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Monetary Policy

CHAPTER FIFTEEN
MONETARY POLICY

CHAPTER OVERVIEW
The objectives and the mechanics of monetary policy are covered in this chapter. It is organized around
seven major topics: (1) the balance sheet of the Federal Reserve Banks; (2) the techniques of monetary
policy; (3) a graphic restatement of monetary policy; (4) the cause-effect chain of monetary policy; (5) a
survey of the advantages and disadvantages of monetary policy; (6) the dilemma of which targets should
be the goal of monetary policy, interest rates, or money supply; and (7) the impact of monetary policy
operating in a world economy. Finally, there is a brief, but important, synopsis of mainstream theory
and policies. The purpose of the concluding sections is to summarize all the macro theory developed so
far and fit the pieces together as an integrated whole for students.

WHAT’S NEW
The early part of the chapter remains much the same, but the section previously titled “Effectiveness of
Monetary Policy” has been reorganized and extensively revised. Its new title is “Monetary Policy in
Action,” and it focuses on current issues and applications while still exposing students to the strengths and
weaknesses of monetary policy.

The definition of the prime interest rate is changed. Instead of referring to it as the rate for the most
creditworthy customers, it is now identified as a “benchmark” or “reference point” upon which many rates
are set.

There is a new “Consider This” box titled “Pushing on a String” to help illustrate the asymmetry of
monetary policy.

Figure 15-2 (c) has been revised to reflect the generalized short-run aggregate supply curve now developed
in Chapter 11. The section on “Monetary Policy and Aggregate Supply” has been deleted.

Two new end-of-chapter questions have been added.

INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to

1. Identify the goals of monetary policy.


2. List the principal assets and liabilities of the Federal Reserve Banks.
3. Explain how each of the three tools of monetary policy may be used by the Fed to expand and to
contract the money supply.
4. Describe three monetary policies the Fed could use to reduce unemployment.
5. Describe three monetary policies the Fed could use to reduce inflationary pressures in the economy.
6. Explain the cause-effect relationship between monetary policy and changes in equilibrium GDP.
7. Demonstrate the money market graphically and show how a change in the money supply will affect
the interest rate.
8. Show the effects of interest rate changes on investment spending.

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9. Describe the impact of changes in investment on aggregate demand and equilibrium GDP.
10. Contrast the effects of an easy money policy with the effects of a tight money policy.
11. Identify the federal funds rate, its relation to the prime interest rate, and its importance for monetary
policy.
12. List two strengths and three shortcomings of monetary policy.
13. Describe the arguments for and against “inflation targeting” versus a more discretionary “artful
management” approach to monetary policy.
14. Explain the net export effect of an expansionary and a contractionary monetary policy.
15. Define and identify the terms and concepts at the end of the chapter.

COMMENTS AND TEACHING SUGGESTIONS


1. The Federal Reserve Banks have numerous educational publications and videos available for
classroom distribution or use. Ask your district Fed for a catalog of materials available. Most of the
high school level materials are suitable for adults as well.
2. Plan a visual demonstration of open market operations. The creation of new reserves in the banking
system seems like a magician’s trick to most students and the further expansion of the money supply
through bank loans, just more smoke and mirrors. This is a good opportunity to get students
involved through role-playing. Assign individual students or small groups parts in the process: the
Fed, commercial banks, or bank customers. Walk through several transactions to show how
purchases by the Fed monetize U.S. Government securities, putting dollars in the hands of bank
customers. When the Fed sells U.S. Government securities, the money supply declines as buyers pay
for the bonds.
3. The discussion of the Federal Reserve Bank’s consolidated balance sheet demonstrates the changes
that take place on the Fed’s balance sheet and the commercial bank’s balance sheets as open market
operations are carried out. Note the focus on open market operations.

STUDENT STUMBLING BLOCKS


1. Open market operations are puzzling to students who may not be familiar with bonds in the first
place. Begin by a brief review of the federal government’s debt, which will inform them that there
are trillions of dollars worth of government bonds in existence. The latest Federal Reserve Bulletin,
will have a table giving the amount of this debt currently held by the Fed. In other words, the Fed
has significant power to affect the money supply by buying or selling these securities. Also remind
students that the Fed deals only in federal government bonds, not corporate stock or bonds.
2. One memory tip suggested by a teacher is to tell students that when the Fed “sells” securities, that
“soaks” up money i.e., the money supply decreases. The link between “sell” and “soak” should be
an easy one for students to remember. Likewise, the Fed’s “purchase” can be associated with “pump
or push.”

