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A CASE STUDY
The Federal Reserve System and Monetary Policy
The Federal Open Market Committee
Date Of Announcement
May 7, 2003
Dates Of Future Federal Open Market Committee Meetings
June 25, 2003.
Announcement (an excerpt)
The Federal Open Market Committee decided to keep its target for the federal funds rate
unchanged at 1-1/4 percent.
Recent readings on production and employment, though mostly reflecting decisions made
before the conclusion of hostilities, have proven disappointing. However, the ebbing of
geopolitical tensions has rolled back oil prices, bolstered consumer confidence, and
strengthened debt and equity markets. These developments, along with the accommodative
stance of monetary policy and ongoing growth in productivity, should foster an improving
economic climate over time.
Although the timing and extent of that improvement remain uncertain, the Committee
perceives that over the next few quarters the upside and downside risks to the attainment of
sustainable growth are roughly equal. In contrast, over the same period, the probability of an
unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation
from its already low level. The Committee believes that, taken together, the balance of risks
to achieving its goals is weighted toward weakness over the foreseeable future.
(The complete press release is available at:
http://www.federalreserve.gov/boarddocs/press/monetary/2003/20030506/
default.htm.)
Reasons for a Case Study on the Federal Open Market Committee
Following most Federal Open Market Committee announcements, newspapers across
the country have front-page stories about the Federal Reserve actions to change interest
rates and increase (or reduce) spending and employment in the U.S. economy. Attention
increased when the economy entered a recession beginning in March of 2001 and as real
GDP fell in the first three quarters of 2001 and has grown at relatively slow rates since.
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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
not growing rapidly enough to increase employment.
This case study is intended to guide students and teachers through an analysis of the
recent and current actions of the Federal Reserve. An understanding of monetary policy
in action is fundamental to developing a thorough understanding of macroeconomic
policy 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 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 from the twelve Federal Reserve Banks. Although it is not
mentioned in the announcement, the discount rate also was left unchanged at this
meeting.
In the second and third paragraphs, the Federal Reserve discusses the reasoning
behind the decision. The second paragraph states that “the ebbing of geopolitical
tensions has rolled back oil prices, bolstered consumer confidence, and strengthened debt
and equity markets. These developments, along with the accommodative stance of
monetary policy and ongoing growth in productivity, should foster an improving
economic climate over time.” The declining oil prices, greater consumer confidence and
presumably greater consumer spending, the increased willingness of businesses to
borrow, and the improved stock market conditions are signs to the Federal Reserve that
short-run prospects have improved. However, the statement that the upside and downside
risks are equal means that the Federal Reserve is not willing to state that the economy is
clearly recovering from the recent rather slow growth.
Recent stimulative monetary policy and continuing increases in output per worker are
good longer term signs.
In the third paragraph includes a statement about inflation that indicates that the
members of the committee believe that falling inflation (and perhaps deflation) is more
likely than increased inflationary pressures. Finally the announcement states “the
Committee believes that, taken together, the balance of risks to achieving its goals is
weighted toward weakness over the foreseeable future.” The FOMC believes that the
long-run prospects are good, the short-run indicators have been somewhat negative and
deflation remains a threat. Thus current monetary policy is biased toward potential
weakness in the economy. This indicates that if changes are made in the near future, the
Fed is most likely to consider lowering interest rates.
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A fourth paragraph (not included above) 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. The decision to
include voting details, which was implemented at the March 2002 meeting, is one step in
a FOMC trend toward releasing more information immediately following the meetings.
In this instance, 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. In the press release, the Fed states that it believes inflation and inflation
expectations are well contained, and in fact mentions deflation as the greater concern.
While real GDP has maintained positive growth since the fourth quarter of 2001, it has
been slow and the latest unemployment rate of 6.0% equals a nine-year high. In addition,
employment has continued to fall. The decision of the Fed will be scrutinized if
employment continues to decrease and unemployment does not begin to return to lower
levels. In such a case, there will be pressure on the Fed to act decisively.
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. 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 one additional .5
percent cut at the November 2002 meeting, the FOMC decided to leave the federal funds
rate unchanged.
During the fourth quarter of 2001, real GDP increased at an annual rate of 2.7
percent. In the first quarter of 2002, real GDP the annual rate of growth increased even
more rapidly at a rate of 5.0 percent - evidence that the stimulative monetary policy was
having an effect. For the entirety of 2002, real GDP increased by 2.4 percent. (For more
on changes in the rate of growth of real GDP and the recession, see the most recent GDP
Case Study.)
Rate Graph
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
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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,
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 actual declines in real GDP were
announced.
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.
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 June 25.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,
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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.
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 that banks hold in
reserves changes throughout the year and the Federal Reserve will buy or sell bonds
to influence reserve levels and 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 discount
rate, but the 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-half of
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,
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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?
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. (See the
Unemployment Case Study for a more detailed discussion of employment and
unemployment.)
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 2003, 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 to date. This points to one of the key
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differences between fiscal and monetary policy. Fiscal policy is much more difficult to
implement. However, fiscal policy, once adopted, will be likely to have a faster effect on
spending. Monetary policy decisions are much easier to institute and more responsive to
economic conditions, but take longer to actually have an 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
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 begin to change their spending 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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7. If Federal Reserve Board members are concerned that unemployment is increasing
while inflation is decreasing and they are considering changing the required reserve ratio,
they will likely ______________ the required reserve ratio.
Decrease the required reserve ratio to increase the total amount of loans (and
therefore the money supply) that banks can make.
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?
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 may be a
possibility.
2. The Federal Reserve can buy or sell bonds, which in turn will 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)
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borrowing and spending. In the case of too little growth or a reduction in spending,
the Fed will buy bonds and the resulting 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 attacks and war in Iraq.
Related risks include outcomes such as higher oil prices, as well as reductions 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 further 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
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.
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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
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
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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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