Following recent Federal Open Market Committee announcements, newspapers across the country have had front-page stories about the most recent Federal Reserve actions to lower interest rates and boost spending and employment in the U.S. economy. The announcements reflect serious concerns with the state and direction of the economy. This lesson is intended to guide students and teachers through an analysis of the actions the Federal Reserve began to take earlier this 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.
Current Key Economic Indicatorsas of November 30, -0001
"The Federal Open Market Committee decided today to lower its target for the federal funds rate by 25 basis points to 1-3/4 percent. In a related action, the Board of Governors approved a 25 basis point reduction in the discount rate to 1-1/4 percent.
"Economic activity remains soft, with underlying inflation likely to edge lower from relatively modest levels. To be sure, weakness in demand shows signs of abating, but those signs are preliminary and tentative. The Committee continues to believe that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.
"Although the necessary reallocation of resources to enhance security may restrain advances in productivity for a time, the long-term prospects for productivity growth and the economy remain favorable and should become evident once the unusual forces restraining demand abate.
"In taking the discount rate action, the Federal Reserve Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Chicago and San Francisco."
This press release is available at: www.federalreserve.gov/boarddocs/press/general/2001/20011211/default.htm
Reasons For A Case Study On The Federal Reserve Open Market Committee
Following recent Federal Open Market Committee announcements, newspapers across the country have had front-page stories about the most recent Federal Reserve actions to lower interest rates and boost spending and employment in the U.S. economy. The announcements reflect serious concerns with the state and direction of the economy. This case study is intended to guide students and teachers through an analysis of the actions the Federal Reserve began to take earlier this 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.
Guide To Announcement
From January 3 to November 6 of this year, the Federal Reserve Open Market Committee (FOMC) lowered the target federal funds rate from 6.50 percent to 2.00 percent. The announcement on December 11 lowers the rate once more and marks the eleventh time that it was lowered in response to concerns of slowing growth in spending and the possibility of a recession. The target federal funds rate is now at its lowest level in forty years.
The FOMC establishes monetary policy. The first paragraph of the announcement summarizes the current policy changes - the decision to lower the target federal funds rate by one-quarter of a percentage point. (There are 100 basis points in one percent. Twenty-five basis points equal one-quarter of one 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. (See the last paragraph of the announcement.) The discount rate was also lowered by one-quarter of one percent.
In the second paragraph, the Federal Reserve discusses the reasoning behind changes in monetary policy. Inflation is not a problem. Spending in the economy is falling. However, those decreases may not continue much longer. The statement that the conclusion is "preliminary and tentative" means that the Federal Reserve is still concerned with worsening conditions. With these economic concerns in mind, the Federal Reserve believes the best way to maintain stable prices and sustain economic growth is a further reduction in the target federal funds interest rate. This paragraph also indicates that continued economic weakness in the coming months may necessitate further reductions in the target federal funds rate.
The Federal Reserve indicates in the third paragraph (which is identical to the October announcement) that increases in expenditures for homeland security may adversely affect the growth rate of productivity. This is the result of businesses devoting some resources for security measures, thereby raising the costs of production of a wide variety of products. However, the Federal Reserve's long-run outlook for productivity growth and the state of economy remains optimistic.
The final paragraph refers to the request by several regional Federal Reserve Banks to the Board of Governors of the Federal Reserve System to lower the discount rate by one-quarter of a percentage point.
You may wish to use the following larger versions of the graphs and tables from this lesson for overhead projection or handouts in class:
The Federal Reserve 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.
The rate of growth in real GDP has been increasing over the last several years, but began to slow in the middle of last year. Changes in real GDP at annual rates were 2.3, 5.7, 1.3, and 1.9 percent for each quarter of 2000. During the first three quarters of 2001, GDP grew at an annual rate of 1.3, 0.3 and -1.1 percent respectively. The slowing growth over the last two quarters of 2000 and the first two quarters of 2001, cumulating in the decline in the third quarter of 2001, has been one indicator of the need to use a monetary policy that will boost spending in the economy. (For more on changes in the rate of growth of real GDP and the current recession, see the most recent GDP Case Study.)
On November 26, The National Bureau of Economic Research 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. Real income growth has slowed but not declined. Manufacturing and trade sales and industrial production have both declined and have been doing so for some time.
While the common media definition of a recession is two consecutive quarters of decline in real GDP, this recession is beginning before quarterly real GDP actually has declined.
Current news reports do discuss possibilities of the recent terrorist attacks actually increasing the severity and length of the recession. If that happens, it would likely be due to falling consumption spending due to declining consumer confidence, declines in industries most directly affected by the terrorism (travel and tourism, being prime examples), and further cutbacks in business investment spending.
The last recession began in July of 1990 and ended in March of 1991, a period of eight months. However, the beginning of the recession was not announced until April of 1991 (after the recession had actually ended). The end of the recession was announced in December of 1992, almost 21 months later. One of the reasons the end of the recession was so difficult to determine was the economy did not grow very rapidly even after it came out a period of falling output and income.
