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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. 1 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. 2 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 3 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. 4 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 5 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 6 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. 7 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. 8 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 9 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 10