Industrial Production & Capacity Utilization Web address: Industrial Production (IP) Index: IP covers nearly everything produced in the U.S. (20% of the economy) for manufacturing (82%), mining (8%), electric utilities (10%) and gas industries. Does not include output from agriculture, construction, transportation, communications, and service industries. Measures changes in the volume of goods produced (does not take price into account) IP corresponds to real GDP (close relationship between  IP and  GDP) Manufacturing is most cyclically sensitive part of economy, follows the ups and downs of the business cycle. Manufacturing activity is highly sensitive to changes in interest rates and aggregate demand. Good forecaster of manufacturing employment, average hourly earnings and personal income IP data has 2 formats: Supply Side: Output by industry (manufacturing, mining, utility) Demand Side: Type of product, (consumer/business/intermediate goods and materials) Real GDP growth estimator = 3-month  IP/IP Nominal GDP/Factory Sales/Manufacturing Revenues Growth estimator = (3-month  IP/IP) x (3-month  CPI/CPI) Capacity Utilization (CU): Present production divided by maximum potential production capacity 81% long-run average Measure of spare capacity/slack at factories, mines, utilities. Leading indicator of business investment spending and inflation pressures. High CU => rising investment spending and hiring, shortage of vendor parts, higher prices Low CU => low investment spending and hiring, surplus of vendor parts, lower prices. Follows the ups and downs of the business cycle. CU = 82-85% => production bottlenecks => rising producer prices High IP/CU => fast growing economy => rising profits => rising stock prices => production bottlenecks => rising inflation => rising interest rates => falling bond demand => fast growing economy => rising demand for dollar => rising exchange rate

Full capacity = 82-84%

Chapter 14: Goals of Monetary Policy 1.High Employment Employment Act of 1946, Humphrey–Hawkins Act 1978 “high employment consistent with stable prices”. Full employment (natural rate of unemployment) frictional/structural = 5% 2.Economic Growth r  =>  I =>  (Y/L) =>   Y/Y 3.Price Stability (Most important goal) Stable  P/P => clear price-signal effect =>  I uncertainty =>   Y/Y 4.Interest Rate Stability r stability =>  I uncertainty =>  I =>   Y/Y 5.Financial Market Stability  stability =>  financial intermediation =>  efficiency of capital =>   Y/Y 6.Foreign Exchange Market Stability  (e/$) => U.S. exports less competitive =>  X =>  GDP  (e/$) => U.S. exports more competitive =>  X =>  pricing power =>  P/P Goals often in conflict Y  => U.R.  => wages  =>  P/P  => r  => OMP  => MB  => M1  =>  P/P 

Hoarding money => deflation Austerity => stagnation/deflation Deflation => rising purchase power of dollar Deflation => lower wages => rising debt burden Deflation leads to: Households postpone spending Rising real interest rates Rising debt burdens 2.5% Target

Monetary policy options to prevent deflation and increase inflation expectations 1.Quantitative easing: print money to buy long-term government debt 2.Buy private-sector debt 3.Change expectations by announcing it will keep short-term rates low for a long time 4.Raise its long-run inflation target (encourage borrowing, discourage cash hoarding) 5.Reduce the interest rate paid on excess reserves. 6. Move from inflation targeting (rate of change) to price level targeting Anticipated inflation is expected and built into planning Unanticipated inflation is unexpected and disrupts planning Alters expected outcome of long-term projects Reduces long-term investment Distorts the information in prices – reduces the effectiveness of markets Results in actions based on price anticipation, instead of production

Keynes’s Liquidity Preference Theory 3 Motives for Money Demand 1.Transactions motive—related to Y 2.Precautionary motive—related to Y 3.Speculative motive A. related to W and Y B. negatively related to i Liquidity Preference MdMd = f(i; Y) P – +

New York-FRB Empire State Manufacturing Survey (Indicator of New York Manufacturing Activity) Web: Slight month-to-month revisions. ESMS determines present and future condition of NY’s manufacturing industries. ESMS is correlated with the Philadelphia-FRB, Chicago-FRB and ISM surveys. ESMS gives early indications of manufacturing strength or weakness and incipient signs of inflation. NY-FRB polls 175 manufacturing CEOs on 1 st business day of every month. Survey asks how manufacturing conditions have changed in the month and what changes they expect to see in 6 months. Three possible answers: increasing activity, decreasing activity, no change in activity. The NY-FRB uses a diffusion index = percentage of positive scores minus percentage of negative scores. A diffusion index of zero is the breakeven point. Index greater than zero is expansion, less than zero is contraction. The larger the index, the greater the consensus. To detect an underlying trend, calculate 3-month and 6-month moving averages. Key Survey Questions: General business conditions – measure of current and future factory activity. New orders – harbinger of business confidence. Increase in new orders => increase future production, employment and capital spending. Unfilled orders – If increase in demand is greater than production => overburdened manufacturers =>  unfilled orders =>  in delay in deliveries to wholesalers =>  capital expenditures =>  production capacity. Prices paid – Seeds of inflation begin here at this first stage of the production process. Increase in prices paid =>  prices charged to wholesales =>  prices charged to retailers =>  prices charged to consumers. Prices received – measures manufacturers’ ability to set prices (pricing power). Increase in prices received => increase corporate earnings and profit margins. Global competition and a weak economy can reduce pricing power. Number of employees – early indicator of manufacturing job market and labor market conditions Market Analysis: Bonds: If ESMS Index/Prices paid/Prices received increases =>   P/P =>  D Bonds =>  i Bonds Stocks:  ESMS Index =>  profits =>  P Stocks Dollar:  ESMS Index =>  manufacturing sector =>   Y/Y =>   P/P =>  D Bonds =>  i Bonds =>  dollar New Orders Unfilled Orders Shipments = Production –  Inventory

*Percentage of respondents indicating an increase minus percentage indicating a decrease

Currency CHK Dep.s Savings MMDA CDs Other assets Assets HHs Liab. + NW Loans Net Worth Assets FED RES Liab. + NW Assets BANKs Liab. + NW CHK Dep.s Savings MMDA CDs Disc. Loans Net Worth Currency in Circulation Reserves Treasury Bonds Loans Reserves Treasury Bonds FX Reserves

Central Bank Strategy TOOLS OF MONETARY POLICY 1.Open Market Operations 2.Discount Policy 3.Reserve Requirements OPERATING (Instrument) TARGETS Reserve AggregatesInterest Rates ReservesShort-term (fed funds rate) Nonborrowed reserves Monetary base Nonborrowed base INTERMEDIATE TARGETS Monetary AggregatesInterest Rates M1,M2,M3Short-term rates Long-term rates GOALS Price Stability Low Unemployment High Economic Growth

Percent Federal funds rate The interest rate banks charge each other for overnight loans.

Taylor rule A rule developed by John Taylor that links the Fed’s target for the federal funds rate to economic variables. Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + (1/2) x Inflation gap + (1/2) x Output gap Inflation targeting Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.