Principles of Economics Chapter 26 Monetary Policy and the Fed

Chapter 26 Monetary Policy and the Fed Start Up The Fed Extraordinary Challenges in 2008 The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability . In particular , the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some So went the statement issued by the Federal Open Market Committee on December 16 , 2008 , that went on to say that the new target range for the federal funds rate would be between and . For the first time in its history , the Fed was targeting a rate below . It was also acknowledging the difficulty of hitting a specific rate target when the target is so low . And , finally , it was experimenting with extraordinary measures based on a section of the Federal Reserve Act that allows it to take such measures when conditions in financial markets are deemed unusual and The Fed was responding to the weakness of the economy , the strains in financial markets , and the tightness of credit . Unlike some other moments in economic history , it did not have to worry about inflation , at least not in the short term . On the same day , consumer prices were reported to have fallen by for the month of November . Indeed , commentators were beginning to fret over the possibility of and how the Fed could continue to support the economy when it had already used all of its federal funds rate ammunition . Anticipating this concern , the Fed statement went on to discuss other ways it was planning to support the economy over the months to come . These included buying securities to support the mortgage and housing markets , buying Treasury bills , and creating other new credit facilities to make credit more easily available to households and small businesses . These options recalled a speech that Ben had made six years earlier , when he was a member of the Federal Reserve Board of Governors but still nearly four years away from being named its chair , titled Deflation Making Sure It Doesn Happen In the 2002 speech he laid out how these tools , along with tax cuts , were the equivalent of what Nobel prize winning economist Milton meant by a helicopter drop of money . The speech earned the nickname of Helicopter Ben . The Fed decisions of put it in uncharted territory . Japan had tried a similar strategy , though somewhat less comprehensively and more belatedly , in the 19905 when faced with a situation similar to that of the United States in 2008 with only limited success . In his 2002 speech , suggested that Japanese authorities had not gone far enough . Only history will tell us whether the Fed will be more successful and how well these new strategies will work . This chapter examines in greater detail monetary policy and the roles of central banks in carrying out that policy . Our primary focus will be on the Federal Reserve System . The basic tools used by central banks in many countries are similar , but their institutional structure and their roles in their respective countries can differ . 883

Monetary Policy in the United States Learning Objectives . Discuss the Fed primary and secondary goals and relate these goals to the legislation that created the Fed as well as to subsequent legislation that affects the Fed . State and show graphically how expansionary and monetary policy can be used to close gaps . In many respects , the Fed is the most powerful maker of economic policy in the United States . Congress can pass laws , but the president must execute them the president can propose laws , but only Congress can pass them . The Fed , however , both sets and carries out monetary policy . Deliberations about fiscal policy can drag on for months , even years , but the Federal Open Market Committee ( can , behind closed doors , set monetary policy in a see that policy implemented within hours . The Board of Governors can change the discount rate or reserve requirements at any time . The impact of the Fed policies on the economy can be quite dramatic . The Fed can push interest rates up or down . It can promote a recession or an expansion . It can cause the inflation rate to rise or fall . The Fed wields enormous power . But to what ends should all this power be directed ?

With what tools are the Fed policies carried out ?

And what problems exist in trying to achieve the Fed goals ?

This section reviews the goals of monetary policy , the tools available to the Fed in pursuing those goals , and the way in which monetary policy affects variables . Goals of Monetary Policy When we think of the goals of monetary policy , we naturally think of standards of performance that seem low unemployment rate , a stable price level , and economic growth . It thus seems reasonable to conclude that the goals of monetary policy should include the maintenance of full employment , the avoidance of inflation or deflation , and the promotion of economic growth . But these goals , each of which is desirable in itself , may conflict with one another . A monetary policy that helps to close a recessionary gap and thus promotes full employment may accelerate inflation . A monetary policy that seeks to reduce may increase unemployment and weaken economic growth . You might expect that in such cases , monetary authorities would receive guidance from legislation spelling out goals for the Fed to pursue and specifying what to do when achieving one goal means not achieving another . But as we shall see , that kind of guidance does not exist . 884

Monetary Policy in the United States 885 The Federal Reserve Act When Congress established the Federal Reserve System in 1913 , it said little about the policy goals the Fed should seek . The closest it came to spelling out the goals of monetary policy was in the first paragraph of the Federal Reserve Act , the legislation that created the Fed An Act to provide for the establishment of Federal reserve banks , to furnish an elastic currency , to make loans to banks , to establish a more effective supervision of banking in the United States , and for other In short , nothing in the legislation creating the Fed anticipates that the institution will act to close recessionary or inflationary gaps , that it will seek to spur economic growth , or that it will strive to keep the price level steady . There is no guidance as to what the Fed should do when these goals with one another . The Employment Act of 1946 The first effort to specify goals came after World War II . The Great Depression of the had instilled in people a deep desire to prevent similar calamities in the future . That desire , coupled with the 1936 publication of John Maynard Keynes prescription for avoiding such problems through government policy ( The General Theory of Employment , Interest and Money ) led to the passage of the Employment Act of 1946 , which declared that the federal government should use all practical means . to promote maximum employment , production and purchasing The act also created the Council of Economic Advisers ( to advise the president on economic matters . The Fed might be expected to be influenced by this specification of federal goals , but because it is an independent agency , it is not required to follow any particular path . Furthermore , the legislation does not suggest what should be done if the goals of achieving full employment and maximum purchasing power conflict . The Full Employment and Balanced Growth Act of 1978 The clearest , and most specific , statement of federal economic goals came in the Full Employment and Balanced Growth Act of 1978 . This act , generally known as the Act , specified that by 1983 the federal government should achieve an unemployment rate among adults of or less , a civilian unemployment rate of or less , and an inflation rate of or less . Although these goals have the virtue of specificity , they offer little in terms of practical policy guidance . The last time the civilian unemployment rate in the United States fell below was 1969 , and the inflation rate that year was . In 2000 , the unemployment rate touched , and the inflation rate that year was , so the goals were close to being met . Except for 2007 when inflation hit , inflation has hovered between and in all the other years between 1991 and 2008 , so the inflation goal was met or nearly met , but unemployment fluctuated between and during those years . The Act requires that the chairman of the Fed Board of Governors report twice each year to

886 Principles of Economics Congress about the Fed monetary policy . These sessions provide an opportunity for members of the House and Senate to express their views on monetary policy . Federal Reserve Policy and Goals Perhaps the clearest way to see the Fed goals is to observe the policy choices it makes . Since 1979 , following a bout of inflation , its actions have suggested that the Fed primary goal is to keep inflation under control . Provided that the inflation rate falls within acceptable limits , however , the Fed will also use stimulative measures to close recessionary gaps . In 1979 , the Fed , then led by Paul , launched a deliberate program of reducing the inflation rate . It stuck to that effort through the early , even in the face of a major recession . That effort achieved its goal the annual inflation rate fell from in 1979 to in 1982 . The cost , however , was great . Unemployment soared past during the recession . With the rate below , the Fed shifted to a stimulative policy early in 1983 . In 1990 , when the economy slipped into a recession , the Fed , with Alan at the helm , engaged in aggressive operations to stimulate the economy , despite the fact that the inflation rate had jumped to . Much of that increase in the inflation rate , however , resulted from an boost that came in the wake of Iraq invasion of Kuwait that year . A jump in prices that occurs at the same time as real is slumping suggests a leftward shift in aggregate supply , a shift that creates a recessionary gap . Fed officials concluded that the upturn in inflation in 1990 was a temporary phenomenon and that an expansionary policy was an appropriate response to a weak economy . Once the recovery was clearly under way , the Fed shifted to a neutral policy , seeking neither to boost nor to reduce aggregate demand . Early in 1994 , the Fed shifted to a policy , selling bonds to reduce the money supply and raise interest rates . Then Fed Chairman indicated that the move was intended to head off any possible increase in inflation from its 1993 rate of . Although the economy was still in a recessionary gap when the Fed acted , indicated that any acceleration of the inflation rate would be unacceptable . By March 1997 the inflation rate had fallen to . The Fed became concerned that inflationary pressures were increasing and tightened monetary policy , raising the goal for the federal funds interest rate to . Inflation remained well below throughout the rest of 1997 and 1998 . In the fall of 1998 , with inflation low , the Fed was concerned that the economic recession in much of Asia and slow growth in Europe would reduce growth in the United States . In steps it reduced the goal for the federal funds rate to . With real growing briskly in the first half of 1999 , the Fed became concerned that inflation would increase , even though the inflation rate at the time was about , and in June 1999 , it raised its goal for the federal funds rate to and continued raising the rate until it reached in May 2000 . With inflation under control , it then began lowering the federal funds rate to stimulate the economy . It continued lowering through the brief recession of 2001 and beyond . There were 11 rate cuts in 2001 , with the rate at the end of that year at in late 2002 the rate was cut to , and in it was cut to . Then , with growth picking up and inflation again a concern , the Fed began again in the middle of 2004 to increase rates . By the end of 2006 , the rate stood at as a result of 17 rate increases .

