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A CASE STUDY
The Federal Reserve System and Monetary Policy
The Federal Open Market Committee
Date of Announcement
Dates of Future Federal Open
Market Committee Meetings
February 2, 2005
March 22, 2005
The Federal Reserve
increased the target
federal funds rate by
¼ of one percent.
Interactive question
Is this a change in recent policy?
Yes, it is a
change.
Yes, but
only a
slight
adjustment.
No, it is not
a change.
“No, it is not a change” is the correct answer.
The Federal Reserve continued a pattern of gradually increasing its target for
short-term interest rates. It was the sixth consecutive increase of .25 percent. The
Federal Reserve is steadily reducing the monetary stimulus which it used to
encourage expansion in the U.S. economy following the 2001 recession.
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The Announcement
“The Federal Open Market Committee decided today to raise its target for the
federal funds rate by 25 basis points to 2-1/2 percent.
“The Committee believes that, even after this action, the stance of monetary
policy remains accommodative and, coupled with robust underlying growth in
productivity, is providing ongoing support to economic activity. Output appears to
be growing at a moderate pace despite the rise in energy prices, and labor market
conditions continue to improve gradually. Inflation and longer-term inflation
expectations remain well contained.
“The Committee perceives the upside and downside risks to the attainment of
both sustainable growth and price stability for the next few quarters to be roughly
equal. With underlying inflation expected to be relatively low, the Committee
believes that policy accommodation can be removed at a pace that is likely to be
measured. Nonetheless, the Committee will respond to changes in economic
prospects as needed to fulfill its obligation to maintain price stability.
“Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman;
Timothy F. Geithner, Vice Chairman; Ben S. Bernanke; Susan S. Bies; Roger W.
Ferguson, Jr.; Edward M. Gramlich; Jack Guynn; Donald L. Kohn; Michael H.
Moskow; Mark W. Olson; Anthony M. Santomero; and Gary H. Stern.
“In a related action, the Board of Governors unanimously approved a 25-basispoint increase in the discount rate to 3-1/2 percent. In taking this action, the Board
approved the requests submitted by the Boards of Directors of the Federal
Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond,
Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San
Francisco.”
This press release is available at:
http://www.federalreserve.gov/BoardDocs/Press/monetary/2005/20050202/
Reasons for a Case Study on the Federal Open Market Committee
This case study is intended to guide students and teachers through an analysis of
the actions the Federal Open Market Committee (or FOMC) is taking to ensure stable
prices and sustainable growth in output and income. An understanding of monetary
policy in action is fundamental to developing a thorough understanding of
macroeconomics and the U.S. economy.
Note to Teachers
The material in this case study in italics is not included in the student version.
This initial case study of the semester introduces relevant concepts and issues.
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Subsequent case studies following FOMC announcements will describe the
announcement and add concepts and complexity throughout the semester.
Guide to Announcement
The first paragraph of the meeting announcement summarizes the current
monetary policy changes - this month it is the decision to raise the target federal
funds rate by one-quarter of one percent. (There are 100 basis points in one
percentage point. Thus, 25 basis points is one-quarter of one percent.)
The Federal Reserve Board of Governors also sets the discount rate, through a
technical process of approving requests of the twelve Federal Reserve Banks. The
discount rate is discussed in the final paragraph of the announcement. It was also
increased by one-quarter of a percent. This change parallels the change in the target
federal funds rate.
The second paragraph of the release is a discussion of the reasoning behind the
decisions. There is only a one-word change from the previous month’s
announcement. The first sentence means that the committee believes that current
monetary policy remains stimulative. Output is increasing at a rate fast enough to
gradually increase employment, yet not so fast that inflationary pressures are created.
An indication of likely future policy is in the third paragraph. The Federal
Reserve indicates that the risks of inflation are not great and that the rate of growth of
real GDP will likely continue. Because of this view, committee members believe that
there is no longer a need for stimulative monetary policy. Therefore, they will
continue to raise target federal funds rates until there is no longer monetary stimulus.
(That likely implication is that the target federal funds rate will continue to be raised
by .25 percent at each meeting until it somewhere between 3 and 4 percent.)
The last sentence of the paragraph simply refers to the very real possibility of
changes in economic conditions in the meantime and that the committee will respond
to those changes in manners it believes are appropriate.
