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Chapter 11 - Monetary Policy and the Fed
Read pages 221- 242
I The Goals and Outcomes of Monetary
Policy
A) Goals of Monetary Policy
Goals are not easy since the obvious may be
in conflict. In particular, high growth and
low inflation are not exactly compatible.
1) The Federal Reserve Act of 1913 said
little about policy goals.
2) The first effort to specify goals came in
the Employment Act of 1946. This act
said, “…use all practical means … to
promote maximum employment,
production and purchasing power.” The
act also created the council of economic
advisors.
3) The Full Employment and Balanced
Growth Act of 1978, commonly known as
the Humphrey-Hawkins Act, specified that
by 1983 the federal government should
achieve an unemployment rate among
adults of 3 percent or less, a civilian
unemployment rate of 4 percent or less and
an inflation rate of 3 percent or less. Also
requires the Fed chairman to report twice a
year to the congress.
4) Federal Reserve Policy and Goals based on
observation.
a) Over the past 20 years the Fed is
generally more concerned about inflation.
b) It may have a target inflation around 2%.
c) It only takes on output expansion when it
feels that inflation is not a concern.
B) Monetary Policy and Macroeconomic
Variables
1) Policy tools
a) Targeting the Fed Funds rate using open
market operations.
b) Setting the discount rate.
c) Setting reserve requirements.
2) Typical Expansionary Policy – Buy bonds,
expanding the money supply, bringing down
market interest rates stimulating investment
and thus aggregate demand.
II Problems and Controversies of Monetary
Policy
A) Fed policy is decided without political
constraints.
B) 3 Lags associated with policy
1) The delay between the time a
macroeconomic problem arises and the
time at which policymakers become aware
of it is called a recognition lag.
2) The delay between the time at which a
problem is recognized and the time at which a
policy to deal with it is enacted, is called the
implementation lag.
Fiscal policy has a long one while monetary
policy has a short one
3) The delay between the time a policy is
enacted and the time that policy has its impact
on the economy is called the impact lag.
Fiscal policy has a short one, monetary policy
has a long one.
C) Choosing Targets
1) Federal funds targets. This is carried out
through open market operations.
2) Fed is required by law to announce to
Congress at the beginning of the year its
monetary growth rate target. The Fed
typically gives a broad range. This target is
not used because the Federal Funds target
requires certain money supply levels.
3) Could announce a price level target.
D) Political Pressures
Although they are largely independent, the
Fed Governors and Chairman are selected
by the President and confirmed by congress
and they have to report to Congress
regularly.
E) The Degree of Impact on the Economy
A liquidity trap is said to exist when a
change in monetary policy has no effect on
interest rates.
F) Rational Expectations
Rational expectations hypothesis is that
people use all available information to make
forecasts about future economic activity and
the price level, and that they adjust their
behavior to these forecasts.
III Monetary Policy and the Equation of
Exchange.
A) The Equation of Exchange
1) The equation of exchange shows that the
money supply M times its velocity V
equals nominal GDP.
2) Velocity is the number of times the
money supply is spent to obtain the goods
and services that make up GDP during a
particular period.
3) M x V = nominal GDP
4) Using P=nominal GDP/Real GDP, we see
an alternative form is,
MV=PY.
5) Example 1: M=$500, Y=50 (50 car
washes), P=$10 (per car wash). Then V=1.
6) Example 2: US economic data for 1999.
M=$4,443.5 Billion, P=1.135, Y=7,754.7
Billion. Then V=1.98.
B) Money, Nominal GDP, and Price-Level
Changes.
1) Implications of a constant velocity.
a) Nominal GDP, I.e. PY, will change only if
there is a change in the money supply.
b) A change in the money supply would
always change nominal GDP by an equal
percentage.
2) Note the equation of exchange implies
% AM + % AV = % AP + % AY
If the velocity is constant %AV = 0 , thus
% AM - % AY = % AP
If % AY is determined by exogenous
factors, as they are in the long run, then
changes in money are reflected only in price
changes.
3) The quantity theory of money holds that in
the long run the price level moves in
proportion to changes in the money supply.
B) Why the Quantity Theory of Money is
Less useful in Analyzing the Short Run.
1) In the short run the velocity of money is
not very stable.
2) The same factors which influence money
demand will also influence short run
velocity, e.g, interest rates, income,
expectations. This can be seen by using
M=PY/V. This implies things that change
M, but not PY will impact V.