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A CASE STUDY
The Federal Reserve System and Monetary Policy
The Federal Open Market Committee
Date Of Announcement
January 29, 2003
Dates Of Future Federal Open Market Committee Meetings
March 18, 2003
Announcement
The Federal Open Market Committee decided today to keep its target for the
federal funds rate unchanged at 1-1/4 percent.
Oil price premiums and other aspects of geopolitical risks have reportedly
fostered continued restraint on spending and hiring by businesses. However,
the Committee believes that as those risks lift, as most analysts expect, the
accommodative stance of monetary policy, coupled with ongoing growth in
productivity, will provide support to an improving economic climate over
time.
In these circumstances, 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 for 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; J. Alfred Broaddus, Jr.;
Roger W. Ferguson, Jr.; Edward M. Gramlich; Jack Guynn; Donald L. Kohn; Michael H.
Moskow; Mark W. Olson, and Robert T. Parry.
This complete press release is available at:
http://www.federalreserve.gov/BoardDocs/Press/monetary/2002/20021210/de
fault.htm
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
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interest rates and boost spending and employment in the U.S. economy. Attention
increased as the economy entered a recession beginning in March of 2001 and real gross
domestic product (GDP) actually fell in the first three quarters of 2001. Concern has
continued as the economy grew slowly in the second and fourth quarters of 2002. 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 has not returned to the strength of years past.
This case study is intended to guide students and teachers through an analysis of the
actions the Federal Reserve began to take in January of 2001 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. This
initial case study of the semester introduces relevant concepts and issues. 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). That was the lowest target federal funds
rate in forty years. At all 2002 meetings before the cut at the November meeting, 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 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 was left unchanged at this meeting and is not mentioned in the announcement when
there are no changes.
In the second and third paragraphs, the Federal Reserve discusses the reasoning
behind their decision. The statement that “the accommodative stance of monetary policy,
coupled with ongoing growth in productivity, will provide support to an improving
economic climate over time” shows that the Fed views current policy as proving
effective. With that said, the Fed also shows it is sensitive to current world events by
mentioning “oil price premiums and other aspects of geopolitical risk”, though the Fed
concludes that these risks will eventually lift. In the third paragraph the Fed indicates
that the risks are balanced between inflation (“price stability”) and sustainable growth,
showing that the Fed is taking care to avoid overheating the economy in the quest to
boost growth. The FOMC indicates that the long-run prospects are good. Current
monetary policy is - meaning it should encourage economic expansion while containing
inflation and not assisting a return to full strength too quickly. The FOMC members
expect positive continued productivity growth. The fourth paragraph describes the votes
of the FOMC members on changing the target federal funds rate. In the past, there has
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been a lag between the announcement and the publication of this information in the
minutes. This change, which was implemented at the March 2002 meeting, is one step in
a FOMC trend toward releasing more information immediately following their meetings.
All members of the FOMC voted to leave the target federal funds rate unchanged.
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 expresses no
concern with potential inflationary pressures. The latest unemployment rate of 6.0%
was a nine-year high and shows that weakness persists in the economy. 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 as well as if unemployment
does not begin to return to lower levels. In either case, there will be pressure on the Fed
to act decisively.
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. Real GDP increased at an
annual rate of 2.4 percent during 2002, with an extremely slow rate of increase in the
most recent quarter of .7 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
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,
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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.
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.
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
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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 year. 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, 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. 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 quicker. Monetary policy decisions are much
easier to institute and more responsive to economic conditions, but take longer to take
effect.
Creation of the Federal Open Market Committee
The seven members of the Board of Governors are appointed by the President and
confirmed by the Senate to serve 14-year terms of office. Members may serve only one
full term, but a member who has been appointed to complete an unexpired term may be
reappointed to a full term. The President designates, and the Senate confirms, two
members of the Board to be Chairman and Vice Chairman, for four-year terms.
Only one member of the Board may be selected from any one of the twelve Federal
Reserve Districts. In making appointments, the President is directed by law to select a
"fair representation of the financial, agricultural, industrial, and commercial interests and
geographical divisions of the country." These aspects of selection are intended to ensure
representation of regional interests and the interests of various sectors of the public.
The seven Board members constitute a majority of the 12-member Federal Open
Market Committee (FOMC), the group that makes the key decisions affecting the cost
and availability of money and credit in the economy. The other five members of the
FOMC are Reserve Bank presidents, one of whom is the president of the Federal Reserve
Bank of New York. The other Bank presidents serve one-year terms on a rotating basis.
By statute the FOMC determines its own organization, and by tradition it elects the
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Chairman of the Board of Governors as its Chairman and the President of the New York
Bank as its Vice Chairman.
(http://www.federalreserve.gov/pubs/frseries/frseri.htm)
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.
QUESTIONS
1. What are the Federal Reserve current observations and concerns?
2. What tools can the Federal Reserve use?
3. If the Federal Reserve is concerned about lack of economic expansion, what is it
likely to do with its open market operations and the federal funds rate?
4. If the Federal Reserve is concerned about lack of economic expansion and decided to
use changes in reserve requirement and the discount rate, what would it do?
5. How do changes in monetary policy affect spending in the economy?
6. (More advanced) What are some "geopolitical risks" that could influence future
economic conditions? How would economic conditions be affected?
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Answers To Questions
1. While the Federal Reserve is optimistic about future conditions, there still is concern
that economic conditions are not rapidly improving
2. The Federal Reserve can buy or sell bonds, which in turn lower or increase the
federal funds rate. The Federal Reserve can also change reserve requirements and
the discount rate.
3. The Federal Reserve would purchase bonds to expand the money supply and reserves
and lower the target federal funds rate.
4. The Federal Reserve would lower reserve requirements and decrease the discount
rate.
5. 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 spending,
the increased availability of loans and lower interest rates may encourage businesses
and consumers to increase their spending.
6. Geopolitical risks include events such as a future terrorist attack or a war with Iraq.
Related risks include actions such as higher oil prices, as well as a reduction in
consumer confidence and spending. If consumers become nervous 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
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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 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
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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
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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