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A CASE STUDY
The Federal Reserve System and Monetary Policy
The Federal Open Market Committee
Date Of Announcement
November 6, 2002
Dates Of Future Federal Open Market Committee Meetings
December 10, 2002.
Announcement (an excerpt)
The Federal Open Market Committee decided today to lower its target for the
federal funds rate by 50 basis points to 1 1/4 percent. In a related action, the
Board of Governors approved a 50 basis point reduction in the discount rate to
3/4 percent.
The Committee continues to believe that an accommodative stance of
monetary policy, coupled with still-robust underlying growth in productivity,
is providing important ongoing support to economic activity. However,
incoming economic data have tended to confirm that greater uncertainty, in
part attributable to heightened geopolitical risks, is currently inhibiting
spending, production, and employment. Inflation and inflation expectations
remain well contained.
In these circumstances, the Committee believes that today's additional
monetary easing should prove helpful as the economy works its way through
this current soft spot. With this action, the Committee believes that, against the
background of its long-run goals of price stability and sustainable economic
growth and of the information currently available, the risks are balanced with
respect to the prospects for both goals in the foreseeable future.
Voting for the FOMC monetary policy action were Alan Greenspan, Chairman; William J.
McDonough, Vice Chairman; Ben S. Bernanke, Susan S. Bies; Roger W. Ferguson, Jr.; Edward
M. Gramlich; Jerry L. Jordan; Donald L. Kohn, Robert D. McTeer, Jr.; Mark W. Olson; Anthony
M. Santomero, and Gary H. Stern.
This complete press release is available at:
http://www.federalreserve.gov/BoardDocs/P
ress/monetary/2002/20021106/default.htm
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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
changeinterest rates and boost spending and employment in the U.S. economy. That
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. While most
economists believe the recession is now over, the economy is still in a fragile state and
growth has not returned to the strength of recent years..
This case study is intended to guide students and teachers through an analysis of the
actions the Federal Reserve began to take last year and continue to take 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. The
initial case study of the semester introduced relevant concepts and issues. This and
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 more than forty years. At all previous 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 cut the target federal funds rate by 0.5% (There
are 100 basis points in one percentage point. Thus a 50 basis point cut is a reduction of
one-half 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 also was cut by 0.5% (to 0.75%) at this meeting.
In the second and third paragraphs, the Federal Reserve discusses the reasoning
behind their decision. The reference to “an accommodative stance” is to the belief by
members of the committee that monetary policy is currently encouraging increased
spending in the economy. The statement that “incoming economic data have tended to
confirm that greater uncertainty, in part attributable to heightened geopolitical risks, is
currently inhibiting spending, production, and employment.” refers to the underlying
foreign threats and the effects on consumer and investment spending are hampering
economic spending. The FOMC indicates that the long-run prospects are good. The
FOMC members expect continued productivity growth. However, the first sentence of
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the third paragraph indicates that additional stimulation of spending through monetary
policy will help.
The second sentence of the third paragraph is a standard sentence in most of the
FOMC announcements. The last part of that sentence indicates the beliefs about future
conditions, given the current actions. In this case, the FOMC announcement states that
risks of increased inflation and increased unemployment are balanced. That is, they don’t
expect to have to make further changes between now and the next meeting or at the next
meeting, unless something else changes.
The fourth paragraph describes the votes of the FOMC members on changing the
target federal funds rate. In the past, there has been a lag between the announcement and
the publication of this information in the minutes. This change, which was implemented
at the March meeting, is one step in a FOMC trend toward releasing more information
immediately following their meetings. All members of the FOMC voted to reduce the
target federal funds rate.
There has been much recent debate about whether the Federal Reserve should lower
rates further and risk inflationary pressures. In the press release, the Fed states that it
believes inflation and inflation expectations are well contained. Recent unemployment
rates have shown a trend toward stabilization in a range of about 5.6 to 5.7% and real
GDP has maintained positive growth for the last four quarters. In the absence of
evidence of further slowing in the economy, the decision of the Fed will be scrutinized if
inflationary aspects return to the economy in the near future.
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 was having an effect. In the second and
third quarters of 2002, real GDP increased at a rates of 1.3 and 3.1 percent. (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
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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 overall. 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
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. That may well be the case today.
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 December 10.)
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
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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.
HOW OFTEN DOES THE FEDERAL RESERVE ENGAGE
IN OPEN MARKET OPERATIONS?
The Federal Reserve engages in open market operations on a daily basis-not just
when they change the target federal funds rate. The amount of money that banks hold
in reserves changes throughout the year and the Federal Reserve will buy or sell
bonds to maintain the target federal funds rate at the desired level.
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 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.
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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.
