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A CASE STUDY
The Federal Reserve System and Monetary Policy
The Federal Open Market Committee
Date of Announcement
October 28, 2003
Dates of Future Federal Open Market Committee Meetings
December 9, 2003
Target
federal funds
rate is
1.0 percent
Target federal
funds rate is
unchanged
from previous
meeting
The
discount
rate is 2.0
percent
Announcement
“The Federal Open Market Committee decided today to keep its target for
the federal funds rate at 1 percent.
“The Committee continues to believe that an accommodative stance of
monetary policy, coupled with robust underlying growth in productivity, is
providing important ongoing support to economic activity. The evidence
accumulated over the intermeeting period confirms that spending is
firming, and the labor market appears to be stabilizing. Business pricing
power and increases in core consumer prices remain muted.
“The Committee perceives that the upside and downside risks to the
attainment of sustainable growth for the next few quarters are roughly
equal. In contrast, the probability, though minor, of an unwelcome fall in
inflation exceeds that of a rise in inflation from its already low level. The
Committee judges that, on balance, the risk of inflation becoming
undesirably low remains the predominant concern for the foreseeable
future. In these circumstances, the Committee believes that policy
accommodation can be maintained for a considerable period.
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“Voting for the FOMC monetary policy action were: Alan Greenspan,
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; Robert T. Parry; and Jamie B.
Stewart, Jr.”
This complete press release is available at:
http://www.federalreserve.gov/BoardDocs/Press/monetary/2003/20031028/
Reasons for a Case Study on the Federal Open Market Committee
The target federal funds rate is at a record low as the Federal Reserve
monetary policy committee has concerned itself with encouraging the recovery
from the 2001 recession and the possibility of experiencing a deflationary period.
Recent announcements reflect serious concerns with the state and direction of the
economy. While 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 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.
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
The first paragraph of the meeting announcement summarizes the current
monetary policy changes - this month it is the decision to leave the target federal
funds rate unchanged at 1 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. The discount rate is not mentioned in the
announcement and that implies that it was left unchanged at the meeting.
In the second paragraph, the Federal Reserve discusses the reasoning behind
their decision. The statement that “an accommodative stance of monetary policy,
coupled with robust underlying growth in productivity, is providing important
ongoing support to economic activity” shows that the Federal Reserve views the
recent current policy as proving effective. The members of the committee believe
that labor markets are improving (that is the interpretation of “appears to be
stabilizing”) and that there is little danger of inflation.
The only change in this announcement from the announcement following the
previous meeting in September is the insertion of the eight words at the end of the
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second sentence in the second paragraph. The committee replaced “although the
labor market has been weakening” with “and the labor market appears to be
stabilizing.” The committee members do believe that as employment increases,
the outlook for increasing future employment continues to improve.
(See the previous FOMC case study. The September 2003 press release is available
at: http://www.federalreserve.gov/BoardDocs/Press/monetary/2003/2003916/)
In the third paragraph is the indication of likely future activities. The Federal
Reserve indicates that the risks of inflation and slowing spending growth are
balanced. The can be interpreted as the FOMC members believing that they will
be unlikely to make additional changes between now and the next FOMC meeting
in December. However, the Federal Reserve is still concerned with the risk of
deflation – that is the interpretation of the stated predominant concern with
“inflation becoming undesirably low”.
The fourth paragraph describes the votes of the FOMC members on changing
the target federal funds rate. In the past, there has been a lag between the
announcement and the publication of this information in the minutes. This
change, which was implemented last year, 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.
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.
During the fourth quarter of 2001, real GDP increased at an annul rate of 2.7
percent. However, real GDP increased only at a rate of 2.4 percent throughout
2002 and this combined with a slowly growing first quarter in 2003, caused the
Federal Reserve committee to lower target federal funds again. (For more on
changes in the rate of growth of real GDP and the recession, see the most recent
GDP Case Study.)