LECTURE NOTES
I. Introduction to Monetary Policy
A. Reemphasize Chapter 13’s points: The Fed’s Board of Governors formulates policy, and the
twelve Federal Reserve Banks implement that policy.
B. The fundamental objective of monetary policy is to aid the economy in achieving
full-employment output with stable prices.
1. To do this, the Fed changes the nation’s money supply.

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2. To change the money supply, the Fed manipulates the size of excess reserves held by
banks.
C. Monetary policy has a very powerful impact on the economy, and the Chairman of the Fed’s
Board of Governors, Alan Greenspan currently, is sometimes called the second most powerful
person in the U.S.
II. Consolidated Balance Sheet of the Federal Reserve Banks
A. The assets column on the Fed’s balance sheet contains two major items.
1. Securities, which are federal government bonds purchased by the Fed
2. Loans to commercial banks (Note: again commercial banks term is used even though the
chapter analysis also applies to other thrift institutions.)
B. The liability side of the balance sheet contains three major items.
1. Reserves of banks held as deposits at Federal Reserve Banks
2. U.S. Treasury deposits of tax receipts and borrowed funds
3. Federal Reserve Notes outstanding, our paper currency
III. The Fed has Three Major “Tools” of Monetary Policy
A. Open-market operations refer to the Fed’s buying and selling of government bonds.
1. Buying securities will increase bank reserves and the money supply (see Figure 15-1).
a. If the Fed buys directly from banks, then bank reserves go up by the value of the securities
sold to the Fed. See impact on balance sheets using text example.
b. If the Fed buys from the general public, people receive checks from the Fed and then
deposit the checks at their bank. Bank customer deposits rise and therefore bank reserves
rise by the same amount. Follow text example to see the impact.
i. Banks’ lending ability rises with new excess reserves.
ii. The money supply rises directly with increased deposits by the public.
c. When the Fed buys bonds from bankers, reserves rise and excess reserves rise by same
amount since no checkable deposit was created.
d. When Fed buys from public, some of the new reserves are required reserves for the new
checkable deposits.
e. Conclusion: When the Fed buys securities, bank reserves will increase and the money
supply potentially can rise by a multiple of these reserves.
f. Note: When the Fed sells securities, points a-e above will be reversed. Bank reserves will
go down, and eventually the money supply will go down by a multiple of the banks’
decrease in reserves.
g. How the Fed attracts buyers or sellers.
i. When the Fed buys, it raises demand and price of bonds, which in turn lowers effective
interest rate on bonds. The higher price and lower interest rates make selling bonds to
Fed attractive.
ii. When the Fed sells, the bond supply increases and bond prices fall, which raises the
effective interest rate yield on bonds. The lower price and higher interest rates make
buying bonds from Fed attractive.