The fourth paragraph describes the votes of the FOMC members on changing the
target federal funds rate. All members of the FOMC voted to leave the target federal
funds rate unchanged. (Some members have been added and some removed since the
previous announcement as the voting rotates among the Federal Reserve Bank
Presidents.)
The final paragraph describes the related change in the discount rate.
Data Trends
The Federal Reserve lowered the target federal funds rate from January of 2001 to
June of 2003 in response to slowing growth and the recession of 2001. In June of
2004, the FOMC began to reduce the amount of stimulus from monetary policy as
members believed that the economy had sufficient stimulus to return to steady growth
and that too much continued stimulus would lead to inflationary pressures. Therefore
the committee has increased the target federal funds rate at every meeting since by
.25 of a percent. It is likely to continue doing so at a similar rate until the committee
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no longer views the policy as a stimulative one. Most observers would say that the
rate will end up being between 3 and 4 percent, perhaps closer to 4 percent.
Figure 1 shows the path of the target federal funds rate since 1990. The gray
areas indicate the recessionary periods in 1990-1991 and in 2001.
Figure 1
Recent History of FOMC Actions
The FOMC used monetary policies actively throughout much of the 1990s. The
FOMC lowered the target federal funds rate in a series of steps beginning in July of
1990 until September of 1992, all in response to a recession beginning in July of 1990
and ending in March of 1991. Then as inflationary pressures began to increase in
1994, the Federal Reserve began to raise rates in February. In response to increased
inflationary pressures once again in 1999, the Federal Reserve raised rates six times
from June 1999 through May of 2000.
During the last half of the 1990s, real GDP grew at more rapid rates than in the
first half of the decade. That growth began to slow in 2000. Real GDP increased at
annual rates of 4.5 percent and 3.7 percent in 1999 and 2000. For 2001 as a whole,
real GDP increased only by .8 percent. The slowing growth and actual decline in real
GDP over the third quarter of 2000 and the eventual declines in the first and third
quarters of 2001 were indications of the need to use a monetary policy that would
boost spending in the economy. The FOMC responded, beginning in January of
2001, by cutting the target federal funds rate throughout the rest of the 2001.
From January 3 to December 11 of 2001, the Federal Reserve Open Market
Committee (FOMC) lowered the target federal funds rate eleven times from 6.50
percent to 1.75 percent, at that time, the lowest target federal funds rate in forty years.
During the fourth quarter of 2001, real GDP rebounded, but only at an annual rate of
1.6 percent. Real GDP increased only at a rate of 1.9 percent in 2002. At all of the
2002 meetings prior to the November meeting, the FOMC decided to leave the
federal funds rate unchanged. In November, the target federal funds rate was once
again lowered to 1.25 percent. Then in June of 2003, following a first quarter
increase in real GDP of only 1.9 percent, the target federal funds rate was lowered
once again, this time to 1 percent. (For more on changes in the rate of growth of real
GDP and the recession, see the most recent GDP Case Study.)
The Federal Open Market Committee (FOMC)
The primary function of the Federal Open Market Committee is to direct
monetary policy for the U.S. economy. The FOMC meets approximately every six
weeks. (The next meeting is March 22, 2005.) The seven Governors of the Federal
Reserve Board and five of the twelve Presidents of the Federal Reserve Banks make
up the committee. The Federal Reserve Governors are appointed by the U.S.
President and confirmed by the U.S. Senate. The Boards of each Federal Reserve
Bank select the presidents of the banks.
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Figure 2
How does Monetary Policy Work?
Monetary policy works by affecting the amount of money that is circulating in the
economy. The Federal Reserve can change the amount of money that banks are
holding in reserves by buying or selling existing U.S. Treasury bonds. When the
Federal Reserve buys a bond, the seller deposits the Federal Reserves' check in her
bank account. As a bank’s reserves increase, it has an increased ability to make more
loans, which in turn will increase the amount of money in the economy.
Competition among banks forces interest rates down as banks compete with one
another to make more loans. If businesses are able to borrow more to build new
stores and factories and buy more computers, total spending increases. Consumer
spending that partially depends upon levels of interest rates (automobile and
appliances, for example) is also affected. Output will tend to follow and employment
may also increase. Thus unemployment will fall. Prices may also increase.