Monetary Policy in the United States 887 Starting in September 2007 , the Fed , since 2006 led by Ben , shifted gears and began lowering the federal funds rate , mostly in larger steps or to percentage points . Though initially somewhat concerned with , it sensed that the economy was beginning to slow down . It moved aggressively to lower rates over the course of the next 15 months , and by the end of 2008 , the rate was targeted at between and . In late 2008 and for at least the following two years , with running quite low and threatening , the Fed seemed quite willing to use all of its options to try to keep financial markets running smoothly and to moderate the recession . What can we infer from these episodes in the , and the first years of this century ?

It seems clear that the Fed is determined not to allow the high inflation rates of the 19705 to occur again . When the inflation rate is within acceptable limits , the Fed will undertake stimulative measures in response to a recessionary gap or even in response to the possibility of a growth slowdown . Those limits seem to have tightened over time . In the late and early , it appeared that an inflation rate above any indication that inflation might rise above lead the Fed to adopt a policy . While on the Federal Reserve Board in the early , Ben had been an advocate of inflation targeting . Under that system , the central bank announces its inflation target and then adjusts the federal funds rate if the rate moves above or below the central bank target . indicated his preferred target to be an expected increase in the price level , as measured by the price index for consumer goods and services excluding food and energy , of between and . Thus , the inflation goal appears to have tightened even a rate of or less . If inflation were expected to remain below , however , the Fed would undertake stimulative measures to close a recessionary gap . Whether the Fed will hold to that goal will not really be tested until further experiences unfold . Monetary Policy and Variables We saw in an earlier chapter that the Fed has three tools at its command to try to change aggregate demand and thus to the level of economic activity . It can buy or sell federal government bonds through operations , it can change the discount rate , or it can change reserve requirements . It can also use these tools in combination . In the next section of this chapter , where we discuss the notion of a liquidity trap , we will also introduce more extraordinary measures that the Fed has at its disposal . Most economists agree that these tools of monetary policy affect the economy , but they sometimes disagree on the precise mechanisms through which this occurs , on the strength of those mechanisms , and on the ways in which monetary policy should be used . Before we address some of these issues , we shall review the ways in which monetary policy affects the economy in the context of the model of aggregate demand and aggregate supply . Our focus will be on operations , the purchase or sale by the Fed of federal bonds . Expansionary Monetary Policy The Fed might pursue an expansionary monetary policy in response to the initial situation shown in Panel ( a ) of Figure Expansionary Monetary Policy to Close a Recessionary Gap . An economy with a potential output of is operating at there is a recessionary gap . One possible policy response is to allow the economy to correct

888 Principles of Economics this gap on its own , waiting for reductions in nominal wages and other prices to shift the aggregate supply curve to the right until it intersects the aggregate demand curve at . An alternative is a stabilization policy that seeks to increase aggregate demand to AD to close the gap . An expansionary monetary policy is one way to achieve such a shift . To carry out an expansionary monetary policy , the Fed will buy bonds , thereby increasing the money supply . That shifts the demand curve for bonds to , as illustrated in Panel ( Bond prices rise to . The higher price for bonds reduces the interest rate . These changes in the bond market are consistent with the changes in the money market , shown in Panel ( in which the greater money supply leads to a fall in the interest rate to . The lower interest rate stimulates investment . In addition , the lower interest rate reduces the demand for and increases the supply of dollars in the currency market , reducing the exchange rate to in Panel ( The lower exchange rate will stimulate net exports . The combined impact of greater investment and net exports will shift the aggregate demand curve to the right . The curve shifts by an amount equal to the multiplier times the sum of the initial changes in investment and net exports . In Panel ( a ) this is shown as a shift to , and the recessionary gap is closed . Figure Monetary Policy to Close a Recessionary Gap Panel ( a ) Panel ( Recessionary Gap Fed buys bonds A . Real Quantity of bonds per period Panel ( Panel ( thus increasing the money supply the exchange rate falls 37 Quantity of money per period Quantity of dollars per period In Panel ( a ) die economy has a recessionary gap yi . An expansionary monetary policy could seek to close this gap by aggregate demand curve to . In Panel ( lit ) the Fed buys bonds , demand curve for bonds to and increasing

Monetary Policy in the United States 889 price . By buying , the Fed increases the money supply to in Panel ( The Fed lowers interest rates to . The interest rate also reduces the demand for and increases the supply uf dollars , reducing the exchange rate to in Panel ( The resulting increases in investment and net shift the aggregate demand curve in Panel ( a ) Monetary Policy The Fed will generally pursue a monetary policy when it considers inflation a threat . Suppose , for example , that the economy faces an gap the aggregate demand and aggregate supply curves intersect to the right of the aggregate supply curve , as shown in Panel ( a ) of Figure A Monetary Policy to Close an Inflationary Gap . Figure A Monetary Policy to close an Inflationary Gap Panel la ) Panel ( gap Fed sells bonds in ! is , Real per year Quantity of bonds per year Panel ( Panel ( thus decreasing the money supply the exchange rate rises a Quantity of money per period Quantity of dollars per period In Panel ( a ) the economy has an gap A monetary policy could seek to close this gap by shifting the aggregate demand curve to . Panel ) the Fed sells , shifting the supply curve bonds to and lowering the price at bonds tu . The lower price of bonds means a higher interest rate , as shown in Panel ( The higher interest rate also increases the demand for and decreases the supply of dollars , raising the exchange rate to in Panel ( which will increase net exports . The decreases in investment and net exports are for decreasing aggregate demand in Panel ( a )

890 Principles of Economics To carry out a policy , the Fed sells bonds . In the bond market , shown in Panel ( of Figure A Monetary Policy to Close an Gap , the supply curve shifts to the right , lowering the price of bonds and increasing the interest rate . In the money market , shown in Panel ( the Fed bond sales reduce the money supply and raise the interest rate . The higher interest rate reduces investment . The higher interest rate also induces a greater demand for dollars as foreigners seek to take advantage of higher interest rates in the United States . The supply of dollars falls people in the United States are less likely to purchase foreign assets now that assets are paying a higher rate . These changes boost the exchange rate , as shown in Panel ( which reduces exports and increases imports and thus causes net exports to fall . The monetary policy thus shifts aggregate demand to the left , by an amount equal to the multiplier times the combined initial changes in investment and net exports , as shown in Panel ( a ) Key Takeaways The Federal Reserve Board and the Federal Open Market Committee are among the most powerful institutions in the United States . The Fed primary goal appears to be the control of . Providing that inflation is under control , the Fed will act to close recessionary gaps . Expansionary policy , such as a purchase of government securities by the Fed , tends to push bond prices up and interest rates down , increasing investment and aggregate demand . policy , such as a sale of government securities by the Fed , pushes bond prices down , interest rates up , investment down , and aggregate demand shifts to the left . The figure shows an economy operating at a real of and a price level of , at the intersection of and . Figure

Monetary Policy in the United States 891 ! Real per year What kind of gap is the economy experiencing ?