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B. The reserve ratio is another “tool” of monetary policy. It is the fraction of reserves required
relative to their customer deposits.
1. Raising the reserve ratio increases required reserves and shrinks excess reserves. Any loss
of excess reserves shrinks banks’ lending ability and, therefore, the potential money supply
by a multiple amount of the change in excess reserves.
2. Lowering the reserve ratio decreases the required reserves and expands excess reserves.
The gain in excess reserves increases banks’ lending ability and, therefore, the potential
money supply by a multiple amount of the increase in excess reserves.
3. Changing the reserve ratio has two effects.
a. It affects the size of excess reserves.
b. It changes the size of the monetary multiplier. For example, if ratio is raised from 10
percent to 20 percent, the multiplier falls from 10 to 5.
4. Changing the reserve ratio is very powerful since it affects banks’ lending ability
immediately. It could create instability, so the Fed rarely changes it.
5. Table 15-2 provides illustrations.
C. The third “tool” is the discount rate, which is the interest rate that the Fed charges to
commercial banks that borrow from the Fed.
1. An increase in the discount rate signals that borrowing reserves is more difficult and will
tend to shrink excess reserves.
2. A decrease in the discount rate signals that borrowing reserves will be easier and will tend
to expand excess reserves.
D. “Easy” monetary policy occurs when the Fed tries to increase the money supply by expanding
excess reserves in order to stimulate the economy. The Fed will enact one or more of the
following measures:
1. The Fed will buy securities.
2. The Fed may lower the reserve ratio, although this is rarely done because of its powerful
impact.
3. The Fed could reduce the discount rate. Although this has little direct impact on the money
supply, it is a way for the Fed to “announce” policy direction.
E. “Tight” monetary policy occurs when Fed tries to the decrease money supply by decreasing
excess reserves in order to slow spending in the economy during an inflationary period. The
Fed will enact one or more of the following policies:
1. The Fed will sell securities.
2. The Fed may raise the reserve ratio, although this is rarely done because of its powerful
impact.
3. The Fed could raise the discount rate. Although it has little direct impact on money
supply, the Fed may use it to “announce” a policy change.
F. For several reasons, open-market operations give the Fed most control of the three “tools.”
1. Open-market operations are most important. This decision is flexible because securities
can be bought or sold quickly and in great quantities. Reserves change quickly in
response.

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2. The reserve ratio is rarely changed since this could destabilize bank’s lending and profit
positions.
3. Changing the discount rate has little direct effect, since only 2-3 percent of bank reserves
are borrowed from Fed. At best it has an “announcement effect” that signals the direction
of monetary policy. The strength of this announcement effect will depend on the credibility
of the Fed to back up its “announcement” with the other policy tools if necessary.
IV. Monetary Policy, Real GDP, and the Price Level: How Policy Affects the Economy
A. A cause-effect chain.
1. Money market impact is shown in Key Graph 15-2.
a. Demand for money is comprised of two parts (recall Chapter 13).
i. Transactions demand is directly related to GDP.
ii. Asset demand is inversely related to interest rates, so total money demands is
inversely related to interest rates.
b. Supply of money is assumed to be set by the Fed.
c. Interaction of supply and demand determines the market rate of interest, as seen in
Figure 15-2(a).
d. Interest rate determines amount of investment businesses will be willing to make.
Investment demand is inversely related to interest rates, as seen in Figure 15-2(b).
e. Effect of interest rate changes on level of investment is great because interest cost of
large, long-term investment is a sizable part of investment cost.
f. As investment rises or falls, equilibrium GDP rises or falls by a multiple amount, as
seen in Figure 15-2(c).
2. Expansionary or easy money policy: The Fed takes steps to increase excess reserves,
which lowers the interest rate and increases investment which, in turn, increases GDP by a
multiple amount. (See Column 1, Table 15-3.)
3. Contractionary or tight money policy is the reverse of an easy money policy: Excess
reserves fall, which raises interest rate, which decreases investment, which, in turn,
decreases GDP by a multiple amount of the change in investment. (See Column 2, Table
15-3.)
4. Aggregate supply and monetary policy.
a. Easy monetary policy may be inflationary if initial equilibrium is at or near full-
employment.
b. If the economy is below full employment, easy monetary policy can shift aggregate
demand and GDP toward full-employment equilibrium.
c. Likewise a tight monetary policy can reduce inflation if the economy is near full
employment, but can make unemployment worse in a recession.
5. Try Quick Quiz 15-2.
V. Monetary Policy in Action
A. Strengths of monetary policy.
1. It is speedier and more flexible than fiscal policy since the Fed can buy and sell securities
daily.

