Download Federal Open Market Committee (FOMC)

A CASE STUDY
The Federal Reserve System and Monetary Policy
The Federal Open Market Committee
Date Of Announcement
September 24, 2002
Dates Of Future Federal Open Market Committee Meetings
November 6, 2002.
Announcement (an excerpt)
“The Federal Open Market Committee decided today to keep its target for the
federal funds rate unchanged at 1 3/4 percent.
"The information that has become available since the last meeting of the
Committee suggests that aggregate demand is growing at a moderate pace.
"Over time, the current accommodative stance of monetary policy, coupled
with still robust underlying growth in productivity, should be sufficient to
foster an improving business climate. However, considerable uncertainty
persists about the extent and timing of the expected pickup in production and
employment owing in part to the emergence of heightened geopolitical risks.
"Consequently, the Committee believes that, for the foreseeable future, against
the background of its long-run goals of price stability and sustainable
economic growth and of the information currently available, the risks are
weighted mainly toward conditions that may generate economic weakness.”
This complete press release is available at:
http://www.federalreserve.gov/BoardDocs/P
ress/monetary/2002/20020924/default.htm
Reasons for a Case Study on the Federal Open Market Committee
Following recent Federal Open Market Committee announcements, newspapers
across the country have had front-page stories about the Federal Reserve actions to target
1
interest rates and boost spending and employment in the U.S. economy. Attention has
only increased as the economy entered a recession beginning in March of last year and
real GDP actually fell in the first three quarters of 2001. The announcements reflect
serious concerns with the state and direction of the economy.
This case study is intended to guide students and teachers through an analysis of the
actions the Federal Reserve began to take last year in an effort to strengthen the economy.
An understanding of monetary policy in action is fundamental to developing a thorough
understanding of macroeconomics and the U.S. economy.
Notes 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. Subsequent
case studies following FOMC announcements will describe the announcement and add
concepts and complexity throughout the semester.
Guide To Announcement
From January 3 to December 11 of 2001, the Federal Reserve Open Market
Committee (FOMC) lowered the target federal funds rate 11 times from 6.50 percent to
1.75 percent (a total reduction of 4.75 percent). This is the lowest target federal funds rate
in forty years. At each of the six 2002 meetings, the FOMC decided to leave the federal
funds rate unchanged.
The first paragraph of the announcement summarizes the current monetary policy
changes - this month it is the decision to leave the target federal funds rate unchanged.
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
also remained unchanged at this meeting and is not mentioned in the announcement.
In the second and third paragraphs, the Federal Reserve discusses the reasoning
behind their decision. The fact that “aggregate demand is growing at a moderate pace”
refers to modest improvement in economic conditions. The FOMC indicates in the third
paragraph that the long-run prospects are good. Current monetary policy is
accommodative - meaning it should permit economic expansion. The FOMC members
expect continued productivity growth. Both should help the economy return to full
strength.
Still, there is concern that production and employment may not grow as rapidly as
one might wish or as fast as is possible.
As a result, the Federal Reserve believes the best way to maintain stable prices and
sustain economic growth is to leave the target federal funds interest rate unchanged. The
risks are reported as weighted towards conditions that may generate economic weakness.
That is, the FOMC has a negative bias regarding possible future changes in the target
federal funds rate, indicating that the Fed is more likely to consider reducing rates in the
near future as opposed to raising them.
2
Rate Graph
Data Trends
During the last half of the 1990s, real GDP grew at rates more rapid than those in the
first half of the decade. That growth began to slow at the end of 2000. Real GDP
increased at annual rates of 4.1 percent and 3.8 percent in 1999 and 2000. During the
first three quarters of 2001, real GDP actually decreased. For the year as a whole, real
GDP increased only by .3 percent. The slowing growth over the last two quarters of 2000
and the first three quarters of 2001 was one indication of the need to use a monetary
policy that would boost spending in the economy. The FOMC responded by cutting the
target federal funds rate throughout the year as noted above. During the fourth quarter of
2001, real GDP increased at an annul rate of 2.7 percent. In the first quarter of 2002, real
GDP the annual rate of growth increased even more rapidly at a rate of 5.0 percent evidence that the stimulative monetary policy is having an effect. In the second quarter
of 2002 GDP increased at a rate of 1.1%. (For more on changes in the rate of growth of
real GDP and the current recession, see the most recent GDP Case Study.)
