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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.