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2. It is less political. Fed Board members are isolated from political pressure, since they
serve 14-year terms, and policy changes are subtler and not noticed as much as fiscal
policy changes. It is easier to make good, if unpopular decisions.
B. Focus on the Federal Funds Rate.
1. Currently the Fed communicates changes in monetary policy through changes in its target
for the Federal funds rate. (Key Question 6)
2. The Fed does not set either the Federal funds rate or the prime rate; (see Figure 15-3) each
is established by the interaction of lenders and borrowers, but rates generally follow the
Fed funds rate.
3. The Fed acts through open market operations, selling bonds to raise interest rates and
buying bonds to lower interest rates.
C. Recent monetary policy.
1. Easy money policy in the early 1990s helped produce a recovery from the 1990-1991
recession and the expansion that lasted until 2001. Tightening in 1994, 1995, and
1997 helped ease inflationary pressure during the expansion.
2. To counter the recession that began in March 2001, the Fed pursued an easy money
policy that saw the prime interest rate fall from 9.5 percent at the end of 2000 to 4.25
percent in December 2002.
3. The Fed has been praised for helping the U.S. economy maintain simultaneously full
employment, price stability, and economic growth for over four years. They have also
received credit for swift and strong responses to the September 11, 2001, terrorist attacks,
significant declines in the stock market, and the overall recessionary conditions.
D. Problems and complications.
1. Recognition and operational lags impair the Fed’s ability to quickly recognize the need
for policy change and to affect that change in a timely fashion. Although policy
changes can be implemented rapidly, there is a lag of at least 3 to 6 months before the
changes will have their full impact.
2. The velocity of money (number of times the average dollar is spent in a year) may be
unpredictable, especially in the short run, and can offset the desired impact of changes in
the money supply. Tight money policy may cause people to spend faster; velocity rises and
the contractionary effect is offset.
3. Cyclical asymmetry may exist: a tight monetary policy works effectively to break inflation,
but an easy monetary policy is not always as effective in stimulating the economy from
recession. “You can lead a horse to water, but you can’t make it drink.”
4. CONSIDER THIS … Pushing on a String
Japan’s ineffective easy money policy illustrates the potential inability of monetary policy
to bring an economy out of recession. While pulling on a string (tight money policy) is
likely to move the attached object to its desired destination, pushing on a string is not.
5. The impact on investment may be less than traditionally thought. Japan provides a good
example. Despite interest rates of zero, investment spending remained low during the
recession.
E. “Artful Management” or “Inflation Targeting”?
1. The Fed under Alan Greenspan has managed the money supply such that the U.S. economy
has enjoyed price stability, high levels of employment, and strong economic growth. This

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leads some to argue that the Fed should take an active policy role and attempt to pursue all
of those objectives in setting policy.
2. Out of concern that the Fed’s success may not be reproducible, some argue for inflation
targeting. This narrower policy objective would make monetary policy more
predictable and “transparent” to those in the economy making decisions based on Fed action.
F. Monetary policy and the international economy.
1. Net export effect occurs when foreign financial investors respond to a change in interest
rates.
a. Tight monetary policy and higher interest rates lead to appreciation of dollar value in
foreign exchange markets; lower interest rates from an easy monetary policy will lead
to dollar depreciation in foreign exchange markets (see Figure 12-5c).
b. When the dollar appreciates, American goods become more costly to foreigners, and
this lowers demand for U.S. exports, which tends to lower GDP. This is the desired
effect of a tight money policy. Conversely, an easy money policy leads to depreciation
of dollar, greater demand for U.S. exports and higher GDP. This policy has the
desired outcome for expanding GDP.
2. Monetary policy works to correct both trade balance and GDP problems together. An easy
monetary policy leads to increased domestic spending and increased GDP, but it also leads
to a depreciated dollar and higher U.S. export demand, which enhances GDP and erases a
trade deficit. The reverse is true for a tight monetary policy, which would tend to reduce
net exports and worsen a trade deficit.
3. Table 15-4 illustrates these points.
VI. The Big Picture (see Key Graph, Figure 15-4) Shows Many Interrelationships
A. Fiscal and monetary policy are interrelated. The impact of an increase in government spending
will depend on whether it is accommodated by monetary policy. For example, if government
spending comes from money borrowed from the general public, it may be offset by a decline in
private spending, but if the government borrows from the Fed or if the Fed increases the money
supply, then the initial increase in government spending may not be counteracted by a decline
in private spending.
B. Study Key Graph 15-4 and you will see that the levels of output, employment, income, and
prices all result from the interaction of aggregate supply and aggregate demand. In particular,
note the items shown in red that constitute, or are strongly influenced by, public policy.
C. Try Quick Quiz 15-4.
VII. LAST WORD: For the Fed, Life is a Metaphor
A. The media use colorful terms to describe the Federal Reserve Board and its chair, Alan
Greenspan. They may loosen or tighten reins while riding herd on a rambunctious economy!
B. The Fed has been depicted as a mechanic, with references to loosening or tightening things, and
to the economy running beautifully or acting sluggish, accelerating, or going out of control.
C. The warrior metaphor has been used—fighting inflation, plotting strategy, protecting the dollar
from attack.
D. The Fed has been depicted as the fall guy in terms of administration officials “leaning heavily”
on it and telling the Fed to ease up or to relax.
E. As a cosmic force, the Fed satisfies three criteria—power, mystery, and a New York office.

