiased Forward Rates
The theory of unbiased forward rates states that the forward rates of a commodity will be equal to the anticipated price of a commodity on a certain date or expiry date.
Purchasing Power Parity
Purchasing power parity is an economic theory that states that the exchange rate between two countries is equal to the ratio of the currencies’ respective purchasing power.
Interest Rate Parity
Interest rate parity is a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
Costs of Inflation
Inflation increases all prices, including wages and salaries, which increase on average by the increase in inflation. When wages increase with inflation, the real wage rate is unchanged. Real wage growth is determined by productivity.
Velocity of Money
The velocity of money is the frequency at which the average same unit of currency is used to purchase newly domestically-produced goods and services within a given time period.
Money Printing
Money printing is financing government budget deficits by selling bonds to the central bank. This causes very high inflation.
Seigniorage Revenue
Seigniorage revenue occurs when the money that is created is worth more than it costs to produce. This revenue is often used by governments to finance portions of their expenditures without having to collect taxes.
Liquidity Trap
The liquidity trap is the situation in which the current interest rates are low and savings rates are high, rendering monetary policy ineffective.
Potential Output
Potential output is the normal or average level of output, as determined by resources and technology. Potential output is determined by the number of workers, the amount of physical capital, and the available technologies.
Natural Rate of Unemployment
The natural rate of unemployment is a combination of frictional and structural unemployment that persists in an efficient, expanding economy when labor and resource markets are in equilibrium.