What type of monetary policy ( expansionary or ) would be appropriate for closing the gap ?

If the Fed decided to pursue this policy , what type of operations would it conduct ?

How would bond prices , interest rates , and the exchange rate change ?

How would investment and net exports change ?

How would the aggregate demand curve shift ?

Case in Point A Brief History of the Fed Figure 892 Principles of Economics Javier Alan . With the passage of time and the fact that the fallout on the economy turned out to be relatively minor , it is hard in retrospect to realize how scary a situation Alan and the Fed faced just two months after his appointment as Chairman of the Federal Reserve Board . On October 12 , 1987 , the stock market had its worst day ever . The Dow Jones Industrial Average plunged 508 points , wiping out more than 500 billion in a few hours of feverish trading on Wall Street . That drop represented a loss in value of over 22 . In comparison , the largest daily drop in 2008 of 778 points on September 29 , 2008 , represented a loss in value of about . When the Fed faced another huge plunge in stock prices in in of the Board of Governors met and decided that no action was necessary . Determined not to repeat the terrible mistake of 1929 , one that helped to usher in the Great Depression , Alan immediately reassured the country , saying that the Fed would provide adequate liquidity , by buying federal securities , to assure that economic activity would not fall . As it turned out , the damage to the economy was minor and the stock market quickly regained value . In the fall of 1990 , the economy began to slip into recession . The Fed responded with expansionary monetary reserve requirements , lowering the discount rate , and buying Treasury bonds . Interest rates fell quite quickly in response to the Fed actions , but , as is often the case , changes to the components of aggregate demand were slower in coming . Consumption and investment began to rise in 1991 , but their growth was weak , and unemployment continued to rise because growth in output was too slow to keep up with growth in the labor force . It was not until the fall of 1992 that the economy started to pick up steam . This episode demonstrates an important difficulty with stabilization policy attempts to manipulate aggregate demand achieve shifts in the curve , but with a lag . Throughout the rest of the , with some tightening when the economy seemed to be moving into an gap and some loosening when the economy seemed to be possibly moving toward a recessionary in 1998 and 1999 when parts of Asia experienced financial turmoil and recession and European growth had slowed Fed helped steer what is now referred to as the Goldilocks ( not too hot , not too cold , just right ) economy . The economy again experienced a mild recession in 2001 under . At that time , the Fed systematically conducted expansionary policy . Similar to its response to the 1987 stock market crash , the Fed has been credited with maintaining liquidity following the stock market crash in early 2001 and the attacks on the World Trade Center and the Pentagon in September 2001 . When retired in January 2006 , many hailed him as the greatest central banker ever . As the economy faltered in 2008 and as the financial crisis unfolded throughout the year , however , the question of how the policies of Fed played into the current difficulties took center stage . Testifying before Congress in October 2008 , he said that the country faces a credit tsunami , and he admitted , I made a mistake in presuming that

Monetary Policy in the United States 893 the of organizations , specifically banks and others , were such as that they were best capable of protecting their own shareholders and their equity in their The criticisms he has faced are twofold that the very low interest rates used to fight the 2001 recession and maintained for too long fueled the real estate bubble and that he did not promote appropriate regulations to deal with the new financial instruments that were created in the early While supporting some additional regulations when he testified before Congress , he also warned that overreacting could be dangerous We have to recognize that this is almost surely a phenomenon , and , in that regard , to realize the types of regulation that would prevent this from happening in the future are so onerous as to basically suppress the growth rate in the economy and . the standards of living of the American Answers to Try It ! Problems Inflationary gap sales of bonds The price of bonds would fall . The interest rate and the exchange rate would rise . Investment and net exports would fall . The aggregate demand curve would shift to the left .

Problems and Controversies of Monetary Policy Learning Objectives . Explain the three kinds of lags that can the effectiveness of monetary policy . Identify the targets at which the Fed can aim in managing the economy , and discuss the difficulties inherent in using each of them as a target . Discuss how each of the following influences a central bank ability to achieve its desired outcomes political pressures , the degree of impact on the economy ( including the situation of a liquidity trap ) and the rational expectations hypothesis . The Fed has some obvious advantages in its conduct of monetary policy . The two bodies , the Board of Governors and the Federal Open Market Committee ( are small and largely independent from other political institutions . These bodies can thus reach decisions quickly and implement them immediately . Their relative independence from the political process , together with the fact that they meet in secret , allows them to operate outside the glare of publicity that might otherwise be focused on bodies that wield such enormous power . Despite the apparent ease with which the Fed can conduct monetary policy , it still faces difficulties in its efforts to stabilize the economy . We examine some of the problems and uncertainties associated with monetary policy in this section . Lags Perhaps the greatest obstacle facing the Fed , or any other central bank , is the problem of lags . It is easy enough to show a recessionary gap on a graph and then to show how monetary policy can shift aggregate demand and close the gap . In the real world , however , it may take several months before anyone even realizes that a particular problem is occurring . When monetary authorities become aware of a problem , they can act quickly to inject reserves into the system or to withdraw reserves from it . Once that is done , however , it may be a year or more before the action affects aggregate demand . The delay between the time a problem arises and the time at which policy makers become aware of it is called a recognition lag . The recession , for example , began in July 1990 . It was not until late October that members of the noticed a slowing in economic activity , which prompted a stimulative monetary policy . In contrast , the most recent recession began in December 2007 , and Fed easing began in September 2007 . Recognition lags stem largely from problems in collecting economic data . First , data are available only after the conclusion of a particular period . Preliminary estimates of real , for example , are released about a month after 894

Problems and Controversies of Monetary Policy 895 the end of a quarter . Thus , a change that occurs early in a quarter will not be reflected in the data until several months later . Second , estimates of economic indicators are subject to revision . The first estimates of real in the third quarter of 1990 , for example , showed it increasing . Not until several months had passed did revised estimates show that a recession had begun . And finally , different indicators can lead to different interpretations . Data on employment and retail sales might be pointing in one direction while data on housing starts and industrial production might be pointing in another . It is one thing to look back after a few years have elapsed and determine whether the economy was expanding or contracting . It is quite another to decipher changes in real when one is right in the middle of events . Even in a world brimming with data on the economy , recognition lags can be substantial . Only after policy makers recognize there is a problem can they take action to deal with it . 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 . For monetary policy changes , the implementation lag is quite short . The meets eight times per year , and its members may confer between meetings through conference calls . Once the determines that a policy change is in order , the required operations to buy or sell federal bonds can be put into effect immediately . Policy makers at the Fed still have to contend with the impact lag , the delay between the time a policy is enacted and the time that policy has its impact on the economy . The impact lag for monetary policy occurs for several reasons . First , it takes some time for the deposit multiplier process to work itself out . The Fed can inject new reserves into the economy immediately , but the deposit expansion process of bank lending will need time to have its full effect on the money supply . Interest rates are affected immediately , but the money supply grows more slowly . Second , firms need some time to respond to the monetary policy with new investment they respond at all . Third , a monetary change is likely to affect the exchange rate , but that translates into a change in net exports only after some delay . Thus , the shift in the aggregate demand curve due to initial changes in investment and in net exports occurs after some delay . Finally , the multiplier process of an expenditure change takes time to unfold . It is only as incomes start to rise that consumption spending picks up . The problem of lags suggests that monetary policy should respond not to statistical reports of economic conditions in the recent past but to conditions expected to exist in the future . In justifying the imposition of a monetary policy early in 1994 , when the economy still had a recessionary gap , indicated that the Fed expected a impact lag . The policy initiated in 1994 was a response not to the economic conditions thought to exist at the time but to conditions expected to exist in 1995 . When the Fed used policy in the middle of 1999 , it argued that it was doing so to forestall a possible increase in inflation . When the Fed began easing in September 2007 , it argued that it was doing so to forestall adverse effects to the economy of falling housing prices . In these examples , the Fed appeared to be looking forward . It must do so with information and forecasts that are far from perfect . Estimates of the length of time required for the impact lag to work itself out range from six months to two years . Worse , the length of the lag can they take action , policy makers can not know whether their choices will affect the economy within a few months or within a few years . Because of the uncertain length of the impact lag , efforts to stabilize the economy through monetary policy could be destabilizing . Suppose , for example , that the Fed responds to a recessionary gap with an expansionary policy but that by the time the policy begins to

