The Federal Open Market Committee (FOMC) holds eight regularly scheduled meetings during a year. Policy statements and minutes of those meetings are posted on the link above. Based on the statement, answer the following questions:
- Identify and explain any four macroeconomic policy terms from the statement that was covered this week.
- Explain how the Federal Reserve characterize the state of the economy in November 2022.
- Discuss the policy actions the Fed announced in the statement.
- Provide ONE reason why you agree or disagree with the Fed’s proposed policy action.
FOUR- FIVE pages; double spaced (not including cover and reference page)
- Must use at least two scholarly, peer-reviewed, and/or other credible sources in addition to the course text.
- The Scholarly, Peer-Reviewed, and Other Credible SourcesLinks to an external site. table offers additional guidance on appropriate source types. If you have questions about whether a specific source is appropriate for this assignment, please contact your Your instructor has the final say about the appropriateness of a specific source for a particular assignment.
- Must document any information used from sources in APA style as outlined in the Writing Center’s Citing Within Your PaperLinks to an external site. guide.
- Must include a separate references page that is formatted according to APA style as outlined in the Writing Center. See the Formatting Your References ListLinks to an external site. resource in the Writing Center for specifications.
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Finance & Development
Monetary Policy: Stabilizing Prices and Output
Back to Basics
Credit: ISTOCK / RASTUDIO
5 min (1403 words) Read
BACK T O BASICS COMPILATION
Central banks use tools such as interest rates to adjust the supply of money to keep the economy humming
Monetary policy has lived under many guises. But however it may appear, it generally boils down to adjusting the supply of money in the economy to achieve some combination of inflation and output stabilization.
Most economists would agree that in the long run, output—usually measured by gross domestic product (GDP)—is fixed, so any changes in the money supply only cause prices to change. But in the short run, because prices and wages usually do not adjust immediately, changes in the money supply can affect the actual production of goods and services. This is why monetary policy—generally conducted by central banks such as the U.S. Federal Reserve (Fed) or the European Central Bank (ECB)—is a meaningful policy tool for achieving both inflation and growth objectives.
In a recession, for example, consumers stop spending as much as they used to; business production declines, leading firms to lay off workers and stop investing in new capacity; and foreign appetite for the country’s exports may also fall. In short, there is a decline in overall, or aggregate, demand to which government can respond with a policy that leans against the direction in which the economy is headed. Monetary policy is often that countercyclical tool of choice.
Such a countercyclical policy would lead to the desired expansion of output (and employment), but, because it entails an increase in the money supply, would also result in an increase in prices. As an economy gets closer to producing at full capacity, increasing demand will put pressure on input costs, including wages. Workers then use their increased income to buy more goods and services, further bidding up prices and wages and pushing generalized inflation upward—an outcome policymakers usually want to avoid.
Twin objectives
The monetary policymaker, then, must balance price and output objectives. Indeed, even central banks, like the ECB, that target only inflation would generally admit that they also pay attention to stabilizing output and keeping the economy near full employment. And at the Fed, which has an explicit “dual mandate” from the U.S. Congress, the employment goal is formally recognized and placed on an equal footing with the inflation goal.
Monetary policy is not the only tool for managing aggregate demand for goods and services. Fiscal policy—taxing and spending—is another, and governments have used it extensively during the recent global crisis. However, it typically takes time to legislate tax and spending changes, and once such changes have become law, they are politically difficult to reverse. Add to that concerns that consumers may not respond in the intended way to fiscal stimulus (for example, they may save rather than spend a tax cut), and it is easy to understand why monetary policy is generally viewed as the first line of defense in stabilizing the economy during a downturn. (The exception is in countries with a fixed exchange rate, where monetary policy is completely tied to the exchange rate objective.)
Independent policy
Although it is one of the government’s most important economic tools, most economists think monetary policy is best conducted by a central bank (or some similar agency) that is independent of the elected government. This belief stems from academic research, some 30 years ago, that emphasized the problem of time inconsistency. Monetary policymakers who were less independent of the government would find it in their interest to promise low inflation to keep down inflation expectations among consumers and businesses. But later, in response to subsequent developments, they might find it hard to resist expanding the money supply, delivering an “inflation surprise.” That surprise would at first boost output, by making labor relatively cheap (wages change slowly), and would also reduce the real, or inflation-adjusted, value of government debt. But people would soon recognize this “inflation bias” and ratchet up their expectations of price increases, making it difficult for policymakers ever to achieve low inflation.