From January 3 to December 11 of 2001, the Federal Reserve Open Market
Committee (FOMC) lowered the target federal funds rate eleven times from 6.50
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percent to 1.75 percent, at that time, the lowest target federal funds rate in forty
years. At all of the 2002 meetings prior to the November meeting, the FOMC
decided to leave the federal funds rate unchanged. In November, the target
federal funds rate was once again lowered to 1.25 percent. Then in June of 2003
the target federal funds rate was lowered once again, this time to 1 percent.
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
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. This year it announced that the recession officially ended in November
of 2001.
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 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 was
actually reported as having declined.
The previous 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/recessions.html
Deflation
Deflation is the opposite of inflation. We experience deflation if prices across
the economy, that is, if most prices or prices on average, are falling. This
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announcement refers to the possibility of “an unwelcome fall in inflation.” As
recent inflation has been quite low, the FOMC announcement points to concerns
that inflation might turn into a deflation.
Why should we be concerned with falling prices? It sounds good. The
concern is that if prices throughout the economy are falling and if consumers and
businesses expect prices to continue to fall, they may reduce spending because
they expect even lower prices in the near future. That would put further
downward pressure on spending, production, and employment and perhaps lead to
a recession.
In addition, businesses and individual debtors may face increased pressures.
As sales (and incomes) and therefore profits fall in nominal terms, the amount of
debt does not change. Instead it becomes an ever-increasing percentage of
income and makes it more difficult to make timely payments.
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 9, 2003.) 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.
Tools of the Federal Reserve
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
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bank’s reserves. The bank, in turn, removes the same amount from the
customer’s account. Thus, the money supply shrinks.
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.
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 along with the target federal funds rate, but the discount rate change
does not have a very important effect. In this announcement, the discount rate
is not changed.
(Note: In January of 2003, the discount rate was changed to a level one
percent above the target federal funds rate. The discount rate had normally
been about one-half of a percent less than the target federal funds rate.
Technical aspects of borrowing from the Fed were also changed at the same
time. The basic functions of monetary policy were not changed.)
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.
For more background on the Federal Reserve and resources to use in the
classroom, go to www.federalreserve.gov.
How does Monetary Policy Work?
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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 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
year. The challenges of quick responses point to one of the key differences
between fiscal and monetary policy. Fiscal policy is much more difficult to
implement but has a faster effect spending. Monetary policy decisions are much
easier to institute and more responsive to economic conditions, but may take
longer to have a full effect.
Creation of the Federal Open Market Committee
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“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 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.
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Interactive Button Questions
1. What are the Federal Reserve’s monetary policy tools?
Open market operations (changing the target federal funds rate), the discount
rate, and the required reserves ratio.
2. If the Federal Reserve Open Market Committee is concerned with increasing
inflationary pressures at the same time unemployment is likely to fall, it will
likely ______________ bonds.
Sell bonds in order to reduce the money supply and increase the target federal
funds rate.
3. If the Federal Reserve Board and the Bank presidents are concerned with
increasing inflationary pressures at the same time unemployment is likely to
fall, they will likely ______________ the discount rate.
Increase the discount rate as a signal that the Federal Reserve intends to use
a tight monetary policy.
4. If the Federal Reserve Board members are concerned with increasing
inflationary pressures at the same time unemployment is likely to fall and they
are considering changing the required reserve ratio, they will likely
______________ the required reserve ratio.
Increase the required reserve ratio to reduce the total amount of loans (and
therefore the money supply) that banks can make.
5. If the Federal Reserve Open Market Committee is concerned that
unemployment is increasing while inflation is decreasing, it will likely
______________ bonds.
Purchase bonds in order to increase the money supply and decrease the
target federal funds rate.
6. If the Federal Reserve Board and the Bank presidents are concerned that
unemployment is increasing while inflation is decreasing, they will likely
_____________ the discount rate.
Decrease the discount rate as a signal that the Federal Reserve intends to use
a stimulative monetary policy.
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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?
Answers to Questions
1. While the Federal Reserve is optimistic about future conditions, there still is
concern that economic conditions are not rapidly improving and that deflation
is a potential problem.
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.
Key Concepts
Discount rate
Federal funds rate
Federal Open Market Committee
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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 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
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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
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
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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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