CHAPTER 14 (26)|Monetary Policy
2.Describe the Federal Reserve’s monetary policy targets and explain how expansionary and
contractionary monetary policies affect the interest rate. A macroeconomic policy that
successfully reduces the severity of the business cycle is called a countercyclical policy. To fight a
recession, the Fed conducts an expansionary policy by increasing the money supply. The increase in
the money supply lowers the interest rate. To reduce the inflation rate, the Fed conducts a
contractionary policy by increasing the money supply. The decrease in the money supply raises the
interest rate. In a graphical analysis of the money market, an expansionary policy shifts the money
supply curve to the right, causing a movement down the money demand curve, and a new equilibrium
at a lower interest rate. A contractionary policy shifts the money supply curve to the left, causing a
movement up the money demand curve, and a new equilibrium at a higher interest rate.
3.Use aggregate demand and aggregate supply graphs to show the effects of monetary policy on
real GDP and the price level.An expansionary monetary policy lowers interest rates to increase
consumption, investment, and net exports. This increased spending causes the aggregate demand
curve (AD) to shift to the right more than it otherwise would, raising the level of real GDP and the
price level. A contractionary monetary policy raises interest rates in order to decrease consumption,
investment, and net exports. This decreased spending causes the aggregate demand curve to shift to
the right less than it otherwise would, reducing the level of real GDP and the price level.
4.Discuss the Fed’s setting of monetary policy targets. Some economists have argued that the Fed
should use the money supply as its monetary target, rather than an interest rate. Milton Friedman and
other monetarists argue that the Fed should adopt a monetary growth rule of increasing the money
supply every year at a fixed rate. Support for this proposal declined after 1980 because the
relationship between movements in the money supply and movements in real GDP and the price level
has weakened. John Taylor has analyzed the factors involved in Fed decision making and developed
the Taylor rule for federal funds targeting. The Taylor rule links the Fed’s target for the federal funds
rate to economic variables. Over the past decade, many economists and central bankers have
expressed significant interest in using inflation targeting. Under inflation targeting, monetary policy
is conducted so as to commit the central bank to achieving a publicly announced inflation target. A
number of foreign central banks have adopted inflation targeting, but the Fed has not. The Fed’s
performance in the 1980s, 1990s, and early 2000s has generally received high marks from
economists, even without formal inflation targeting.
5.Assess the arguments for and against the independence of the Federal Reserve. The Fed
conducts monetary policy without input from the Congress or the president. The Fed’s entire
operating budget is the interest it earns from purchasing U.S. Treasury bills. That means the Fed does
not depend on Congress for its operating funds. But the Fed’s independence is not absolute, because
Congress and the president can pass legislation at any time to reorganize (or even abolish) the Fed.
Advocates of Fed independence argue that isolating it from political pressure allows it to choose
policies in the best interest of the economy. Internationally, countries with more independent central
banks tend to have lower inflation rates. Opponents of Fed independence argue that concentrating so
much power in the hands of unelected officials is inconsistent with democratic principles.