896 Principles of Economics affect aggregate demand , the economy has already returned to potential . The policy designed to correct a recessionary gap could create an inflationary gap . Similarly , a shift to a policy in response to an inflationary gap might not affect aggregate demand until after a process had already closed the gap . In that case , the policy could plunge the economy into a recession . Choosing Targets In attempting to manage the economy , on what variables should the Fed base its policies ?

It must have some target , or set of targets , that it wants to achieve . The failure of the economy to achieve one of the Fed targets would then trigger a shift in monetary policy . The choice of a target , or set of targets , is a crucial one for monetary policy . Possible targets include interest rates , money growth rates , and the price level or expected changes in the price level . Interest Rates Interest rates , particularly the federal funds rate , played a key role in recent Fed policy . The does not decide to increase or decrease the money supply . Rather , it engages in operations to nudge the federal funds rate up or down . Up until August 1997 , it had instructed the trading desk at the New York Federal Reserve Bank to conduct market operations in a way that would either maintain , increase , or ease the current degree of pressure on the reserve positions of banks . That degree of pressure was reflected by the federal funds rate if existing reserves were less than the amount banks wanted to hold , then the bidding for the available supply would send the federal funds rate up . If reserves were plentiful , then the federal funds rate would tend to decline . When the Fed increased the degree of pressure on reserves , it sold bonds , thus reducing the supply of reserves and increasing the federal funds rate . The Fed decreased the degree of pressure on reserves by buying bonds , thus injecting new reserves into the system and reducing the federal funds rate . The current operating procedures of the Fed focus explicitly on interest rates . At each of its eight meetings during the year , the sets a specific target or target range for the federal funds rate . When the Fed lowers the target for the federal funds rate , it buys bonds . When it raises the target for the federal funds rate , it sells bonds . Money Growth Rates Until 2000 , the Fed was required to announce to Congress at the beginning of each year its target for money growth that year and each report dutifully did so . At the same time , the Fed report would mention that its money growth targets were benchmarks based on historical relationships rather than guides for policy . As soon as the legal requirement to report targets for money growth ended , the Fed stopped doing so . Since in recent years the Fed has placed more importance on the federal funds rate , it must adjust the money supply in order to move the federal funds rate to the level it desires . As a result , the money growth targets tended to fall by the wayside , even

Problems and Controversies of Monetary Policy 897 over the last decade in which they were being reported . Instead , as data on economic conditions unfolded , the Fed made , and continues to make , adjustments in order to affect the federal funds interest rate . Price Level or Expected Changes in the Price Level Some economists argue that the Fed primary goal should be price stability . If so , an obvious possible target is the price level itself . The Fed could target a particular price level or a particular rate of change in the price level and adjust its policies accordingly . If , for example , the Fed sought an inflation rate of , then it could shift to a policy whenever the rate rose above . One difficulty with such a policy , of course , is that the Fed would be responding to past economic conditions with policies that are not likely to affect the economy for a year or more . Another difficulty is that inflation could be rising when the economy is experiencing a recessionary gap . An example of this , mentioned earlier , occurred in 1990 when inflation increased due to the seemingly temporary increase in oil prices following Iraq invasion of Kuwait . The Fed was faced with a similar situation in the first half of 2008 when oil prices were again rising . If the Fed undertakes monetary policy at such times , then its efforts to reduce the inflation rate could worsen the recessionary gap . The solution proposed by Chairman , who is an advocate of inflation rate targeting , is to focus not on the past rate of inflation or even the current rate of inflation , but on the expected rate of inflation , as revealed by various indicators , over the next year . This concept is discussed in the Case in Point essay that follows this section . Political Pressures The institutional relationship between the leaders of the Fed and the executive and legislative branches of the federal government is structured to provide for the Fed independence . Members of the Board of Governors are appointed by the president , with confirmation by the Senate , but the terms of office provide a considerable degree of insulation from political pressure . A president exercises greater influence in the choice of the chairman of the Board of Governors that appointment carries a term . Neither the president nor Congress has any direct say over the selection of the presidents of Federal Reserve district banks . They are chosen by their individual boards of directors with the approval of the Board of Governors . The degree of independence that central banks around the world have varies . A central bank is considered to be more independent if it is insulated from the government by such factors as longer term appointments of its governors and fewer requirements to finance government budget deficits . Studies in the and early showed that , in general , greater central bank independence was associated with lower average inflation and that there was no systematic relationship between central bank independence and other indicators of economic performance , such as real growth or . By the rankings used in those studies , the Fed was considered quite independent , second only to Switzerland and the German at the time . Perhaps as a result of such findings , a number of countries have granted greater independence to their central banks in the last decade . The charter for the European Central Bank , which began operations in 1998 , was modeled on that of the German . Its charter states explicitly that its primary objective is to maintain price stability . Also , since 1998 , central bank independence has increased in the United Kingdom , Canada , Japan , and New Zealand .

898 Principles of Economics While the Fed is formally insulated from the political process , the men and women who serve on the Board of Governors and the are human beings . They are not immune to the pressures that can be placed on them by members of Congress and by the president . The chairman of the Board of Governors meets regularly with the president and the executive staff and also reports to and meets with congressional committees that deal with economic matters . The Fed was created by the Congress its charter could be even that same body . The Fed is in the somewhat paradoxical situation of having to cooperate with the legislative and executive branches in order to preserve its independence . The Degree of Impact on the Economy The problem of lags suggests that the Fed does not know with certainty when its policies will work their way through the financial system to have an impact on performance . The Fed also does not know with certainty to what extent its policy decisions will affect the . For example , investment can be particularly volatile . An effort by the Fed to reduce aggregate demand in the face of an gap could be partially offset by rising investment demand . But , generally , policies do tend to slow down the economy as if the Fed were pulling on a That may not be the case with expansionary policies . Since investment depends crucially on expectations about the future , business leaders must be optimistic about economic conditions in order to expand production facilities and buy new equipment . That optimism might not exist in a recession . Instead , the pessimism that might prevail during an economic slump could prevent lower interest rates from stimulating investment . An effort to stimulate the economy through monetary policy could be like pushing on a The central bank could push with great force by buying bonds and engaging in quantitative easing , but little might happen to the economy at the other end of the string . What if the Fed can not bring about a change in interest rates ?