When the Federal Reserve employs an expansionary monetary policy, it buys
bonds in order to expand the money supply and simultaneously lower interest rates.
Although gross domestic product and investment increase, this may also stimulate
inflation. If growth in spending exceeds growth in capacity, inflationary pressures
tend to emerge. If growth in spending is less than the growth in capacity, then the
economy will not be producing as much as it could. As a result, unemployment may
rise.
When the Federal Reserve adopts a restrictive monetary policy it sells bonds in
order to reduce the money supply and this results in higher interest rates. A
restrictive monetary policy will decrease inflationary pressures, but it may also
decrease investment and real gross domestic product. See the Inflation Case Study
for a more detailed discussion of inflation.
Tools of the Federal Reserve
Open Market Operations
The Federal Reserve buys and sells bonds and by doing so, increases or
decreases banks' reserves and their abilities to make loans. As banks increase or
decrease loans, the nation's money supply changes. That, in turn, decreases or
increases interest rates. Open market operations are the primary tool of the
Federal Reserve. They are often used and are quite powerful. This is what the
Federal Reserve actually does when it announces a new target federal funds rate.
The federal funds rate is the interest rate banks charge one another in return for a
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loan of reserves. If the supply of reserves is reduced, that interest rate is likely to
increase.
Banks earn profits by accepting deposits and lending some of those deposits to
someone else. They sometimes charge fees for establishing and maintaining
accounts and always charge borrowers an interest rate. Banks are required by the
Federal Reserve System to hold reserves in the form of currency in their vaults or
deposits with Federal Reserve System.
When the Federal Reserve sells a bond, an individual or institution buys the
bond with a check on their account and gives the check to the Federal Reserve.
The Federal Reserve removes an equal amount from the customer’s bank’s
reserves. The bank, in turn, removes the same amount from the customer’s
account. Thus, the money supply shrinks.
Discount Rate
The discount rate is the interest rate the Federal Reserve charges banks if
banks borrow reserves from the Federal Reserve itself. Banks seldom borrow
reserves from the Federal Reserve and tend to rely more on borrowing reserves
from other banks when they are needed. The discount rate is often changed along
with the target federal funds rate, but the discount rate change does not have a
very important effect. In this announcement, the discount rate is not changed.
(Note: In January of 2003, the discount rate was changed to a level one
percent above the target federal funds rate. The discount rate had been about onehalf of a percent less than the target federal funds rate. Technical aspects of
borrowing from the Fed were also changed at the same time. The basic functions
of monetary policy were not changed.)
Reserve Requirements
Banks are required to hold a portion (either 10 or 3 percent of most deposits,
depending upon the size of the bank) of some of their deposits in reserve.
Reserves consist of the amount of currency that a bank holds in its vaults and its
deposits at Federal Reserve banks. If banks have more reserves than they are
required to have, they can increase their lending. If they have insufficient
reserves, they have to curtail their lending or borrow reserves from the Federal
Reserve or from another bank that may have extra, or what are called excess,
reserves. The requirement is seldom changed, but it is potentially very powerful.
Exercises. (with interactive button questions)
1. If the economy is beginning to grow at a faster rate and businesses and individual
are beginning to expect inflation, what would the FOMC be likely to do with the
target federal funds rate?
Raise
Lower
Not change
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Raise the target federal funds rate in order to discourage increased spending.
2. If growth in spending in the economy is slowing and unemployment beginning to
rise, what would the FOMC be likely to do with the target federal funds rate?
Raise
Lower
Not change
Raise the target federal funds rate in order to encourage increased spending.
3. If interest rates increase, what would likely happen to investment in the economy?
Increase
Decrease
Not change
Decrease as borrowing becomes more expensive and that causes businesses to reduce
their investment spending on new factories, stores, and equipment.
4. Of the Federal Reserve’s monetary policy tools, which is the most commonly
used?
Changes in
the discount
rate
Changes in
open market
operations
Changes in
the required
reserve ratio
Open market operations (changing the target federal funds rate) is the most
common tool.
6. If the Federal Open Market Committee announces that it is lowering the target
federal funds rate, the FOMC will ___________ bonds.
Buy
Sell
Buy bonds to increase the supply of reserves banks have, thereby lowering the
federal funds rate - the rate banks charge one another for reserves.