To overcome the problem of time inconsistency, some economists suggested that policymakers should commit to a rule that removes full discretion in adjusting monetary policy. In practice, though, committing credibly to a (possibly complicated) rule proved difficult. An alternative solution, which would still shield the process from politics and strengthen the public’s confidence in the authorities’ commitment to low inflation, was to delegate monetary policy to an independent central bank that was insulated from much of the political process—as was the case already in a number of economies. The evidence suggests that central bank independence is indeed associated with lower and more stable inflation.
Conducting monetary policy
How does a central bank go about changing monetary policy? The basic approach is simply to change the size of the money supply. This is usually done through open-market operations, in which short-term government debt is exchanged with the private sector. If the Fed, for example, buys or borrows Treasury bills from commercial banks, the central bank will add cash to the accounts, called reserves, that banks are required keep with it. That expands the money supply. By contrast, if the Fed sells or lends treasury securities to banks, the payment it receives in exchange will reduce the money supply.
While many central banks have experimented over the years with explicit targets for money growth, such targets have become much less common, because the correlation between money and prices is harder to gauge than it once was. Many central banks have switched to inflation as their target—either alone or with a possibly implicit goal for growth and/or employment.
When a central bank speaks publicly about monetary policy, it usually focuses on the interest rates it would like to see, rather than on any specific amount of money (although the desired interest rates may need to be achieved through changes in the money supply). Central banks tend to focus on one “policy rate”—generally a short-term, often overnight, rate that banks charge one another to borrow funds. When the central bank puts money into the system by buying or borrowing securities, colloquially called loosening policy, the rate declines. It usually rises when the central bank tightens by soaking up reserves. The central bank expects that changes in the policy rate will feed through to all the other interest rates that are relevant in the economy.
Transmission mechanisms
Changing monetary policy has important effects on aggregate demand, and thus on both output and prices. There are a number of ways in which policy actions get transmitted to the real economy (Ireland, 2008).
The one people traditionally focus on is the interest rate channel. If the central bank tightens, for example, borrowing costs rise, consumers are less likely to buy things they would normally finance—such as houses or cars—and businesses are less likely to invest in new equipment, software, or buildings. This reduced level of economic activity would be consistent with lower inflation because lower demand usually means lower prices.
But this is not the end of the story. A rise in interest rates also tends to reduce the net worth of businesses and individuals—the so-called balance sheet channel—making it tougher for them to qualify for loans at any interest rate, thus reducing spending and price pressures. A rate hike also makes banks less profitable in general and thus less willing to lend—the bank lending channel. High rates normally lead to an appreciation of the currency, as foreign investors seek higher returns and increase their demand for the currency. Through the exchange rate channel, exports are reduced as they become more expensive, and imports rise as they become cheaper. In turn, GDP shrinks.
Monetary policy has an important additional effect on inflation through expectations—the self-fulfilling component of inflation. Many wage and price contracts are agreed to in advance, based on projections of inflation. If policymakers hike interest rates and communicate that further hikes are coming, this may convince the public that policymakers are serious about keeping inflation under control. Long-term contracts will then build in more modest wage and price increases over time, which in turn will keep actual inflation low.
When rates can go no lower
After the onset of the global financial crisis in 2008, central banks worldwide cut policy rates sharply—in some cases to zero—exhausting the potential for cuts. Nonetheless, they have found unconventional ways to continue easing policy.
One approach has been to purchase large quantities of financial instruments from the market. This so-called quantitative easing increases the size of the central bank’s balance sheet and injects new cash into the economy. Banks get additional reserves (the deposits they maintain at the central bank) and the money supply grows.
A closely related option, credit easing, may also expand the size of the central bank’s balance sheet, but the focus is more on the composition of that balance sheet—that is, the types of assets acquired. During the recent crisis, many specific credit markets became blocked, and the result was that the interest rate channel did not work. Central banks responded by targeting those problem markets directly. For instance, the Fed set up a special facility to buy commercial paper (very short-term corporate debt) to ensure that businesses had continued access to working capital. It also bought mortgage-backed securities to sustain housing finance.