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ANSWERS TO END-OF-CHAPTER QUESTIONS


15-1 Use commercial bank and Federal Reserve Bank balance sheets to demonstrate the impact of each
of the following transactions on commercial bank reserves:
a. Federal Reserve Banks purchase securities from private businesses and consumers.
b. Commercial banks borrow from the Federal Reserve Banks.
c. The Board of Governors reduces the reserve ratio.
In the tables below, columns “a” through “c” show the changes caused by the answers to the
questions. It is assumed the initial reserve ratio is 20 percent. Thus, as the first column shows, the
commercial banks are initially completely loaned up. The answers are not cumulated: We return
to the first column each time to show the resulting change in column a, b, or c. If you would rather
not use numbers, it would be acceptable to substitute with + or - signs, using symbols to represent
numbers. For example, part (a) could read “the Fed purchases ‘x dollars’ worth of securities,” and
instead of the $2 billion changes on the balance sheet, you would indicate + x. Note: Any numbers
could demonstrate this if direction is the same.
(a) It is assumed the Fed buys $2 billion worth of securities. This should increase checkable
deposits and commercial bank reserves by $2 billion. With demand deposits of $202 billion,
required reserves are $40.4 billion, (= 20 percent of $202 billion). Therefore, excess reserves
are $1.6 billion (= $42 billion - $40.4 billion) and the banking system can increase the money
supply (by making loans) by $8 billion more (= $1.6 billion x 5).
(b) It is assumed the commercial banks borrow $1 billion from the Fed. The commercial banks
may now increase the money supply (through making loans) by $5 billion (= $1 billion x 5).
(c) Changing the reserve ratio in and of itself does not change the balance sheets. However, if we
assume the reserve ratio has been decreased from 20 percent to 19 percent, required reserves
are now $38 billion (= 19 percent of $200 billion) and the commercial banks can now increase
the money supply (through making loans) by $10.53 billion [= $2 billion x (1/0.19)]. Proof:
19 percent of $210.53 billion is $40 billion.

CONSOLIDATED BALANCE SHEET: ALL COMMERCIAL BANKS


a b c
Assets:
Reserves $ 40 $ 42 $ 41 $ 40
Securities 60 60 60 60
Loans 102 102 102 102

Liabilities and net worth:


Checkable deposits 200 202 200 200
Loans from the Federal
Reserve Banks 2 2 3 2

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CONSOLIDATED BALANCE SHEET:


TWELVE FEDERAL RESERVE BANKS
a b c
Assets:
Securities $283 $285 $283 $283
Loans to commercial banks 2 2 3 2

Liabilities and net worth:


Reserves of commercial banks 40 42 41 40
Treasury deposits 5 5 5 5
Federal Reserve Notes 225 225 225 225
Other liabilities and net worth 15 15 15 15

15-2 (Key Question) In the table below you will find simplified consolidated balance sheets for the commercial banking
system and the 12 Federal Reserve Banks. Use columns 1 through 3 to indicate how the balance sheets would read
after each of transactions a to c is completed. Do not cumulate your answers; that is, analyze each transaction
separately, starting in each case from the figures provided. All accounts are in billions of dollars.