7. If the Federal Open Market Committee is concerned that unemployment is
increasing while inflation is decreasing, the FOMC will likely ______________
bonds.
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Buy
Sell
Buy bonds in order to increase the money supply and decrease the target federal
funds rate.
8. If the Federal Open Market Committee is concerned with increasing
inflationary pressures at the same time unemployment is likely to fall, it will
likely ______________ bonds.
Buy
Sell
Sell bonds in order to reduce the money supply and increase the target federal
funds rate.
Key Concepts
Discount rate
Federal funds rate
Federal Open Market Committee
Federal Reserve System
Fiscal policy
Interest rates
Monetary policy
Open market operations
Reserve requirements
Relevant National Economic Standards
11. Money makes it easier to trade, borrow, save, invest, and compare the
value of goods and services. Students will be able to use this knowledge to
explain how their lives would be more difficult in a world with no money, or in
a world where money sharply lost its value.
12. Interest rates, adjusted for inflation, rise and fall to balance the amount
saved with the amount borrowed, which affects the allocation of scarce
resources between present and future uses. Students will be able to use this
knowledge to explain situations, in which they pay or receive interest, and
explain how they would react to changes in interest rates if they were making
or receiving interest payments.
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15. Investment in factories, machinery, new technology and in the health,
education, and training of people can raise future standards of living.
Students will be able to use this knowledge to predict the consequences of
investment decisions made by individuals, businesses, and governments.
16. There is an economic role for government in a market economy whenever
the benefits of a government policy outweigh its costs. Governments often
provide for national defense, address environmental concerns, define and
protect property rights, and attempt to make markets more competitive. Most
government policies also redistribute income. Students will be able to use this
knowledge to identify and evaluate the benefits and costs of alternative public
policies, and assess who enjoys the benefits and who bears the costs.
18. A nation's overall levels of income, employment, and prices are
determined by the interaction of spending and production decisions made by
all households, firms, government agencies, and others in the economy.
Students will be able to use this knowledge to interpret media reports about
current economic conditions and explain how these conditions can influence
decisions made by consumers, producers, and government policy makers.
19. Unemployment imposes costs on individuals and nations. Unexpected
inflation imposes costs on many people and benefits some others because it
arbitrarily redistributes purchasing power. Inflation can reduce the rate of
growth of national living standards because individuals and organizations use
resources to protect themselves against the uncertainty of future prices.
Students will be able to use this knowledge to make informed decisions by
anticipating the consequences of inflation and unemployment.
20. Federal government budgetary policy and the Federal Reserve System's
monetary policy influence the overall levels of employment, output, and
prices. Students will be able to use this knowledge to anticipate the impact of
federal government and Federal Reserve System macroeconomic policy
decisions on themselves and others.
Sources Of Additional Activities
Advanced Placement Economics: Macroeconomics. (National Council on
Economic Education)
UNIT FOUR: Money, Monetary Policy, and Economic Stability
UNIT FIVE: Monetary and Fiscal Combinations: Economic Policy in
the Real World
Entrepreneurship in the U.S. Economy--Teacher Resource Manual
LESSON 10: The Nature of Consumer Demand
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LESSON 11: What Causes Change in Consumer Demand?
LESSON 19: Financing the Entrepreneurial Enterprise
LESSON 32: Government Policies, the Economy, and the
Entrepreneur
On Reserve: A Resource for Economic Educators from the Federal Reserve
Bank of Chicago. Number 28, April 1994: Basics to Bank on
Economics USA: A Resource Guide for Teachers
LESSON 11: The Federal Reserve: Does Money Matter?
LESSON 12: Monetary Policy: How Well Does It Work?
LESSON 13: Stabilization Policy: Are We Still in Control?
Handbook of Economic Lesson Plans for High School Teachers
LESSON EIGHTEEN: The Federal Reserve System
LESSON NINETEEN: Making Monetary Policy: The Tools of the
Federal Reserve System
Focus: High School Economics
20. Money, Interest, and Monetary Policy
All are available in Virtual Economics, An Interactive Center for Economic
Education (National Council on Economic Education) or directly through the
National Council on Economic Education.
For more background on the Federal Reserve and resources to use in the
classroom, go to www.federalreserve.gov.
Authors: Stephen Buckles
Erin Kiehna
Vanderbilt University
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