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ECONhomework.docxRead the article "Monetary Policy and Interest Rates" from The Economics of Macro Issues, by Roger LeRoy Miller and Daniel K. Benjamin.
Monetary Policy and Interest Rates
From The Economics of Macro Issues, by Roger LeRoy Miller and Daniel K. Benjamin
“The Fed lowers interest rates by one-half point.” That and similar headlines appeared numerous times in the financial press during the early 2000s. The Fed – short for the Federal Reserve System – is America’s central bank. Interest rates can be affected by the Fed; when they are, that is part of monetary policy, defined as the use of changes in the amount of money in circulation to affect interest rates, credit markets, inflation, and unemployment.
The theory behind monetary policy is relatively simple. An increase in the money supply raises spending on goods and services and, thus, stimulates the economy, tending to lower unemployment in the short run and raise inflation in the long run. (One important version of the money supply is composed of checking—type account balances and currency in the hands of the public.) The flip side is that a decrease in the money supply reduces spending, thereby depressing the economy; the short-run result is higher unemployment, and the long-run effect is a lower inflation rte.
Monetary Policy and the Fed
Congress established the Federal Reserve system in 1913. A board of Governors consisting of seven members, including the very powerful chairperson, governs it. All of the governors, including the chair, are nominated by the president and approved by the Senate. Their appointments are for fourteen years (although the chair serves in that role for only four years at a time).
Through the Fed, and its Federal Open market Committee (FOMC), decisions about monetary policy ae made eight times a year. The Federal Reserve System is independent; the Board even has its own budget, financed with interest earnings on the portfolio of bonds it owns. The president can attempt to persuade the board to follow a particular policy, and Congress can threaten to merge the Fed with the Treasury of otherwise restrict its behavior. But unless Congress takes the radical step of passing legislation to the contrary, the Fed’s chair and governors can do what they please. Hence, talking about “the president’s monetary policy” or “Congress’s monetary policy” is inaccurate. To be sure, the Fed has, on occasion, yielded to presidential pressure to pursue a particular policy, and the Fed’s chair follows a congressional resolution directing him to report on what the Fed is doing on the policy front. But now, more than ever before, the Fed remains the single most important and truly independent source of economic power in the federal government. Monetary policy is Fed policy and no one else’s.
Federal Reserve monetary policy, in principle, is supposed to be counter-cyclical. That is, it is supposed to counteract other forces that might be making the economy contract or expand too rapidly. The economy goes through so-called business cycles, made up of recessions (and sometimes depressions), when unemployment is rising, and expansions, when unemployment is falling and businesses often are straining their productive capacity. For the Fed to stabilize the economy, it must create policies that go counter to business activity. Although Fed policy can be put into place much faster than most federal policies, it still does not operate instantaneously. Indeed, researchers have estimated that it takes almost fourteen months for a change in monetary policy to become effective. Thus, by the time monetary policy goes into effect, a different policy might be appropriate.
Policy in Practice
Researchers examining the evidence over the period from 1913 until the 1990s have concluded that, on average, the Fed’s policy has turned out to be pro-cyclical, rather than counter-cyclical. That is, by the time the Fed started pumping money into the economy, it was time to do the opposite; and by the time the Fed started reducing the growth rate of the money supply, it was time to start increasing it. Perhaps the Fed’s biggest pro-cyclical blunder occurred during the Great Depression in the 1930s. Many economist believe that what would have been a severe recession turned into the Great Depression because the Fed’s actions resulted in an almost one-third decrease in the amount of money in circulation, drastically reducing aggregate spending. It has also been argued that the rapid inflation experienced in the 1970s was largely the result of excessive monetary expansion by the Fed.
In the 1990s, few commentators were able to complain about monetary policy. Inflation almost disappeared by the end of the decade, which also saw the unemployment rate drop to its lowest level in nearly forty years. Why the fed was successful in the 1990s remains unclear. It could have been due to the uniquely superior insights of its chair, Alan Greenspan. Or perhaps the Fed had learned from its past experiences. Or it simply may have been a run of good luck. But whatever the reason, it is clear that the Fed remains far from perfect. Late in the decade, it tightened monetary policy sharply, reducing monetary growth and thereby contributing to the recession of 2001. Moreover, some economists are worried that the Fed may have increased the growth rate of the money supply too much in 2001 and 2002 to counter that recession. If they are correct, this means that the Fed will have set the stage for renewed inflation later. Indeed, by 2004, the Fed itself was worried about just that possibility. This led it to change its policy to a more restrictive stance, resulting in headlines that read, “Fed raises interest rates by one-quarter point.”
Inflation and Interest Rates
Most newspaper discussions of Fed policy focus on its decisions to raise or lower interest rates. Before we can make any sense out of such discussions, first we need to understand the relationship between nominal interest rates, that is, the rates that you see in the newspaper and pay for loans, and the expected rate of inflation.
Let’s start in a hypothetical world where there is no inflation, so expected (or anticipated) inflation is zero. In that world, you might be able to borrow – obtain a mortgage to buy a home, for example – at a nominal rate of interest of, say, 4 percent. If you borrow the funds and your anticipation of zero inflation turns out to be accurate, neither you nor the lender will have been fooled. The dollars you pay back in the years to come will be just as valuable in terms of purchasing power as the dollars that you borrowed. In this situation, we would say that the real rate of interest (equal to the nominal rate of interest minus the anticipated rate of inflation) was exactly equal to the nominal interest rate.
