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A CASE STUDY
The Federal Reserve System and Monetary Policy
The Federal Open Market Committee
Date Of Announcement
Economic Case Studies (as of November 6, 2001)
Inflation
+0.4 percent monthly increase in the
CPI in September 2001
November 6, 2001
Dates Of Future Federal Reserve Open Market
Committee Meetings
December 11, 2001, January 29 and 30,
March 19, and May 7, 2002.
Unemployment
5.4 percent in October 2001
Real GDP
-0.4 percent annual rate of increase
3rd quarter, 2001
Productivity
+2.1 percent annual rate of increase
2nd quarter, 2001
International
Trade
The trade deficit decreased in August
Announcement
“The Federal Open Market Committee decided today to
lower its target for the federal funds rate by 50 basis
points to 2 percent. In a related action, the Board of
Governors approved a 50 basis point reduction in the
discount rate to 1-1/2 percent.”
Federal Reserve The FOMC lowered the target
federal funds rate on November 6
(Click on an indicator above to be directed to
the most recent case studies.)
“Heightened uncertainty and concerns about a
deterioration in business conditions both here and abroad
are damping economic activity. For the foreseeable
future, then, the Committee continues to believe 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 weighted
mainly toward conditions that may generate economic weakness.”
“Although the necessary reallocation of resources to enhance security may restrain advances in productivity
for a time, the long-term prospects for productivity growth and the economy remain favorable and should
become evident once the unusual forces restraining demand abate.”
“In taking the discount rate action, the Federal Reserve Board approved the request submitted by the Board
of Directors of the Federal Reserve Bank of Richmond.”
This press release is available at:
http://www.federalreserve.gov/board
docs/press/general/2001/20011106/d
efault.htm
Reasons For A Case Study On The Federal Reserve Open Market Committee
Following the announcement on November 6th, newspapers across the country had
front-page stories about the most recent Federal Reserve action to lower interest rates and
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boost spending and employment in the U.S. economy. The announcement reflects
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 earlier this year in an effort to strengthen the economy. An understanding
of the 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 October 2 of this year, the Federal Reserve Open Market
Committee (FOMC) lowered the target federal funds rate from 6.50 percent to 2.50
percent. The announcement on November 6 lowers the rate once more and marks the
tenth time that it was lowered in response to concerns of slowing growth in spending and
the possibility of a recession. The target federal funds rate is now at its lowest level in
forty years.
The FOMC establishes monetary policy. The first paragraph of the announcement
summarizes the current policy changes - the decision to lower the target federal funds rate
by one-half of a percentage point. (There are 100 basis points in one percent. Fifty basis
points equals 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. (See the last paragraph of the announcement.) The discount rate
was also lowered by one-half of one percent.
In the second paragraph, the Federal Reserve discusses the reasoning behind changes
in monetary policy. The board expresses concern about the state of both the domestic
and global economy. With these economic concerns in mind, the Federal Reserve
believes the best way to maintain stable prices and sustain economic growth is a further
reduction in the target interest rate. This paragraph also indicates that continued
economic weakness in the coming months may necessitate further reductions in the target
federal funds rate.
The Federal Reserve indicates in the third paragraph that increases in expenditures for
homeland security may adversely affect the growth rate of productivity. This is the result
of businesses devoting some resources for security measures, thereby raising the costs of
production of a wide variety of products. However, the Federal Reserve’s long run
outlook for productivity growth and the state of economy remains optimistic.
The final paragraph refers to the request by Federal Reserve Bank of Richmond to the
Board of Governors of the Federal Reserve System to lower the discount rate by one-half
of a percentage point.
Rate Graph
Data Trends
The Federal Reserve 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
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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.
The rate of growth in real GDP has been increasing over the last several years, but
began to slow in the middle of last year. Changes in real GDP at annual rates were 2.3,
5.7, 1.3, and 1.9 percent for each quarter of 2000. During the first three quarters of 2001,
GDP grew at an annual rate of 1.3, 0.3 and -0.4 percent respectively. The slowing growth
over the past four quarters, relative to the last several years, has been one indicator of the
need to use a monetary policy that will boost spending in the economy and help to avoid
a recession. (For more on changes in the rate of growth of real GDP and a potential
recession, see the most recent GDP Case Study.)
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 11th
followed by one on January 29 and 30,). 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.
Presidents of the Federal Reserve Banks are selected by the Boards of each Bank.
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, appliances, etc.) 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.
HOW LONG DOES IT TAKE MONETARY POLICY TO HAVE AN EFFECT
ON THE ECONOMY?
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(Jeramy. This is the answer and goes in a pop-up window.) 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.