For the full press release from the National Bureau of Economic Research see: 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 on January 29 and 30.) 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. Presidents of the Federal Reserve Banks are selected by the Boards of each Bank.
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, appliances, etc.) 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.
[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.]
Comparison of Monetary and Fiscal Policy
The FOMC has been reacting to the slowing economy throughout this year. While the monetary policy has not been sufficient to prevent a recession, it surely has made the recession milder than it would have otherwise been 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. Those debates continue and little has been accomplished. This points to one of the key differences between fiscal and monetary policy. Fiscal policy is much more difficult to implement. Monetary policy decisions are much easier and more responsive to economic conditions.
Federal Reserve Goals
The stated goals of the Federal Reserve Open Market Committee are to maintain price stability and sustainable economic growth. (See the last sentence in the second paragraph of the announcement.) The price stability goal means that the Federal Reserve will try to minimize inflation or at least hold inflation to an amount that will not change most peoples' decisions. For all practical purposes, that rate has been between about 2 to 4 percent in recent years.
The goal of sustainable economic growth translates into holding the growth in spending to a level that equals the growth in our capacity. The latter is determined by changes in technology, the amount and quality of labor and the amount of capital - machines, factories, computers, and inventories.
Tools of the Federal Reserve
Banks are required to hold a portion (either 10 or 3 percent, 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 excess reserves. The requirement is seldom changed, but it is potentially very powerful.
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 bank's reserves. The bank, in turn, removes the same amount from the customer's account. Thus, the money supply shrinks.
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 as it is in this announcement, but the change does not have a very important effect.
For more background on the Federal Reserve and resources to use in the classroom, go to www.federalreserve.gov.
[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.]
Explain why the Federal Reserve lowered target federal funds rate in November and December 2001.
[The Federal Open Market Committee press release states there has been deterioration in business conditions over the past few months and that combined with increased uncertainty has weakened the state of the economy. In order to reduce the likelihood of further slowing, the Federal Reserve is undertaking steps to encourage increased spending in the economy. Since the November Federal Reserve announcement, a recession starting in March of 2001 has been declared.]
Explain why the Federal Reserve raised the target federal funds rate in 1999 and 2000.
[In 1999 and 2000, spending was growing more rapidly than capacity. In order to prevent the resulting increased inflationary pressures, the Federal Reserve reduced the rate of growth in the money supply and thus caused interest rates to increase.]
How does a change in the target federal funds rate affect spending?
[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. If the growth in spending falls, there is less upward pressure on prices. 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.]
What are the risks in the Federal Reserve lowering interest rates?
[The risks are that the economy will turn back to a faster rate of growth in spending on its own, before the recent stimulative changes take effect. If that is the case, the lowering of interest rates may begin to encourage more spending just as the economy begins to recover. That result could add to eventual increased inflationary pressures.]
Additional question to test understanding:
A role of the Federal Reserve is to maintain the money supply. What is money?
[The two primary definitions of money are M1 and M2. The M1 definition of money includes currency, checking account deposits, and traveler's checks. The M2 definition of money includes all of the money in the M1 definition, plus savings deposits, and money market mutual funds.]
How do changes in the target federal funds rate affect GDP?
[Changes in the federal funds rate will tend to lead to reductions in other short-term interest rates. Changes in interest rates that banks charge for loans and pay on deposits will primarily affect investment expenditures, as interest rates are a cost of investing. When interest rates decrease, it is less expensive for businesses to invest. Increases in investment expenditures will increase the amount of capital available for production and eventually the productive capacity of the economy. Consumers also change spending on houses as interest costs change. Consumption spending on appliances and automobiles and other items requiring consumer loans also increase as interest rates fall.
More advanced: Changes in interest rates also affect the exchange rate. A decrease should lead to a lower international value of the U.S. dollar (assuming other interest rates around the world do not change). Therefore, imports will decrease and exports will increase.]
A productive activity is to form a Federal Open Market Committee in your class. Current data and forecasts can be examined. Votes can be taken as to the proper policy. Some roles can be assigned. Bankers, farmers, laborers, stockholders all have opinions and interests in the outcomes of the meetings.
The "beige book" consists of the reports of the economic conditions in the 12 Federal Reserve Banks across the country. Those data are part of the information considered by the FOMC when it makes its decisions. Refer to the most recent (November 28) beige book (www.federalreserve.gov/fomc/BeigeBook/2001/20011128/default.htm) in order to discern the opinions of different workers, industries and retailers. In the current economic slowdown, the following questions might be asked:
Which cities are faring the worst; which are the best?
Which sectors of the economy are faring the worst; which are the best?
The Federal Reserve also has a web-site for economic students located at: www.federalreserveeducation.org/. Additional information on monetary policy may be found there.