The FOMC used policies actively throughout much of the 1990s. The FOMC had
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.
Recessions
On November 26, 2001, the National Bureau of Economic Research (NBER)
announced though its Business Cycle Dating Committee that it had determined that a
peak in business activity occurred in March of 2001. That signals the official beginning
to a recession.
The NBER defines a recession as a "significant decline in activity spread across the
economy, lasting more than a few months, visible in industrial production, employment,
real income, and wholesale-retail trade." The current data show a decline in employment,
but not as large as in the previous recession. Unemployment has also increased during
the period, only beginning to fall in the last two months. Real income growth slowed but
did not decline. Manufacturing and trade sales and industrial production have both
declined and now appear to be turning around.
While the common media definition of a recession is two consecutive quarters of
decline in real GDP, this recession began before quarterly real GDP actually declined.
The last recession began in July of 1990 and ended in March of 1991, a period of
eight months. However, the beginning of the recession was not announced until April of
1991 (after the recession had actually ended). The end of the recession was announced in
December of 1992, almost 21 months later. One of the reasons the end of the recession
3
was so difficult to determine was the economy did not grow very rapidly even after it
came out a period of falling output and income.
Many observers are now stating that the 2001 recession may have ended in December
of 2001. The National Bureau of Economic Research has not yet declared the end of the
recession.
For the full press release from the National Bureau of Economic Research, see:
http://cycles-www.nber.org/cycles/november2001/recessnov.html
Federal Open Market Committee (FOMC)
The primary function of the FOMC is to direct monetary policy for the U.S.
economy. The FOMC meets about every six weeks. (The next meeting is November 6.)
The seven Governors of the Federal Reserve Board and five of the twelve Presidents of
the Federal Reserve Banks make up the committee. 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.
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 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
4
when they are needed. The discount rate is often changed along with the discount
rate, but the change does not have a very important effect. In this announcement, the
discount rate is 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.
For more background on the Federal Reserve and resources to use in the
classroom, go to www.federalreserve.gov.
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.
5
QUESTIONS
1. What are the Federal Reserve current observations and concerns?
2. What tools can the Federal Reserve use?
3. If the Federal Reserve is concerned about lack of economic expansion, what is it
likely to do with its open market operations and the federal funds rate?
4. If the Federal Reserve is concerned about lack of economic expansion and decided to
use changes in reserve requirement and the discount rate, what would it do?
5. How do changes in monetary policy affect spending in the economy?
6. (More advanced) What are some "geopolitical risks" that could influence future
economic conditions? How would economic conditions be affected?
Answers To Questions
1. While the Federal Reserve is optimistic about future conditions, there still is concern
that economic conditions are not rapidly improving
2. The Federal Reserve can buy or sell bonds, which in turn lower or increase the
federal funds rate. The Federal Reserve can also change reserve requirements and
the discount rate.
3. The Federal Reserve would purchase bonds to expand the money supply and reserves
and lower the target federal funds rate.
4. The Federal Reserve would lower reserve requirements and decrease the discount
rate.
5. If banks have fewer reserves, they cannot make as many loans. The reduction in
loans and the resulting higher interest rates discourage business (and consumer)
borrowing and spending. In the case of too little growth or a reduction in spending,
the increased availability of loans and lower interest rates may encourage businesses
and consumers to increase their spending.
6. Geopolitical risks include events such as a future terrorist attack or a war with Iraq.
Related risks include actions such as higher oil prices, as well as a reduction in
consumer confidence and spending. If consumers become nervous about future
economic and political conditions, some may reduce spending leading to a falling
real GDP and rising unemployment.
6
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.
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,
7
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
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
8
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.
Authors: Stephen Buckles
Erin Kiehna
Bharath Subramanian
Vanderbilt University
9