Federal Reserve Goals
The stated goals of the Federal Reserve Open Market Committee are to maintain
price stability and sustainable economic growth. (See the second 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:
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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
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?
(Jeramy, another pop-up answer.) 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.
The Beige Book – A Survey Of Current Economic Conditions
The Federal Reserve’s report on economic conditions across the country is released in
the “Beige Book” (named for its beige cover) two weeks prior to each meeting of the
Federal Reserve Open Market Committee. The following is an excerpt from the Beige
Book released on October 24, 2001, in preparation for the meeting on November 6, 2001.
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“Reports from all Federal Reserve Districts indicate weak economic activity
in September and the first weeks of October. In all Districts, the tragedy of
September 11 was followed by a short period of sharply reduced activity.
Business activity recovered quickly from some aspects of the shock, such as
reduced air cargo capacity, but longer-run effects are more difficult to assess.
Retail sales, other than autos, were slightly lower than before September 11, but
this weakness might have already been in train. The same is true for
manufacturing. Insurance premiums have increased, and security precautions are
disrupting productivity.
“Retail sales softened in September and early October in almost all
Districts. Auto sales fell at the beginning of the period but have now rebounded
following new zero-financing incentive plans. Both shipments and orders for a
broad spectrum of manufactured goods, ranging from steel to semiconductors,
are weak in most of the country. Construction generally slowed during the
period. The softness in consumer spending, manufacturing, and construction is
affecting the labor market, where layoffs and plant closings have been reported
in many industries, from financial services on the East Coast to media and
advertising on the West Coast to auto parts in the central states. There has been
little upward pressure on either wages or prices, and, in some cases, they have
actually fallen. Dallas and San Francisco also report an increase in health care
costs.
“Most Districts report steady or declining consumer prices. Districts
reporting steady retail prices included Kansas City and Richmond. Districts
reporting lower retail prices included Atlanta, Boston, Chicago, and Dallas.
Input prices are reported as decreasing or holding steady, except in Cleveland,
where they were mixed.”
The Beige Book report can be found at:
www.federalreserve.gov/fomc/BeigeBook/2001/2001
1024/default.htm
From this summary several important trends can be noted.
1. Most of the Federal Reserve Bank regions are noting slower growth or actual
reductions in spending.
2. Prices remain stable and some are actually falling in the absence of input price
pressures from wages and energy.
3. Growth in demand for labor has slowed tremendously over the past six months
and upward pressure on wages does not seem to exist. Unemployment has
increased to 5.4 percent from its low of 3.9 percent last fall. (See the
unemployment case study.) The decreased intensity of competition for employees
has reduced some of the wage pressures. However, employees are demanding
better benefit packages and health costs are rising, both of which increase the
costs of labor.
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4. Consumer spending is not growing as rapidly as it was, even with the federal
income tax rebates of this summer and early fall. Part of this decrease in growth
may be due to falling confidence in future economic conditions and to falling
stock prices.
The Federal Reserve And Growth In Real GDP
On October 2, 2001 the FOMC released the following unscheduled statement:
“The Federal Open Market Committee decided today to lower
its target for the federal funds rate by 50 basis points to 2-1/2
percent. In a related action, the Board of Governors approved a 50
basis point reduction in the discount rate to 2 percent.
“The terrorist attacks have significantly heightened uncertainty
in an economy that was already weak. Business and household
spending as a consequence are being further damped. Nonetheless,
the long-term prospects for productivity growth and the economy
remain favorable and should become evident once the unusual
forces restraining demand abate.
“The Committee continues to believe 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 weighted mainly toward conditions that may generate
economic weakness in the foreseeable future.
“In taking the discount rate action, the Federal Reserve Board
approved requests submitted by the Boards of Directors of the
Federal Reserve Banks of Boston, New York, Cleveland,
Richmond, Atlanta, St. Louis, Kansas City and San Francisco.”
To see the original press release. (This press release is available at:
www.federalreserve.gov/BoardDocs/Press/General/2001/20011002/default.htm)
QUESTIONS
1. Explain why the Federal Reserve lowered target federal funds rate in October and
November 2001.
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:
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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. The Federal Open Market Committee press release states there has been deterioration
in business conditions over the past few months and that combined with increased
uncertainty has weakened the state of the economy. In order to reduce the likelihood
of further slowing, the Federal Reserve is undertaking steps to encourage increased
spending in the economy.
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 is only slowing and will turn back to a faster rate of
growth in spending on its own. 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 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
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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.
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 beige book
(www.federalreserve.gov/fomc/BeigeBook/2001/20010919/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
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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,
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
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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
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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