CONSOLIDATED BALANCE SHEET: ALL COMMERCIAL BANKS


(1) (2) (3)
Assets:
Reserves $ 33 _____ _____ _____
Securities 60 _____ _____ _____
Loans 60 _____ _____ _____

Liabilities and net worth:


Checkable deposits 150 _____ _____ _____
Loans from the Federal
Reserve Banks 3 _____ _____ _____

CONSOLIDATED BALANCE SHEET:


TWELVE FEDERAL RESERVE BANKS
(1) (2) (3)
Assets:
Securities $60 _____ _____ _____
Loans to commercial banks 3 _____ _____ _____

Liabilities and net worth:


Reserves of commercial banks $33 _____ _____ _____
Treasury deposits 3 _____ _____ _____
Federal Reserve Notes 27 _____ _____ _____

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a. A decline in the discount rate prompts commercial banks to borrow an additional $1 billion
from the Federal Reserve Banks. Show the new balance-sheet figures in column 1 of each
table.
b. The Federal Reserve Banks sell $3 billion in securities to members of the public, who pay for
the bonds with checks. Show the new balance-sheet figures in column 2 of each table.
c. The Federal Reserve Banks buy $2 billion of securities from commercial banks. Show the new
balance-sheet figures in column 3 of each table.
d. Now review each of the above three transactions, asking yourself these three questions: (1)
What change, if any, took place in the money supply as a direct and immediate result of each
transaction? (2) What increase or decrease in commercial banks’ reserves took place in each
transaction? (3) Assuming a reserve ratio of 20 percent, what change in the money-creating
potential of the commercial banking system occurred as a result of each transaction?
(a) Column (1) data (top to bottom): Bank Assets: $34, 60, 60; Liabilities: $150, 4; Fed Assets:
$60, 4; Liabilities: $34, 3, 27.
(b) Column (2) data (top to bottom): Bank Assets: $30, 60, 60; Liabilities: $147, 3; Fed Assets:
$57, 3, 30, 3, 27.
(c) Column (3) data (top to bottom): $35; $58; $60; $150; $3; Fed banks: $62; $3; $35; $3; $27.
(d) (d1) Money supply (checkable deposits) directly changes only in (b), where it decreases by $3
billion; (d2) See balance sheets; (d3) Money-creating potential of the banking system increases
by $5 billion in (a); decreases by $12 billion in (b) (not by $15 billion—the writing of $3
billion of checks by the public to buy bonds reduces demand deposits by $3 billion, thus
freeing $0.6 billion of reserves. Three billion dollars minus $0.6 billion equals $2.4 billion of
reduced reserves, and this multiplied by the monetary multiplier of 5 equals $12 billion); and
increases by $10 billion in (c).
15-3 (Key Question) Suppose that you are a member of the Board of Governors of the Federal Reserve
System. The economy is experiencing a sharp and prolonged inflationary trend. What changes in
(a) the reserve ratio, (b) the discount rate, and (c) open-market operations would you recommend?
Explain in each case how the change you advocate would affect commercial bank reserves, the
money supply, interest rates, and aggregate demand.
(a) Increase the reserve ratio. This would increase the size of required reserves. If the commercial
banks were fully loaned up, they would have to call in loans. The money supply would
decrease, interest rates would rise, and aggregate demand would decline.
(b) Increase the discount rate. This would decrease commercial bank borrowing from the Fed.
Actual reserves of the commercial banks would fall, as would excess reserves and lending.
The money supply would drop, interest rates would rise, and aggregate demand would decline.
(c) Sell government securities in the open market. Buyers of the bonds would write checks to the
Fed on their demand deposits. When these checks cleared, reserves would flow from the
banking system to the Fed. the decline in reserves would reduce the money supply, which
would increase interest rates and reduce aggregate demand.
15-4 What is the basic objective of monetary policy? State the cause-effect chain through which
monetary policy is made effective. What are the major strengths of monetary policy?
The basic objective of monetary policy is to assist the economy in achieving a full-employment,
noninflationary level of total output. Changes in the money supply affect interest rates, which
affect investment spending and therefore aggregate demand.
The major strengths of monetary policy are its speed and flexibility compared to fiscal policy, the
fact that the Board of Governors is somewhat removed from political pressure, and its successful

