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Lesson 11-1
The Goals and Outcomes of Monetary Policy
Goals of Monetary Policy
The Federal Reserve Act
The original legislation establishing the Fed said
nothing about economic growth, inflation or
deflation, or unemployment.
The Employment Act of 1946
The act specified promoting maximum
employment, production, and purchasing power.
The act did not specify how to reconcile
inconsistencies among these goals.
The Full Employment and Balanced Growth Act of 1978
Also known as the Humphrey-Hawkins Act, this act set
objectives
To achieve an unemployment rate among adults of 3 percent
or less by 1983.
To achieve a civilian unemployment rate of 4 percent or less by
1983.
To achieve an inflation rate of 3 percent or less by 1983.
Requires the chairman of the Fed’s Board of Governors to
appear twice each year before Congress and report about
monetary policy—The Humphrey-Hawkins Report.
Federal Reserve Policy and Goals
In practice during the past 20 years, the Fed’s
policy has primarily aimed at controlling inflation.
Given acceptable inflation rates, the Fed is willing
to try to close a recessionary gap.
In recent years, it appears that an inflation rate of 3
percent or a prediction that the 3 percent rate will
be exceeded is cause for restrictive monetary
policy by the Fed.
Monetary Policy and Macroeconomic Variables
Expansionary Monetary Policy
Assume a recessionary gap. Policy choices are to let
the economy correct itself or to take expansionary
action.
Expansionary monetary policy is one active policy for
this situation.
The Fed would buy bonds thus expanding the money
supply. The effects would be as follows:
Demand for bonds increases, thereby raising bond
prices and lowering the interest rate.
Lower interest rates stimulate consumption and
investment.
Lower interest rates reduce the demand for and raise
the supply of dollars in the currency market,
generating a lower exchange rate.
A lower exchange rate stimulates net exports.
Increases in consumption, investment, and net
exports increase aggregate demand and begin to
close the recessionary gap.
Contractionary Monetary Policy
To implement contractionary monetary policy, the Fed would
sell bonds on the open market.
The supply of bonds increases, thereby lowering the price of
bonds and raising the interest rate.
A higher interest rate discourages consumption and
investment.
A higher interest rate also raises demand for dollars and
reduces the supply of dollars leading to an increase in the
exchange rate.
A higher exchange rate discourages foreign demand and
increases domestic demand for foreign goods, thereby leading
to reduced net exports.