A liquidity trap is said to exist when a change in monetary policy has no effect on interest rates . This would be the case if the money demand curve were horizontal at some interest rate , as shown in Figure A Liquidity Trap . If a change in the money supply from to can not change interest rates , then , unless there is some other change in the economy , there is no reason for investment or any other component of aggregate demand to change . Hence , traditional monetary policy is rendered totally ineffective its degree of impact on the economy is nil . At an interest rate of zero , since bonds cease to be an attractive alternative to money , which is at least useful for transactions purposes , there would be a liquidity trap . Figure A Liquidity Trap

Problems and Controversies of Monetary Policy 899 Interest rate Quantity of money per year When a change in the money supply has no effect on the interest rate , the economy is said to be in a liquidity trap . With the federal funds rate in the United States close to zero at the end of 2008 , the possibility that the country is in or nearly in a liquidity trap can not be dismissed . As discussed in the introduction to the chapter , at the same time the Fed lowered the federal funds rate to close to zero , it mentioned that it intended to pursue additional , nontraditional measures . What the Fed seeks to do is to make firms and consumers want to spend now by using a tool not aimed at reducing the interest rate , since it can not reduce the interest rate below zero . It thus shifts its focus to the price level and to avoiding expected . For example , if the public expects the price level to fall by and the interest rate is zero , by holding money , the money is actually earning a positive real interest rate of difference between the nominal interest rate and the expected deflation rate . Since the nominal rate of interest can not fall below zero ( Who would , for example , want to lend at an interest rate below zero when lending is risky whereas cash is not ?

In short , it does not make sense to lend 10 and get less than 10 back . expected makes holding cash very attractive and discourages spending since people will put off purchases because goods and services are expected to get cheaper . To combat this mentality , the Fed or other central bank , using a strategy referred to as quantitative easing , must convince the public that it will keep interest rates very low by providing substantial reserves for as long as is necessary to avoid deflation . In other words , it is aimed at creating expected . For example , at the Fed October 2003 meeting , it announced that it would keep the federal funds rate at for a considerable When the Fed lowered the rate to between and in December 2008 , it added that the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some After working so hard to convince economic players that it will not tolerate inflation above , the Fed must now convince the public that it will , but of course not too much ! If it

900 Principles of Economics is successful , this extraordinary form of expansionary monetary policy will lead to increased purchases of goods and services , compared to what they would have been with expected deflation . Also , by providing banks with lots of liquidity , it is hoping to encourage them to lend . The Japanese economy provides an interesting modern example of a country that attempted quantitative easing . With a recessionary gap starting in the early and in most years from 1995 on , Japan central bank , the Bank of Japan , began to lower the call money rate ( equivalent to the federal funds rate in the United States ) reaching near zero by the late 19905 . With growth still languishing , Japan appeared to be in a traditional liquidity trap . In late 1999 , the Bank of Japan announced that it would maintain a zero interest rate policy for the foreseeable future , and in March 2001 it officially began a policy of quantitative easing . In 2006 , with the price level rising modestly , Japan ended quantitative easing and began increasing the call rate again . It should be noted that the government simultaneously engaged in expansionary fiscal policy . How well did these policies work ?

The economy began to grow modestly in 2003 , though deflation between and remained . Some researchers feel that the Bank of Japan ended quantitative easing too early . Also , delays in implementing the policy , as well as delays in restructuring the banking sector , exacerbated Japan problems ( Economic Surveys , 2008 Spiegel , 2006 ) Fed Chairman and other Fed officials have argued that the Fed is also engaged in credit easing ( 2009 , 2009 ) Credit easing is a strategy that involves the extension of central bank lending to influence more broadly the proper functioning of credit markets and to improve liquidity . The specific new credit facilities that the Fed has created were discussed in the Case in Point in the chapter on the nature and creation of money . In general , the Fed is hoping that these new credit facilities will improve liquidity in a variety of credit markets , ranging from those used by money market mutual funds to those involved in student and car loans . Rational Expectations One hypothesis suggests that monetary policy may affect the price level but not real . The rational expectations hypothesis states that people use all available information to make forecasts about future economic activity and the price level , and they adjust their behavior to these forecasts . Figure Monetary Policy and Rational Expectations uses the model of aggregate demand and aggregate supply to show the implications of the rational expectations argument for monetary policy . Suppose the economy is operating at , as illustrated by point A . An increase in the money supply boosts aggregate demand to . In the analysis we have explored thus far , the shift in aggregate demand would move the economy to a higher level of real and create an inflationary gap . That , in turn , would put upward pressure on wages and other prices , shifting the aggregate supply curve to and moving the economy to point , closing the inflationary gap in the long run . The rational expectations hypothesis , however , suggests a quite different interpretation . Figure Monetary Policy and Rational Expectations

Problems and Controversies of Monetary Policy 901 Price level Real per year Suppose the economy is operating at point A and that individuals have rational expectations . They calculate that an expansionary monetary policy at price level will raise prices to . They adjust their wage , quickly shifting the aggregate supply curve to . The result is a movement along the aggregate supply curve to point , with no change in real . Suppose people observe the initial monetary policy change undertaken when the economy is at point A and calculate that the increase in the money supply will ultimately drive the price level up to point . Anticipating this change in prices , people adjust their behavior . For example , if the increase in the price level from to is a 10 change , workers will anticipate that the prices they pay will rise 10 , and they will demand 10 higher wages . Their employers , anticipating that the prices they will receive will also rise , will agree to pay those higher wages . As nominal wages increase , the aggregate supply curve immediately shifts to . The result is an upward movement along the aggregate supply curve , There is no change in real . The monetary policy has no effect , other than its impact on the price level . This rational expectations argument relies on wages and prices being sufficiently sticky , as described in an earlier that the change in expectations will allow the aggregate supply curve to shift quickly to . One important implication of the rational expectations argument is that a monetary policy could be painless . Suppose the economy is at point in Figure Monetary Policy and Rational Expectations , and the Fed reduces the money supply in order to shift the aggregate demand curve back to . In the model of aggregate demand and aggregate supply , the result would be a recession . But in a rational expectations world , people expectations change , the aggregate supply immediately shifts to the right , and the economy moves painlessly down its aggregate supply curve to point A . Those who support the rational expectations hypothesis , however , also tend to argue that monetary policy should not be used as a tool of stabilization policy .

902 Principles of Economics For some , the events of the early weakened support for the rational expectations hypothesis for others , those same events strengthened support for this hypothesis . As we saw in the introduction to an earlier chapter , in 1979 President Jimmy Carter appointed Paul as Chairman of the Federal Reserve and pledged his full support for whatever the Fed might do to contain inflation . made it clear that the Fed was going to slow money growth and boost interest rates . He acknowledged that this policy would have costs but said that the Fed would stick to it as long as necessary to control . Here was a monetary policy that was clearly announced and carried out as advertised . But the policy brought on the most severe recession since the Great result that seems inconsistent with the rational expectations argument that changing expectations would prevent such a policy from having a substantial effect on real . Others , however , argue that people were aware of the Fed pronouncements but were skeptical about whether the effort would persist , since the Fed had not vigorously fought inflation in the late and the . Against this history , people adjusted their estimates of downward slowly . In essence , the recession occurred because people were surprised that the Fed was serious about fighting inflation . Regardless of where one stands on this debate , one message does seem clear once the Fed has proved it is serious about maintaining price stability , doing so in the future gets easier . To put this in concrete , fight made work easier , and legacy of low inflation should make easier . Key Takeaways policy makers must contend with recognition , implementation , and impact lags . Potential targets for policy include interest rates , money growth rates , and the price level or expected rates of change in the price level . Even if a central bank is structured to be independent of political pressure , its officers are likely to be affected by such pressure . To counteract liquidity traps , central banks have used and strategies . No central bank can know in advance how its policies will affect the economy the rational expectations hypothesis predicts that central bank actions will affect the money supply and the price level but not the real level of economic activity . The scenarios below describe the recession and recovery in the early . Identify the lag that may have contributed to the difficulty in using monetary policy as a tool of economic stabilization . The economy entered into a recession in July 1990 . The Fed countered with expansionary monetary policy in October 1990 , ultimately lowering the federal funds rate from to in 1992 . Investment began to increase , although slowly , in early 1992 , and surged in 1993 .

