There is no better example of social and economic policy discussion as an idle pastime for the rich than the World Economic Forum at Davos. These guys make the millionaire schmoozers at the Aspen Ideas Festival look like short-order cooks.
Macroeconomic Issues and Policy
(Part C)
by
Charles Lamson
Monetary Policy
There are two key points that we must add to the monetary policy story to make the story realistic, which we do in this section. The first point is that in practice the Fed targets the interest rate rather than the money supply. The second point is that the interest rate value that the Fed chooses depends on the state of the economy. Targeting the Interest Rate The buying and selling of government securities by the Fed has two effects at the same time: it changes the money supply and it changes the interest rate. If the Fed buys securities, this increases the money supply and lowers the interest rate, and if the Fed sells securities, this decreases the money supply and raises the interest rate. How much the interest rate changes depends on the shape of the demand for money curve. The steeper the money demand curve, the larger is the change in the interest rate for a given size change in government securities.  What this means is that if the Fed wants to achieve a particular value of the money supply, it must accept whatever interest rate value is implied by this choice. (Again, the interest rate value depends on the shape of the demand for money curve.) Conversely, If the Fed wants to achieve a particular value of the interest rate, it must accept whatever money supply value is implied by this. If, for example, the Fed wants to lower the interest rate by one percentage point, it must keep buying government securities until the interest rate value is reached. As the Fed is buying government securities, the money supply is increasing. In short, the Fed can pick a money supply value and accept the interest rate consequences, or it can pick an interest rate value and accept the money supply consequences. The first key point is that in practice the Fed chooses the interest rate value and accept the money supply consequences rather than vice versa. The Federal Open Market Committee (FOMC) meets every six weeks and sets the value of the interest rate. It then instructs the open market desk at the New York Federal Reserve Bank to keep buying or selling government securities until the desired interest rate value is achieved. In other words, the Fed targets the interest rate. For most of the rest of this analysis we will talk about monetary policy as being a change in the interest rate. Keep in mind, of course, that monetary policy also changes the money supply. We can talk about an expansionary monetary policy as either one in which the money supply is increased or one in which the interest rate is lowered. We will talk about the interest rate being lowered because the interest rate is what the Fed targets in practice. However we talk about it, an expansionary monetary policy is achieved by the Fed's buying government securities.  The Fed's Response to the State of the Economy When the FOMC meets every six weeks to set the volume of the interest rate it does not set the volume in a vacuum. An important question in macroeconomics is what influences the interest rate decision. To answer this, we must first consider what the main goals of the Fed are. What ultimately is the Fed trying to achieve? Two of the Fed's main goals are high levels of output and employment and a low rate of inflation. From the Fed's point of view, the best situation is a fully employed economy with an inflation rate near zero. The worst situation is stagflation---high unemployment and high inflation. If the economy is in a low output/low inflation situation, it will be producing on the relatively flat portion of the aggregate supply (AS) curve (Figure 3). In this case, the Fed can increase output by lowering the interest rate (and thus increasing the money supply) with little effect on the price level. The expansionary monetary policy will shift the aggregate demand (AD) curve to the right, leading to an increase in output with little change in the price level.  The Fed is likely to lower the interest rate (and thus increase the money supply) during times of low output and low inflation. The opposite is true in times of high output and high inflation. In this situation, the economy is producing on the relatively steep portion of the AS curve (Figure 4), and the Fed can increase the interest rate (and thus decrease the money supply) with little effect on output. The contractionary monetary policy will shift the AD curve to the left, which will lead to a fall in the price level and little effect on output.   The Fed is likely to increase the interest rate (and thus decrease the money supply) during times of high output and high inflation. Stagflation is a more difficult problem to solve. If the Fed lowers the interest rate, output will rise, but so will the inflation rate (which is already too high). If the Fed increases the interest rate, the interest rate will fall, but so will output (which is already too low). The Fed is faced with a trade-off. In this case, the Fed's decisions depend on how it weighs output relative to inflation. If it dislikes high inflation more than low output, it will increase the interest rate; If it dislikes low output more than high inflation, it will lower the interest rate. In practice, the Fed probably dislikes high inflation more than low output, but how the Fed behaves depends in part on the beliefs of the chair of the Fed. The Fed sometimes "leans against the wind," meaning as the economy expands, the Fed uses open market operations to raise the interest rate gradually to try to prevent the economy from expanding too quickly. Conversely, as the economy contracts the Fed lowers the interest rate gradually to lessen (and eventually stop) the contraction. This type of stabilization is, of course, not easily achieved.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 579-581* end |
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