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A CASE STUDY
The Federal Reserve System and Monetary Policy
The Federal Open Market Committee
Date Of Announcement
March 19, 2002
Dates Of Future Federal Open Market Committee Meetings
May 7, 2002.
Announcement
“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
indicates that the economy, bolstered by a marked swing in inventory investment, is
expanding at a significant pace. Nonetheless, the degree of the strengthening in final
demand over coming quarters, an essential element in sustained economic expansion, is
still uncertain.
“In these circumstances, although the stance of monetary policy is currently
accommodative, 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 balanced with respect to the prospects
for both goals.
“The Committee decided to include in its announcements following its meetings the roll
call of the vote on the federal funds rate target, including the preferred policy choice of
any dissenters. This action accelerates the release of this information, currently available
in the Minutes with a lag. To conform to this new practice, the Board of Governors also
decided to report in the written announcement the roll call of any vote on the discount
rate, also including the preferred policy choice of any dissenters.
“Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman;
William J. McDonough, Vice Chairman; Susan S. Bies; Roger W. Ferguson, Jr.; Edward
M. Gramlich; Jerry L. Jordan; Robert D. McTeer, Jr.; Mark W. Olson; Anthony M.
Santomero, and Gary H. Stern.”
This press release is available at:
http://www.federalreserve.gov/board
docs/press/general/2002/20020319/d
efault.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 target
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 third quarter of the year. 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.
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 both the January 29 and 30 and the March 19 meetings, the FOMC
decided to leave the federal funds rate unchanged.
The FOMC establishes monetary policy. The first paragraph of the announcement
summarizes the current 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 paragraph, the Federal Reserve discusses the reasoning behind their
decision. The reference to "a marked swing in inventory investment" refers to a reversal
in what businesses are doing with inventories. Throughout 2001, inventories have fallen,
as many businesses were forecasting slowing or falling spending and thus less of a need
for inventories. To accomplish the desired reduction in inventories, businesses reduced
production to lower levels and let inventories fall.
Now it appears that many businesses are satisfied that they have reduced inventories
sufficiently and are beginning to increase production. An upturn in inventory investment
signals that business have positive expectations of future sales and are preparing to
increase production. This increased production could result in an economic expansion.
However, the overall strength of increases in spending and investment is uncertain and it
is unclear whether they will be sufficient to drive economy out of a recession during the
coming year.
The Federal Open Market Committee indicates in the third paragraph that current
policy encourages growth in spending and that the members believe that the economy is
free from any significant inflationary or recessionary pressures. As a result, the Federal
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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 balanced.
That is the FOMC is neutral regarding possible future changes in the target federal funds
rate. The last time the FOMC reported such a neutral stance was following their
December 1999 meeting. The committee then shifted to a position that stated the risks
were for increased inflation. That view remained until it was changed to a risk of
increasing weakness in the economy following the December 2000 meeting and has
remained the same until now.
The fourth paragraph describes a change in the format of the Federal Open Market
Committee meeting press releases and the amount of information provided. In this press
release and future ones, the voting results on the target federal funds rate and the discount
rate will be disclosed. In the past, there has been a lag between the announcement and
the publication of this information in the minutes. This change is one step in a FOMC
trend toward releasing more information immediately following their meetings. Note that
the are five members (Greenspan through Gramlich) of the Board of Governors and five
Federal Reserve Bank presidents (Jordan through Stern) listed as voting. Two of the
Board of Governors positions are unfilled.
The fifth paragraph lists the roll call of the votes. All members of the FOMC voted in
favor of leaving the target federal funds rate unchanged at this time.
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 in both 1999 and 2000. During 2001, the rate of
growth of GDP slowed significantly to 1.1 percent overall. The annual rates of increase
for each of the first three quarters were 1.3, 0.3, and -1.3 percent, respectively. The
slowing growth over the last two quarters of 2000 and the first two quarters of 2001,
cumulating in the decline in GDP during the third quarter 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 thought the year as noted above.
During the fourth quarter, real GDP increased at a rate of 1.4 percent, evidence that the
stimulative monetary policy was beginning to take effect. (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.
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Recessions
On November 26, The National Bureau of Economic Research 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 most recent GDP revision shows a positive rate of growth of GDP during the fourth
quarter, therefore this recession has experienced only one quarter of decreasing real GDP.
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.
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 May 7.)
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.
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.
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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.
HOW LONG DOES IT TAKE MONETARY POLICY TO HAVE AN 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 now, 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.
Comparison of Monetary and Fiscal Policy
The FOMC has been reacting to the slowing economy over the past year. While the
monetary policy has not been sufficient to prevent a recession, it surely has made the
recession milder than it would have otherwise been and has likely contributed to the
recession ending sooner.