Problems and Controversies of Monetary Policy 903 Case in Point Targeting Monetary Policy Figure BY . Ben , the chairman of the Federal Reserve Board , is among a growing group of economists who ( at least under normal circumstances ! advocate targeting as an approach to monetary policy . The idea , first proposed in 1993 by Stanford University economist John Taylor , calls for the central bank to set an inflation target and , if the actual rate is above or below it , raise or lower the federal funds rate . The approach would be a change from the policy carried out under Alan , who chaired the board from 1987 to 2006 . who opposed targeting , favors a discretionary approach , one that some critics ( and admirers ) have called a approach to monetary policy . Targeting would not , according to , be entirely formulaic , replacing the judgment of the Open Market Committee with a rigid rule . has noted , for example , that if the inflation were to increase as a result of a supply side shock ( such as an increase in oil prices ) then an automatic increase in the federal funds rate would not be appropriate . One danger of using the current inflation rate as a target is that it might be destabilizing . After all , the current rate is actually the rate for the past month or past several months . Adjusting the federal funds rate to past inflation could , given the inherent recognition and impact lags of monetary policy , easily lead to a worsening of the business cycle . Imagine that past inflation has increased as a result of a much earlier increase in the money supply . That inflation might already be correcting itself by the time a tightening effort takes hold in the economy . It thus could cause a contraction . has said that his preferred target is the expected rate of increase for the next year in the price index for consumer goods and services , excluding food and energy prices . That would avoid the danger of relying on previous inflation rates . He has said that his comfort zone for expected inflation is between and . The central banks of Australia , Brazil , Canada , Great Britain , New Zealand , South Korea , and Sweden adopted targeting . Japan and the United States did not . A study by Goldman , the investment consulting and management firm , examined the performance of countries that did and did not engage in targeting . It found that countries that used targeting had more stable interest rates and sustained steady growth . Japan and the United States had much more volatile stock and bond markets . In short , the results of the study tended to support the practice of targeting inflation .

904 Principles of Economics Sources Peter Coy , What the Fuss over Inflation Targeting ?

Business Week 3958 ( November , 2005 ) 34 Justin Fox , Who Will Replace ?

Who Cares ?

Fortune 152 , no . October 31 , 2005 ) 114 . Answers to Try It ! Problems . The recognition lag the Fed did not seem to recognize the economy was in a recession until several months after the recession began . The impact lag investment did not pick up quickly after interest rates were reduced . Alternatively , it could be attributed to the expansionary monetary policy not having its desired effect , at least initially , on investment . for example , Alberto and Lawrence Summers , Central Bank Independence and Performance Some Comparative Evidence , Journal of Money , Credit , and Banking 25 , no . May 1993 ) References , The Crisis and the Policy Response ( Stamp Lecture , London School of Economics , London , England , January 13 , 2009 ) Economic Surveys Bringing an End to under the New Monetary Policy Framework , Japan 2008 ( April 2008 ) Spiegel , Did Quantitative Easing by the Bank of Japan Work ?

Economic Letter 2006 , no . 28 ( October 20 , 2006 ) US . Monetary Policy Objectives in the Short Run and the Long Run ( speech , Allied Social Sciences Association annual meeting , San Francisco , California , January , 2009 ) Monetary Policy and the Equation of Exchange Learning Objectives . Explain the meaning of the equation of exchange , and tell why it must hold true . Discuss the usefulness of the quantity theory of money in explaining the behavior of nominal and inflation in the long run . Discuss why the quantity theory of money is less useful in analyzing the short run . So far we have focused on how monetary policy affects real and the price level in the short run . That is , we have examined how it can be close recessionary or inflationary gaps and to stabilize the price level In this section , we will explore the relationship between money and the economy in the context of an equation that relates the money supply directly to nominal . As we shall see , it also identifies circumstances in which changes in the price level are directly related to changes in the money supply . The Equation of Exchange We can relate the money supply to the aggregate economy by using the equation of exchange Equation nominal The equation of exchange shows that the money supply times its velocity equals nominal . Velocity is the number of times the money supply is spent to obtain the goods and services that make up during a particular time period . To see that nominal is the price level multiplied by real , recall from an earlier chapter that the implicit price deflator equals nominal divided by real Equation Nominal Real Multiplying both sides by real , we have Equation 905

906 Principles of Economics Nominal real Letting equal real , we can rewrite the equation of exchange as Equation We shall use the equation of exchange to see how it represents spending in a hypothetical economy that consists of 50 people , each of whom has a car . Each person has 10 in cash and no other money . The money supply of this economy is thus 500 . Now suppose that the sole economic activity in this economy is car washing . Each person in the economy washes one other person car once a month , and the price of a car wash is 10 . In one month , then , a total of 50 car washes are produced at a price of 10 each . During that month , the money supply is spent once . Applying the equation of exchange to this economy , we have a money supply of 500 and a velocity of . Because the only good or service produced is car washing , we can measure real as the number of car washes . Thus equals 50 car washes . The price level is the price of a car wash 10 . The equation of exchange for a period of month is 500 10 50 Now suppose that in the second month everyone washes someone else car again . Over the full period , the money supply has been spent velocity over a period of two months is . The total output in the economy is car washes have been produced over a period at a price of 10 each . Inserting these values into the equation of exchange , we have 500 10 100 Suppose this process continues for one more month . For the period , the money supply of 500 has been spent three times , for a velocity of . We have 500 10 150 The essential thing to note about the equation of exchange is that it always holds . That should come as no surprise . The left side , gives the money supply times the number of times that money is spent on goods and services during a period . It thus measures total spending . The right side is nominal . But that is a measure of total spending on goods and services as well . Nominal is the value of all final goods and services produced during a particular period . Those goods and services are either sold or added to inventory . If they are sold , then they must be part of total spending . If they are added to inventory , then some firm must have either purchased them or paid for their production they thus represent a portion of total spending . In effect , the equation of exchange says simply that total spending on goods and services , measured as , equals total spending on goods and services , measured as ( or nominal ) The equation of exchange is thus an identity , a mathematical expression that is true by definition . To apply the equation of exchange to a real economy , we need measures of each of the variables in it . Three of these variables are readily available . The Department of Commerce reports the price level ( that is , the implicit

Monetary Policy and the Equation of Exchange 907 price deflator ) and real . The Federal Reserve Board reports , a measure of the money supply . For the second quarter of 2008 , the values of these variables at an annual rate were billion billion To solve for the velocity of money , we divide both sides of Equation by Equation Using the data for the second quarter of 2008 to compute velocity , we find that then was equal to . A velocity of means that the money supply was spent times in the purchase of goods and services in the second quarter of 2008 . Money , Nominal , and Changes Assume for the moment that velocity is constant , expressed as . Our equation of exchange is now written as Equation A constant value for velocity would have two important implications . Nominal could change only if there were a change in the money supply . Other kinds of changes , such as a change in government purchases or a change in investment , could have no effect on nominal . A change in the money supply would always change nominal , and by an equal percentage . In short , if velocity were constant , a course in would be quite simple . The quantity of money would determine nominal nothing else would matter . Indeed , when we look at the behavior of economies over long periods of time , the prediction that the quantity of money determines nominal output holds rather well . Figure Inflation , Growth , and Growth compares averages in the growth rates of and nominal in the United States for more than a century . The lines representing the two variables do seem to move together most of the time , suggesting that velocity is constant when viewed over the long run .

908 Principles of Economics Figure , Growth , and Growth 20 15 10 Nominal 1875 1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 Year The Chan shows the behavior uf changes , the growth uf , and the growth uf nominal one using moving averages . Viewed in this light , the relationship between and nominal seems quite strong . William , Historical Money Growth , and Credibility , Federal Reserve Bank of Louis Review ( 1998 ) 1323 . Moreover , changes also follow the same pattern that changes in and nominal do . Why is this ?