Comparison of Monetary and Fiscal Policy
The FOMC has been reacting to the slowing economy over the past two years. While
the monetary policy has not been sufficient to prevent a recession, it surely has made the
recession milder than it would have been otherwise and has likely contributed to the
recession ending sooner.
Fiscal policy, the taxing and spending policies of the federal government, also has the
potential to influence economic conditions. Throughout this year, there have been
debates in Congress about what to do with spending and taxes in order to stimulate
overall spending in the economy. These debates continue and little has been
accomplished. This points to one of the key differences between fiscal and monetary
policy. Fiscal policy is much more difficult to implement but takes effect more rapidly
once the decision is made. Monetary policy decisions are much easier to institute and
more responsive to economic conditions, but take longer to have an effect on spending in
the economy.
HOW LONG DOES IT TAKE MONETARY POLICY TO HAVE AN
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EFFECT ON THE ECONOMY?
Businesses and consumers do not normally change their spending plans immediately
upon an interest rate change. Businesses must reevaluate, make new decisions and order
reductions or expansions in production and expenditures. This means that months pass
before spending is affected. Monetary policy typically has a short policy lag (the time it
takes to create and implement policy) and a long expenditure lag (the time it takes
businesses and consumers to adjust to the new interest rates). The total lag time is
usually 9-12 months and varies a good bit. Thus when the Federal Reserve changes
interest rates, their decisions will affect economic conditions in approximately a year
from the time of the change.
Fiscal policy (changing taxes and government spending) also has a significant lag time.
It typically has a long policy lag (the time it takes Congress to approve a tax or spending
change) and a short expenditure lag (the time it takes consumers to experience the tax
changes and government to change spending). The combined lags may be anywhere
from one to almost five years.
Interactive Button Questions
1. What are the Federal Reserve’s monetary policy tools?
Open market operations (changing the target federal funds rate), the discount rate,
and the required reserves ratio.
2. If the Federal Reserve Open Market Committee is concerned with increasing
inflationary pressures at the same time unemployment is likely to fall, it will likely
______________ bonds.
Sell bonds in order to reduce the money supply and increase the target federal funds
rate.
3. If the Federal Reserve Board and the Bank presidents are concerned with increasing
inflationary pressures at the same time unemployment is likely to fall, they will likely
______________ the discount rate.
Increase the discount rate as a signal that the Federal Reserve intends to use a tight
monetary policy.
4. If the Federal Reserve Board members are concerned with increasing inflationary
pressures at the same time unemployment is likely to fall and they are considering
changing the required reserve ratio, they will likely ______________ the required reserve
ratio.
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Increase the required reserve ratio to reduce the total amount of loans (and therefore
the money supply) that banks can make.
5. If the Federal Reserve Open Market Committee is concerned that unemployment is
increasing while inflation is decreasing, it will likely ______________ bonds.
Purchase bonds in order to increase the money supply and decrease the target
federal funds rate.
6. If the Federal Reserve Board and the Bank presidents are concerned that
unemployment is increasing while inflation is decreasing, they will likely
______________ the discount rate.
Decrease the discount rate as a signal that the Federal Reserve intends to use a
stimulative monetary policy.
7. If Federal Reserve Board members are concerned that unemployment is increasing
while inflation is decreasing and they are considering changing the required reserve ratio,
they will likely ______________ the required reserve ratio.
Decrease the required reserve ratio to increase the total amount of loans (and
therefore the money supply) that banks can make.
CASE STUDY QUESTIONS
1. What are the Federal Reserve current observations and concerns?
2. If the Federal Reserve is concerned as you outlined in the answer to question 1, what
is it likely to do with its open market operations and the federal funds rate?
3. How do changes in monetary policy affect spending in the economy?
4. (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 in the long run, there
still is concern that economic conditions are not rapidly improving. Productivity and
thus real incomes are likely to continue to increase in the future. However,
employment and real GDP are not increasing as much as the Federal Reserve
believes possible.
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2. The Federal Reserve would purchase bonds to expand the money supply and bank
reserves and lower the target federal funds rate. The federal funds rate is determined
in the market for bank reserves. By increasing bank reserves through the purchase of
bonds, the Federal Reserve increase the supply of reserves and thus the price of those
reserves (the federal funds rate) decreases.
3. 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 business
and consumer spending, the increased availability of loans and lower interest rates
may encourage businesses and consumers to increase their spending.
4. Geopolitical risks include events such as a future terrorist attack or a war with Iraq.
Related risks include higher oil prices, a reduction in consumer confidence and
spending, and a decrease in the willingness of business to invest in new factories,
stores, and equipment. For example, if consumers are uncertain about future
economic and political conditions, some may reduce spending leading to a falling
real GDP and rising unemployment.
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.
Authors: Stephen Buckles
Erin Kiehna
Bharath Subramanian
Vanderbilt University
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