Fedpolicy Lecture Materials
Fedpolicy Lecture Materials
Fedpolicy Lecture Materials
Learning Objectives
Predicting Federal Reserve Policy
Describe and explain the economic significance of inflation, unemployment, and real
GDP growth.
Analyze and explain the relationship among inflation, unemployment, and real GDP using
the aggregate demand/aggregate supply model.
Describe the goals and objectives of Federal Reserve policy and the Federal Reserves
policy instruments.
Use the aggregate demand/aggregate supply model to describe and explain how the
Federal Reserve uses its policy instruments (in particular, the Federal Funds rate) to
meet its policy goals and objectives.
Learning Objectives
At the end of this module, students should be able to:
Lecture Outline
Predicting Federal Reserve Policy
1. Introduction: The Relationship Between Economic Policy and the State of the Economy
Policy Goals
Recession and Inflation
Offsetting Shifts in Aggregate Demand
Offsetting (Negative) Shifts in Aggregate Supply
A Self-Regulating Macro-Economy? Potential GDP and the Natural Rate
The New Economy and the Role of Economic Policy
2. Role of the Federal Reserve
Policy Goals and Objectives
Policy Instruments: The Fed Funds Rate
FOMC Meetings
Effects of Federal Reserve Policy
What can Fed Policy Accomplish?
3. Predicting Federal Reserve Policy
Summarizing Current Economic Conditions
Recent Federal Reserve Behavior
Predicting Federal Reserve Policy
Example: The November, 1999 FOMC Meeting and the IEM FedPolicy Market
4. Summary
Lecture Notes
Predicting Federal Reserve Policy
Note: The material in this section is adapted from material published on the Board of
Governors of the Federal Reserve Web site.
Board of Governors Home Page
http://www.bog.frb.fed.us/default.htm
Web links for additional related information are provided below:
The Structure of the Federal Reserve System
http://www.bog.frb.fed.us/pubs/frseries/frseri.htm
Purposes and Functions of the Federal Reserve
http://www.bog.frb.fed.us/pf/pf.htm
1. Introduction: The Relationship between Economic Policy and the State of the
Economy.
Goals of Monetary Policy
Monetary policy has two basic goals: to promote "maximum" output and employment
and to promote "stable" prices. These goals are prescribed in a 1977 amendment to
the Federal Reserve Act of 1913.
In the long run, the level of output and employment in the economy depends on
factors other than monetary policy. These include technology and people's
preferences for saving, risk, and work effort. So, "maximum" employment and output
means the levels consistent with these factors in the long run. But the economy goes
through business cycles in which output and employment are above or below their
long-run levels.
Even though monetary policy can't affect either output or employment in the long run,
it can affect them in the short run. For example, when demand contracts and there's
a recession, the Fed can stimulate the economytemporarilyand help push it back
toward its long-run level of output by lowering interest rates. Therefore, in the short
run, the Fed and many other central banks are concerned with stabilizing the
economythat is, smoothing out the peaks and valleys in output and employment
around their long-run growth paths.
Although monetary policy cannot expand the economy beyond its potential growth
path or reduce unemployment in the long run, it can stabilize prices in the long run.
Price "stability" is basically low inflationthat is, inflation that's so low that people
don't worry about it when they make decisions about what to buy, whether to borrow
or invest, and so on.
In practice, the Fed, like most central banks, cares about both inflation and measures
of the short-run performance of the economy.
The Federal Reserves Concern with Inflation
The Federal Reserve is concerned about high inflation because it can hinder
economic growth. For example, when inflation is high, it also tends to vary a lot, and
that makes people uncertain about what inflation will be in the future. That
uncertainty can hinder economic growth in a couple of waysit adds an inflation risk
premium to long-term interest rates, and it complicates the planning and contracting
by businesses and households that are so essential to capital formation.
High inflation also hinders economic growth in other ways. For example, because
many aspects of the tax system are not indexed to inflation, high inflation distorts
economic decisions by arbitrarily increasing or decreasing after-tax rates of return to
different kinds of economic activities. In addition, it leads people to spend time and
resources hedging against inflation instead of pursuing more productive activities.
Federal Reserve Policy: Offsetting Shocks to the Economy
Output, employment, and inflation are influenced not only by monetary policy, but
also by such factors as our government's taxing and spending policies, the
availability and price of key natural resources (such as oil), economic developments
abroad, financial conditions at home and abroad, and the introduction of new
technologies. In order to have the desired effect on the economy, the Fed must take
into account the influences of these other factors and either offset them or reinforce
them as needed. This isn't easy because sometimes these developments occur
unexpectedly, and because the size and timing of their effects are difficult to
estimate.
The 1997-98 currency crisis in East Asia is a good example. Over this period,
economic activity in several countries in that region either slowed or declined, and
this reduced their demand for U.S. products. In addition, the foreign exchange value
of most of their currencies depreciated, and this made Asianproduced goods less
expensive for us to buy and U.S.produced goods more expensive in Asian
countries. By themselves, these factors would reduce the demand for U.S. products
and therefore lower our output and employment. As a result, this was a factor that
the Fed had to consider in setting monetary policy.
Another example is the spread of new technologies that can enhance productivity.
When workers and capital are more productive, the economy can expand more
rapidly without creating inflationary pressures. During the past decade, there have
been indications that the U.S. economy may have experienced a productivity surge,
perhaps brought on by computers and other high-tech developments. The issue for
monetary policymakers is how much faster productivity is increasing and whether
those increases are temporary or permanent. The answer to that question may
determine to what extent the Federal Reserve should intervene in the economy.
steady citing increasing labor producivity that helped to keep labor costs and
inflation low the Fed eventually raised interest rates on multiple occasions in late
1999 and early-to-mid 2000 to slow the economy.
Predicting future Federal Reserve monetary policy changes requires (1) an
understanding of the Federal Reserves policy objectives, and (2) a comprehensive
picture of the current economic conditions in the macroeconomy. As new information
is received on economic conditions in the economy, predictions of upcoming Federal
Reserve policy actions can change, especially during periods when the future course
of economic activity is uncertain. In these cases, each new piece of economic data
that is released may play a critical role in determining Federal Reserve policy
actions.
Note: For an example of how contract prices in the Iowa Electronic Markets change
during such periods, please see the Powerpoint slides that accompany this curriculum
guide.