Contrast this with a situation in which the expected inflation rate is, say, 5 percent. Although you would be delighted to borrow at a 4 percent interest rate, lenders would be reluctant to oblige you, and their reluctance would be based on exactly the same reasoning you would be using: the dollars with which you would be repaying the debt would be declining in purchasing power every year of the debt. Lenders would likely insist upon (and you would agree to) an inflationary premium of 5 percent, to make up for the expected inflation. Hence, the nominal interest rate would rise to about 9 percent, keeping the real rat at its previous level of 4 percent.
There is strong evidence that inflation rates and nominal interest rates move in parallel. During periods of rapid inflation, people come to anticipate that inflation rather promptly, and higher nominal interest rates are the result. In the early 1970s, when the inflation rate was between 4 and 5 percent, nominal interest rates on mortgages were around 8 to 10 percent. At the beginning of the 1980s, when the inflation rate was near 10 percent, nominal interest rates on mortgages had risen to between 14 and 16 percent. By the middle of the 1990s, when the inflation rate was 2 to 3 percent, nominal interest rates had fallen to between 6 and 8 percent.
Policy and Interest Rates
Now let’s go back to Fed policy and the headlines. When the chair of the Fed states that the Fed is raising “the” interest rate from, say, 1.25 percent to 1.5 percent, he really means something else. In the first place, the interest rate referred to is the federal funds rate, or the rate at which banks can borrow excess reserves from other banks. Any effects of Fed policy here will show up in other rates only indirectly. More importantly, even when the Fed decides to try to alter the federal funds rate, it can do so only by actively entering the market for federal government securities (usually Treasury bills). So, if the Fed wants to lower “the” interest rate as it did in the early 20000s, it essentially must buy Treasury bills from banks and other private holders of the bills. This action bids up the prices of these bills and simultaneously lowers the interest rates on them. This, in turn, lowers the interest rates at which banks are willing to lend to each other and to the public. (In terms of our earlier discussion, this policy also has the effect of increasing the money supply and so incr3eases spending throughout the economy.) Conversely, when the Fad wants to increase “the” rate of interest as in the mid-2000s, it sells Treasury bills, driving their prices down and pushing up interest rates. The result is a reduction in the money supply and a reduction in spending throughout the economy. The pre-announcement of the policy change, which comes in the form of a Fed declaration that interest rates are going to be changed, simply serves to alert people that a new policy is on the way.
The other key point to note is that the changes in interest rates we have been talking about are very much short-term changes – and are occurring over a period of time short enough that the expected inflation rate is constant. Once the effects of the Fed’s new policy begin to kick in, however, the expected inflation rate will tend to respond, which can create a whole new set of problems. For example, suppose the Fed decides to “lower interest rates,” that is, to increase the money supply by buying Treasury bills. In the early weeks and months, this will indeed lower interest rates and stimulate spending. But, for a given level of productive capacity in the economy, this added spending will eventually be translated into a higher inflation rate. This will soon cause nominal interest rates to rise, as inflationary expectations get added onto the real interest rate.
The fact of the matter is that although the Fed can cause interest rates to move up or down in the short run via its choice of monetary policy, forces beyond its control determine what interest rates will be in the long run. The real rate is determined by the underlying productivity of the economy and the consumption preferences of individuals, and the expected inflation rate is determined by people’s beliefs about future policy. Thus, when you read that the chair of the Fed has raised “the” interest rate, you know that the growth of the money supply has been reduced. But you also now know that whether the Fed likes it or not, if this policy persists long enough, the eventual result will be less inflation in the future and thus lower, not higher, interest rates.
For Critical Analysis
1. Why do you suppose the Fed likes to signal its intentions about monetary policy ahead of time?
2. Some economists have argued that the Fed should stick to a simple “monetary rule,” such as a stable growth rate of the money supply, regardless of what is going on in the economy. Given the Fed’s performance history, can you suggest why we might benefit from such a rule? Why do you think the Fed has steadfastly refused to implement such a rule?
3. One effect of the September 11, 2001 terrorist attacks was to temporarily prevent banks from accessing reserves they needed to meet the demands of their customers. (This occurred because the attacks destroyed many records as well as the computers required to access backup records, and it took affected banks several weeks to become fully operational.) In response, the Fed made many billions of dollars of reserves available to banks, gradually withdrawing the new reserves from the banking system as that system returned to normality. Suppose the Fed had not injected reserves in this way. What would likely have happened to interest rates as a result? What would have been the likely impact on the stock market and on spending by consumers and businesses? Would the unemployment rate have gone up or down?
1. Briefly summarize the main points of the article in your own words
2. Answer question #3 from the end of the article:
"One effect of the September 11, 2001 terrorist attacks was to temporarily prevent banks from accessing reserves they needed to meet the demands of their customers. (This occurred because the attacks destroyed many records as well as the computers required to access backup records, and it took affected banks several weeks to become fully operational.) In response, the Fed made many billions of dollars of reserves available to banks, gradually withdrawing the new reserves from the banking system as that system returned to normality. Suppose the Fed had not injected reserves in this way. What would likely have happened to interest rates as a result? What would have been the likely impact on the stock market and on spending by consumers and businesses? Would the unemployment rate have gone up or down?"