We can rewrite the equation of exchange , in terms of percentage rates of change . When two products , such as and , are equal , and the variables themselves are changing , then the sums of the percentage rates of Change are approximately equal Equation AM AV AP AY The Greek letter A ( delta ) means change Assume that velocity is Constant in the long run , so that . We also assume that real moves to its potential level , in the long run . With these assumptions , we can rewrite Equation as follows Equation AM AP Subtracting from both sides of Equation , we have the following Equation AM AP Equation has enormously important implications for monetary policy . It tells us that , in the long run , the rate

Monetary Policy and the Equation of Exchange 909 of , AP , equals the difference between the rate of money growth and the rate of increase in potential output , given our assumption of constant velocity . Because potential output is likely to rise by at most a few percentage points per year , the rate of money growth will be close to the rate of in the long run . Several recent studies that looked at all the countries on which they could get data on inflation and money growth over long periods found a very high correlation between growth rates of the money supply and of the price level for countries with high inflation rates , but the relationship was much weaker for countries with rates of less than 10 . These findings support the quantity theory of money , which holds that in the long run the price level moves in proportion with changes in the money supply , at least for countries . Why the Quantity Theory of Money Is Less Useful in Analyzing the Short Run The stability of velocity in the long run underlies the close relationship we have seen between changes in the money supply and changes in the price level . But velocity is not stable in the short run it varies significantly from one period to the next . Figure The Velocity of , shows annual values of the velocity of from 1970 through 2009 . Velocity is quite variable , so other factors must affect economic activity . Any change in velocity implies a change in the demand for money . For analyzing the effects of monetary policy from one period to the next , we apply the framework that emphasizes the impact of changes in the money market on aggregate demand . Figure The Velocity of , Average velocity Velocity of Annual velocity 16 1970 1975 1980 1985 1990 1995 2000 2005 Year The annual velocity of varied about an average of between 1970 and 2009 . Economic Report of the President , 2010 , Tables and . The factors that cause velocity to are those that the demand for money , such as the interest rate and expectations about bond prices and future price levels . We can gain some insight about the demand for money

910 Principles of Economics and its significance by rearranging terms in the equation of exchange so that we turn the equation of exchange into an equation for the demand for money . If we multiply both sides of Equation by the reciprocal of velocity , we have this equation for money demand Equation The equation of exchange can thus be rewritten as an equation that expresses the demand for money as a percentage , given by , of nominal . With a velocity of , for example , people wish to hold a quantity of money equal to ( of nominal . Other things unchanged , an increase in money demand reduces velocity , and a decrease in money demand increases velocity . If people wanted to hold a quantity of money equal to a larger percentage of nominal , perhaps because interest rates were low , velocity would be a smaller number . Suppose , for example , that people held a quantity of money equal to 80 of nominal . That would imply a velocity of . If people held a quantity of money equal to a smaller fraction of nominal , perhaps owing to high interest rates , velocity would be a larger number . If people held a quantity of money equal to 25 of nominal , for example , the velocity would be . As another example , in the chapter on financial markets and the economy , we learned that money demand falls when people expect inflation to increase . In essence , they do not want to hold money that they believe will only lose value , so they turn it over faster , that is , velocity rises . Expectations of lower the velocity of money , as people hold onto money because they expect it will rise in value . In our first look at the equation of exchange , we noted some remarkable conclusions that would hold if velocity were constant a given percentage change in the money supply would produce an equal percentage change in nominal , and no change in nominal could occur without an equal percentage change in We have learned , however , that velocity varies in the short run . Thus , the conclusions that would apply if velocity were constant must be changed . First , we do not expect a given percentage change in the money supply to produce an equal percentage change in nominal . Suppose , for example , that the money supply increases by 10 . Interest rates drop , and the quantity of money demanded goes up . Velocity is likely to decline , though not by as large a percentage as the money supply increases . The result will be a reduction in the degree to which a given percentage increase in the money supply boosts nominal . Second , nominal could change even when there is no change in the money supply . Suppose government purchases increase . Such an increase shifts the aggregate demand curve to the right , increasing real and the price level . That effect would be impossible if velocity were constant . The fact that velocity varies , and varies positively with the interest rate , suggests that an increase in government purchases could boost aggregate demand and nominal . To finance increased spending , the government borrows money by selling bonds . An increased supply of bonds lowers their price , and that means higher interest rates . The higher interest rates produce the increase in velocity that must occur if increased government purchases are to boost the price level and real . Just as we can not assume that velocity is constant when we look at behavior period to period ,

Monetary Policy and the Equation of Exchange 911 neither can we assume that output is at potential . With both in the equation of exchange variable , in the short run , the impact of a change in the money supply on the price level depends on the degree to which velocity and real change . In the short run , it is not reasonable to assume that velocity and output are constants . Using the model in which interest rates and other factors affect the quantity of money demanded seems more fruitful for understanding the impact of monetary policy on economic activity in that period . However , the empirical evidence on the relationship between changes in money supply and changes in the price level that we presented earlier gives us reason to pause . As Federal Reserve Governor from 1996 to 2002 Laurence Meyer put it I believe monitoring money growth has value , even for central banks that follow a disciplined strategy of adjusting their policy rate to ongoing economic developments . The value may be particularly important at the extremes during periods of very high inflation , as in the late and early in the United States and in deflationary episodes ( Meyer , 2001 ) It would be a mistake to allow fluctuations in velocity and output to lead policy makers to completely ignore the relationship between money and price level changes in the long run . Key Takeaways The equation of exchange can be written . When , and are changing , then AM AP AY , where A means change In the long run , Vis constant , so . Furthermore , in the long run toward , so AM AP . In the short run , Vis not constant , so changes in the money supply can affect the level of income . The Case in Point on velocity in the Confederacy during the Civil War shows that , assuming real in the South was constant , velocity rose . What happened to money demand ?

Why did it change ?

Case in Point Velocity and the Confederacy Figure 912 Principles of Economics Confederate 100 Dollar Bill . The Union and the Confederacy financed their respective efforts during the Civil War largely through the issue of paper money . The Union roughly doubled its money supply through this process , and the Confederacy printed enough Confederates to increase the money supply in the South from 1861 to 1865 . That huge increase in the money supply boosted the price level in the Confederacy dramatically . It rose from an index of 100 in 1861 to in 1865 . Estimates of real in the South during the Civil War are unavailable , but it could hardly have increased very much . Although production undoubtedly rose early in the period , the South lost considerable capital and an appalling number of men killed in battle . Let us suppose that real over the entire period remained constant . For the price level to rise with a increase in the money supply , there must have been a increase in velocity . People in the South must have reduced their demand for Confederates . An account of an exchange for eggs in 1864 from the diary of Mary Chestnut illustrates how eager people in the South were to part with their Confederate money . It also suggests that other commodities had assumed much greater relative value She asked me 20 dollars for five dozen eggs and then said she would take it in Then I would have given her 100 dollars as easily . But if she had taken my offer of yarn ! I haggle in yarn for the millionth part of a thread ! When they ask for Confederate money , I never stop to chafer bargain or argue . I give them 20 or 50 dollars cheerfully for Sources Vann Woodward , Mary Chestnuts Civil War ( New Haven , Yale University Press , 1981 ) 749 . Money and price data from , Money , Prices , and Wages in the Confederacy , Journal of Political Economy 63 ( February 1955 ) Answer to Try It ! Problem People in the South must have reduced their demand for money . The fall in money demand was probably due to the expectation that the price level would continue to rise . In periods of high , people try to get rid of money quickly because it loses value rapidly . example , one study examined data on 81 countries using rates averaged for the period 1980 to 1993 ( John , Money Growth , Output Growth , and Inflation Estimation of a Modern Quantity Theory , Southern Economic Journal 69 , no , 2002 ) while another examined data on 160 countries over the period ( Paul De and , Is Inflation Always and Everywhere a Monetary Phenomenon ?