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record in preventing inflation and keeping prices stable. The Fed is given some credit for
prosperity in the 1990s.
15-5 What is “velocity” as it applies to money? Suppose the Fed decreases the money supply from $3
billion to $2 billion, but velocity rises from 3 to 5. By how much, if at all, will total spending
decline? What do economists mean when they say that monetary policy can exhibit cyclical
asymmetry?
The velocity of money is the number of times per year the average dollar is spent on goods and
services. The change in money supply and velocity described above would increase total spending
by $1 billion [3 x $3 billion = $9 billion total spending versus 5 x $2 billion = $10 billion total
spending].
Cyclical asymmetry refers to the condition where a tight monetary policy is relatively potent at
contracting economic activity, while an easy money policy is relatively weak at stimulating an
economy. The weakness in easy money policy results when, even though the Fed increases
liquidity (reserves) in the system, potential borrowers are unwilling to spend (often because of
uncertainly over general weakness in the economy).
15-6 (Key Question) Distinguish between the Federal funds rate and the prime interest rate. In what
way is the Federal funds rate a measure of the tightness or looseness of monetary policy? In 2001
the Fed used open-market operations to significantly reduce the Federal funds rate. What was the
logic of those actions? What was the effect on the prime interest rate?
The Federal funds interest rate is the interest rate banks charge one another on overnight loans
needed to meet the reserve requirement. The prime interest rate is the interest rate banks change on
loans to their most creditworthy customers. The tighter the monetary policy, the less the supply of
excess reserves in the banking system and the higher the Federal funds rate. The reverse is true of
a loose or easy monetary policy, which expands excess reserves, and causes the federal funds rate
to fall.
The Fed wanted to increase excess reserves, increase money supply growth, and lower real interest
rates. In 2001 the U.S. economy was in the midst of recession, with spending in decline and stock
prices falling. The terrorist attacks of September 11, 2001, added further uncertainty to the
already weak economic outlook, and an easy money policy was seen as a way to boost confidence.
The prime interest rate fell as a result of these actions.
15-7 What is inflation targeting, and how does it differ from the current Fed policy? What are the main
benefits of inflation targeting, according to its supporters? Why do many economists feel it is not
needed or even oppose it?
An inflation targeting policy would have the Fed announce each year a target range for the rate of
inflation. Fed policy would then be geared to pursue that objective, and failure to meet the target
would require the Fed to explain what went wrong.
Supporters of inflation targeting argue that it increases the transparency and accountability of Fed
policy. It would also keep the Fed focused on what should be its primary objective – stable prices.
Some supporters would also argue that the success of past Fed action does not ensure that it will
always make the right decision, especially if it attempts to pursue multiple objectives
simultaneously.
Opponents of inflation targeting believe that the Fed needs the discretion and flexibility to adapt
policy to conditions that are changing (sometimes rapidly). They also believe that past success in
inflation targeting is partially the result of ideal economic conditions, and opponents question its
effectiveness during more economically difficult times.
15-8 (Key Question) Suppose the Federal Reserve decides to engage in a tight money policy as a way to
reduce demand-pull inflation. Use the aggregate demand-aggregate supply model to show what

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this policy is intended to accomplish in a closed economy. Now introduce the open economy and
explain how changes in the international value of the dollar might affect the location of your
aggregate demand curve.
The intent of a tight money policy would be shown as a leftward shift of the aggregate demand
curve and a decline in the price level (or, in the real world, a reduction in the rate of inflation). In
an open economy, the interest rate hike resulting from the tight money policy would entice people
abroad to buy U.S. securities. Because they would need U.S. dollars to buy these securities, the
international demand for dollars would rise, causing the dollar to appreciate. Net exports would
fall, pushing the aggregate demand curve farther leftward than in the closed economy.
15-9 (Last Word) How do each of the following metaphors apply to the Federal Reserve’s role in the
economy: Fed as a mechanic; Fed as a warrior; Fed as a fall guy?
The Fed is a mechanic in the sense that it is responsible for “tightening” or “loosening” the money
supply. It uses terms like a “sluggish” economy or an economy “out of control” in discussing the
proper policy to follow. In other words, if we view the economy as a machine and the money
supply as one of its components, the Fed takes on the task of adjusting that part in order to “fix”
the economy machine!
The Fed is a warrior in the sense that it is asked to “fight” inflation. Policies that reduce inflation
are generally unpopular and inflation is often very persistent, hence the term “fight” is used in the
“battle” against inflation.
Because the Fed is independent, its policies are often blamed for many of the economy’s ills or its
failure to perform as desired. It is easy for politicians to blame their own failures to enact
appropriate fiscal policies on the Fed. The Fed is often a “fall guy” whenever the economy does
not behave as desired.

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