Chapter 11 - Monetary Policy and the Fed Read pages I The Goals and Outcomes of Monetary Policy A)Goals of Monetary Policy Goals are not easy since the obvious may be in conflict. In particular, high growth and low inflation are not exactly compatible.

1)The Federal Reserve Act of 1913 said little about policy goals. 2)The first effort to specify goals came in the Employment Act of This act said, “…use all practical means … to promote maximum employment, production and purchasing power.” The act also created the council of economic advisors.

3) The Full Employment and Balanced Growth Act of 1978, commonly known as the Humphrey-Hawkins Act, specified that by 1983 the federal government should achieve an unemployment rate among adults of 3 percent or less, a civilian unemployment rate of 4 percent or less and an inflation rate of 3 percent or less. Also requires the Fed chairman to report twice a year to the congress.

4) Federal Reserve Policy and Goals based on observation. a) Over the past 20 years the Fed is generally more concerned about inflation. b) It may have a target inflation around 2%. c) It only takes on output expansion when it feels that inflation is not a concern.

B) Monetary Policy and Macroeconomic Variables 1) Policy tools a) Targeting the Fed Funds rate using open market operations. b) Setting the discount rate. c) Setting reserve requirements. 2) Typical Expansionary Policy – Buy bonds, expanding the money supply, bringing down market interest rates stimulating investment and thus aggregate demand.

II Problems and Controversies of Monetary Policy A)Fed policy is decided without political constraints. B) 3 Lags associated with policy 1) The delay between the time a macroeconomic problem arises and the time at which policymakers become aware of it is called a recognition lag.

2) The delay between the time at which a problem is recognized and the time at which a policy to deal with it is enacted, is called the implementation lag. Fiscal policy has a long one while monetary policy has a short one 3) The delay between the time a policy is enacted and the time that policy has its impact on the economy is called the impact lag. Fiscal policy has a short one, monetary policy has a long one.

C) Choosing Targets 1) Federal funds targets. This is carried out through open market operations. 2) Fed is required by law to announce to Congress at the beginning of the year its monetary growth rate target. The Fed typically gives a broad range. This target is not used because the Federal Funds target requires certain money supply levels. 3) Could announce a price level target.

D) Political Pressures Although they are largely independent, the Fed Governors and Chairman are selected by the President and confirmed by congress and they have to report to Congress regularly. E) The Degree of Impact on the Economy A liquidity trap is said to exist when a change in monetary policy has no effect on interest rates.

F) Rational Expectations Rational expectations hypothesis is that people use all available information to make forecasts about future economic activity and the price level, and that they adjust their behavior to these forecasts.

III Monetary Policy and the Equation of Exchange. A)The Equation of Exchange 1) The equation of exchange shows that the money supply M times its velocity V equals nominal GDP. 2) Velocity is the number of times the money supply is spent to obtain the goods and services that make up GDP during a particular period. 3) M x V = nominal GDP

4) Using P=nominal GDP/Real GDP, we see an alternative form is, MV=PY. 5) Example 1: M=$500, Y=50 (50 car washes), P=$10 (per car wash). Then V=1. 6) Example 2: US economic data for M=$4,443.5 Billion, P=1.135, Y=7,754.7 Billion. Then V=1.98.

B) Money, Nominal GDP, and Price-Level Changes. 1) Implications of a constant velocity. a) Nominal GDP, I.e. PY, will change only if there is a change in the money supply. b) A change in the money supply would always change nominal GDP by an equal percentage.

2) Note the equation of exchange implies % A M + % A V = % A P + % A Y If the velocity is constant % A V = 0, thus % A M - % A Y = % A P If % A Y is determined by exogenous factors, as they are in the long run, then changes in money are reflected only in price changes. 3) The quantity theory of money holds that in the long run the price level moves in proportion to changes in the money supply.

B) Why the Quantity Theory of Money is Less useful in Analyzing the Short Run. 1) In the short run the velocity of money is not very stable. 2) The same factors which influence money demand will also influence short run velocity, e.g, interest rates, income, expectations. This can be seen by using M=PY/V. This implies things that change M, but not PY will impact V.