Scandinavian Journal 107 , no , 2005 ) Monetary Policy and the Equation of Exchange 913 References Meyer , Does Money Matter ?

Federal Reserve Bank of Louis Review 83 , no . 2001 ) Review and Practice Summary Part of the Fed power stems from the fact that it has no legislative mandate to seek particular goals . That leaves the Fed free to set its own goals . In recent years , its primary goal has seemed to be the maintenance of an rate below to . Given success in meeting that goal , the Fed has used its tools to stimulate the economy to close recessionary gaps . Once the Fed has made a choice to undertake an expansionary or policy , we can trace the impact of that policy on the economy . There are a number of problems in the use of monetary policy . These include various types of lags , the issue of the choice of targets in conducting monetary policy , political pressures placed on the process of policy setting , and uncertainty as to how great an impact the Feds policy decisions have on variables . We highlighted the difficulties for monetary policy if the economy is in or near a liquidity trap and discussed the use of quantitative easing and credit easing in such situations . If people have rational expectations and respond to those expectations in their wage and price choices , then changes in monetary policy may have no effect on real . We saw in this chapter that the money supply is related to the level of nominal by the equation of exchange . A crucial issue in that relationship is the stability of the velocity of money and of real . If the velocity of money were constant , nominal could change only if the money supply changed , and a change in the money supply would produce an equal percentage change in nominal . If velocity were constant and real were at its potential level , then the price level would change by about the same percentage as the money supply . While these predictions seem to hold up in the long run , there is less support for them when we look at behavior in the short run . Nonetheless , policy makers must be mindful of these relationships as they formulate policies for the short run . Concept Problems . Suppose the Fed were required to conduct monetary policy so as to hold the unemployment rate below , the goal specified in the Act . What implications would this have for the economy ?

The statutes of the recently established European Central Bank ( state that its primary objective is to maintain price stability . How does this charter differ from that of the Fed ?

What significance does it have for monetary policy ?

Do you think the Fed should be given a clearer legislative mandate concerning goals ?

If so , what should it be ?

Referring to the Case in Point on targeting , what difference does it make whether the target is the rate of the past year or the expected inflation rate over the next year ?

In a speech in January 19951 , Federal Reserve Chairman Alan used a transportation metaphor to describe some of the difficulties of implementing monetary policy . He referred to the criticism levied against the Fed for shifting in 1994 to an , policy when the inflation rate was still quite low To successfully navigate a bend in the river , the barge must begin the turn well before the bend is reached . Even so , currents are always changing and even an experienced crew can not foresee all the events that might occur as the river is 914

Review and Practice 915 10 . 11 . being navigated . A year ago , the Fed began its turn ( a shift toward an expansionary monetary policy ) and it was was referring , of course , to the problem of lags . What kind of lag do you think he had in mind ?

What do you suppose the reference to changing currents means ?

In a speech in August 1999 ( 1999 ) said , We no longer have the luxury to look primarily to the flow of goods and services , as conventionally estimated , when evaluating the environment in which monetary policy must function . There are extremely surrounding the behavior of asset prices and the implications of this behavior for the decisions of households and businesses . The asset price that was referring to was the stock market , which had been rising sharply in the weeks and months preceding this speech . and unemployment were both low at that time . What issues concerning the conduct of monetary policy was raising ?

Suppose we observed an economy in which changes in the money supply produce no changes whatever in nominal . What could we conclude about velocity ?

Suppose the price level were falling 10 per day . How would this affect the demand for money ?

How would it affect velocity ?

What can you conclude about the role of velocity during periods of rapid price change ?

Suppose investment increases and the money supply does not change . Use the model of aggregate demand and aggregate supply to predict the impact of such an increase on nominal . Now what happens in terms of the variables in the equation of exchange ?

The text notes that prior to August 1997 ( when it began specifying a target value for the federal funds rate ) the adopted directives calling for the trading desk at the New York Federal Reserve Bank to increase , decrease , or maintain the existing degree of pressure on reserve positions . On the meeting dates given in the first column , the voted to decrease pressure on reserve positions ( that is , adopt a more expansionary policy ) On the meeting dates given in the second column , it voted to increase reserve pressure July , 1995 February 341 , 1994 December 19 , 1995 January , 1995 January 3031 , 1996 March 25 , 1997 Recent minutes of the can be found at the Federal Reserve Board of Governors website . Pick one of these dates on which a decrease in reserve pressure was ordered and one on which an increase was ordered and find out why that particular policy was chosen . Since August 1997 , the Fed has simply set a specific target for the federal funds rate . The four dates below show the first four times after August 1997 that the Fed voted to set a new target for the federal funds rate on the following dates September 29 , 1998 November 17 , 1998 June 29 , 1999 August 24 , 1999 Pick one of these dates and find out why it chose to change its target for the federal funds rate on that date . Four recent meetings at which the Fed changed the target for the federal funds rate are shown below .

916 Principles of Economics January 30 , 2008 March 18 , 2008 October , 2008 October 29 , 2008 Pick one of these dates and find out why it chose to change its target for the federal funds rate on that date . 13 . The text notes that a 10 increase in the money supply may not increase the price level by 10 in the short run . Explain why . 14 . Trace the impact of an expansionary monetary policy on bond prices , interest rates , investment , the exchange rate , net exports , real , and the price level . Illustrate your analysis graphically . 15 . Trace the impact of a monetary policy on bond prices , interest rates , investment , the exchange rate , net exports , real , and the price level . Illustrate your analysis graphically . Numerical Problems . Here are annual values for and for nominal ( all figures are in billions of dollars ) for the . Year Nominal 1993 1994 1995 1996 1997 . Compute the velocity for each year . Compute the fraction of nominal that was being held as money . What is your conclusion about the stability of velocity in this period ?

Here are annual values for and for nominal ( all figures are in billions of dollars ) for the . Year Nominal 2003 2004 2005 2006 2007 . Compute the velocity for each year . Compute the fraction of nominal that was being held as money .

Review and Practice 917 . What is your conclusion about the stability of velocity in this period ?

The following data show for the years 1993 to 1997 , respectively ( all figures are in billions of dollars ) Compute the velocity for these years . Nominal for these years is shown in problem . If you were going to use a money target , would or have been preferable during the 19905 ?

Explain your reasoning . The following data show for the years 2003 to 2007 , respectively ( all figures are in billions of dollars ) Compute the velocity for these years . Nominal for these years is shown in problem . If you were going to use a money target , would or have been preferable during the 20005 ?

Explain your reasoning . Assume a hypothetical economy in which the velocity is constant at and real is always at a constant potential of . Suppose the money supply is in the first year , in the second year , in the third year , and in the fourth year . Using the equation of exchange , compute the price level in each year . Compute the inflation rate for each year . Explain why varies , even though the money supply rises by 100 each year . If the central bank wanted to keep inflation at zero , what should it have done to the money supply each year ?

If the central bank wanted to keep inflation at 10 each year , what money supply should it have targeted in each year ?

Suppose the velocity of money is constant and potential output grows by per year . By what percentage should the money supply grow in order to achieve the following rate targets ?

Suppose the velocity of money is constant and potential output grows by per year . For each of the following money supply growth rates , what will the inflation rate be ?

Suppose that a country whose money supply grew by about 20 a year over the long run had an annual rate of about 20 and that a country whose money supply grew by about 50 a year had an annual rate of about 50 . Explain this finding in terms of the equation of exchange . by Alan before the Board of Directors of the National Association of Home Builders , January 28 , 1995 .

918 Principles of Economics References , New challenges for monetary policy , speech delivered before a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole , Wyoming , on August 27 , 1999 . was famous for his convoluted speech , which listeners often found difficult to understand . correspondent Andrea Mitchell , to whom is married , once joked that he had proposed to her three times and that she had not understood what he was talking about on his first two efforts .