Fiscal policy, the taxing and spending policies of the federal government, 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
spending. Those 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. Monetary policy decisions are much easier and more responsive
to economic conditions.
Federal Reserve Goals
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The stated goals of the Federal Reserve Open Market Committee are to maintain
price stability and sustainable economic growth. (See the third paragraph of the
announcement.) The price stability goal means that the Federal Reserve will try to
minimize inflation or at least hold inflation to an amount that will not change most
peoples’ decisions. For all practical purposes, that rate has been between about 2 to 4
percent in recent years.
The goal of sustainable economic growth translates into holding the growth in
spending to a level that equals the growth in our capacity. The latter is determined by
changes in technology, the amount and quality of labor and the amount of capital –
machines, factories, computers, and inventories.
Tools Of The Federal Reserve
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.
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.
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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 as it is in this
announcement, but the change does not have a very important effect.
For more background on the Federal Reserve and resources to use in the classroom,
go to www.federalreserve.gov.
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.
QUESTIONS
1. Explain why the Federal Reserve lowered target federal funds rate throughout 2001
and left the target rate unchanged in January and March 2002.
2. Explain why the Federal Reserve raised the target federal funds rate in 1999 and
2000.
3. How does a change in the target federal funds rate affect spending?
4. What are the risks in the Federal Reserve lowering interest rates?
Additional questions to test understanding:
5. A role of the Federal Reserve is to maintain the money supply. What is money?
6. How do changes in the target federal funds rate affect real GDP?
Answers To Questions
1. Business conditions deteriorated during 2001 and that combined with increased
uncertainty weakened the state of the economy. In order to reduce the likelihood of
further slowing, the Federal Reserve lowered the target federal funds rate from
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January to December in an effort to encourage increased spending in the economy. In
November, a recession starting in March of 2001 was declared. In January and
March 2002, the Federal Reserve left the target federal funds rate unchanged as
spending in the economy was beginning to increase at a more rapid rate. It appears
that the previous cuts in the target federal funds rate are beginning to take effect.
2. In 1999 and 2000, spending was growing more rapidly than capacity. In order to
prevent the resulting increased inflationary pressures, the Federal Reserve reduced the
rate of growth in the money supply and thus caused interest rates to increase.
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. If the growth in spending falls, there is less upward
pressure on prices. 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.
4. The risks are that the economy will turn back to a faster rate of growth in spending on
its own, before the recent stimulative changes take effect. If that is the case, the
lowering of interest rates may begin to encourage more spending just as the economy
begins to recover. That result could add to eventual increased inflationary pressures.
5. The two primary definitions of money are M1 and M2. The M1 definition of money
includes currency, checking account deposits, and traveler’s checks. The M2
definition of money includes all of the money in the M1 definition, plus savings
deposits, and money market mutual funds.
6. Changes in the federal funds rate will tend to lead to reductions in other short-term
interest rates. Changes in interest rates that banks charge for loans and pay on
deposits will primarily affect investment expenditures, as interest rates are a cost of
investing. When interest rates decrease, it is less expensive for businesses to invest.
Increases in investment expenditures will increase the amount of capital available for
production and eventually the productive capacity of the economy. Consumers also
change spending on houses as interest costs change. Consumption spending on
appliances and automobiles and other items requiring consumer loans also increase as
interest rates fall.
More advanced: Changes in interest rates also affect the exchange rate. A
decrease should lead to a lower international value of the U.S. dollar (assuming other
interest rates around the world do not change). Therefore, imports will decrease and
exports will increase.
An Activity
A productive activity is to form a Federal Open Market Committee in your class.
Current data and forecasts can be examined. Votes can be taken as to the proper policy.
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Some roles can be assigned. Bankers, farmers, laborers, stockholders all have opinions
and interests in the outcomes of the meetings.
The “beige book” consists of the reports of the economic conditions in the 12 Federal
Reserve Banks across the country. Those data are part of the information considered by
the FOMC when it makes its decisions. Refer to the most recent (March 6) beige book
(www.federalreserve.gov/fomc/BeigeBook/2002/20020306/default.htm) in order to
discern the opinions of different workers, industries and retailers. In the current
economic slowdown, the following questions might be asked:
Which cities are faring the worst; which have better economic conditions?
Which sectors of the economy are faring the worst; which are the best?
The Federal Reserve also has a web site for economic students located at
www.FederalReserveEducation.gov. Additional information on monetary policy may
be found there.
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
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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
LESSON 11: What Causes Change in Consumer Demand?
LESSON 19: Financing the Entrepreneurial Enterprise
LESSON 32: Government Policies, the Economy, and the Entrepreneur
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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
Vanderbilt University
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