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Explore the connection between the economic indicators and real-world issues. These lessons typically can be done in one class period.

KEY CONCEPTS

Discount Rate, Federal Reserve, Federal Reserve Structure, Fiscal Policy, Interest Rate, Monetary Policy, Open Market Operations, Reserve Requirements

Current Key Economic Indicators

as of May 5, 2013

Inflation

On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers decreased 0.2 percent in March after increasing 0.7 percent in February. The index for all items less food and energy rose 0.1 percent in March after rising 0.2 percent in February.

Employment and Unemployment

Total nonfarm payroll employment rose by 165,000 in April, and the unemployment rate was little changed at 7.5 percent. Employment increased in professional and business services, food services and drinking places, retail trade, and health care.

Real GDP

Real gross domestic product increased at an annual rate of 2.5 percent in the first quarter of 2013 (that is, from the fourth quarter to the first quarter), according to the "advance" estimate released by the Bureau of Economic Analysis. In the fourth quarter, real GDP increased 0.4 percent.

Federal Reserve

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent...


The Federal Open Market Committee decided to keep its target for the federal funds rate unchanged at 1-1/4 percent.

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.

This complete press release is available at: www.federalreserve.gov/boarddocs/press/monetary/2003/20030506/default.htm

Reasons For A Case Study On The Federal Reserve 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.

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.

You may wish to use the following larger versions of the graphs and tables from this lesson for overhead projection or handouts in class:

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.

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 current recession, see the most recent GDP Case Study.)

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.

The Target Federal Funds Rate and the Discount Rate

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

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, 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, 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 .

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.

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 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.

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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, 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.]

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.]

  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.]

Additional Questions

  1. What are the Federal Reserve current observations and concerns?

    [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. What tools can the Federal Reserve use?

    [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. 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?

    [The Federal Reserve would purchase bonds to expand the money supply and reserves and lower the target 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?

    [The Federal Reserve would lower reserve requirements and decrease the discount rate.]
  5. How do changes in monetary policy affect spending in the economy?

    [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 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. (More advanced) What are some "geopolitical risks" that could influence future economic conditions? How would economic conditions be affected?

    [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.]