Some argue that credit easing moves monetary policy too close to industrial policy, with the central bank ensuring the flow of finance to particular parts of the market. But quantitative easing is no less controversial. It entails purchasing a more “neutral” asset, like government debt, but it moves the central bank toward financing the government’s fiscal deficit, possibly calling its independence into question.
Koshy Mathai is the IMF’s Resident Representative in Sri Lanka.
Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.
References:
Ireland, Peter N., 2008, “Monetary Transmission Mechanism,” The New Palgrave Dictionary of Economics, 2nd ed., ed. by Steven N. Durlauf and Lawrence E. Blume (Houndmills, United Kingdom: Palgrave MacMillan).
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ECO203.W4A1.02.2023
Description:
Total Possible Score: 8.00
Identifies and Explains Any Four Macroeconomic Policy Terms From the Statement Covered in Week 5
Total: 2.00
Distinguished – Clearly and accurately identifies and thoroughly explains any four macroeconomic policy terms from the statement covered in Week 5.
Proficient – Identifies and explains any four macroeconomic policy terms from the statement covered in Week 5. Minor details are missing.
Basic – Partially identifies and minimally explains any four macroeconomic policy terms from the statement covered in Week 5. Relevant details are missing.
Below Expectations – Attempts to identify and explain any four macroeconomic policy terms from the statement covered in Week 5; however, significant details are missing.
Non-Performance – The identification and explanation of any four macroeconomic policy terms from the statement covered in Week 5 are either nonexistent or lack the components described in the assignment instructions.
Explains How the Federal Reserve Characterize the State of the Economy in November 2022
Total: 1.00
Distinguished – Thoroughly explains how the federal reserve characterize the state of the economy in November 2022.
Proficient – Explains how the federal reserve characterize the state of the economy in November 2022. The explanation is slightly underdeveloped.
Basic – Minimally explains how the federal reserve characterize the state of the economy in November 2022. The explanation is underdeveloped.
Below Expectations – Attempts to explain how the federal reserve characterize the state of the economy in November 2022; however, the explanation is significantly underdeveloped.
Non-Performance – The explanation of how the federal reserve characterize the state of the economy in November 2022 is either nonexistent or lacks the components described in the assignment instructions.
Discusses the Policy Actions the Federal Reserve Announced in the Statement
Total: 2.00
Distinguished – Comprehensively discusses the policy actions the federal reserve announced in the statement.
Proficient – Discusses the policy actions the federal reserve announced in the statement. Minor details are missing.
Basic – Partially discusses the policy actions the federal reserve announced in the statement. Relevant details are missing.
Below Expectations – Attempts to discuss the policy actions the federal reserve announced in the statement; however, significant details are missing.
Non-Performance – The discussion of the policy actions the federal reserve announced in the statement is either nonexistent or lacks the components described in the assignment instructions.
Provides One Reason for Agreeing or Disagreeing With the Federal Reserve’s Proposed Policy Action
Total: 1.00
Distinguished – Provides one thorough reason for agreeing or disagreeing with the Federal Reserve’s proposed policy action.
Proficient – Provides one reason for agreeing or disagreeing with the Federal Reserve’s proposed policy action. Minor details are missing.
Basic – Provides one limited reason for agreeing or disagreeing with the Federal Reserve’s proposed policy action. Relevant details are missing.
Below Expectations – Attempts to provide one reason for agreeing or disagreeing with the Federal Reserve’s proposed policy action; however, significant details are missing.
Non-Performance – The reason for agreeing or disagreeing with the Federal Reserve’s proposed policy action is either nonexistent or lacks the components described in the assignment instructions.
Written Communication: Control of Syntax and Mechanics
Total: 0.50
Distinguished - Displays meticulous comprehension and organization of syntax and mechanics, such as spelling and grammar. Written work contains no errors and is very easy to understand.
Proficient - Displays comprehension and organization of syntax and mechanics, such as spelling and grammar. Written work contains only a few minor errors and is mostly easy to understand.
Basic - Displays basic comprehension of syntax and mechanics, such as spelling and grammar. Written work contains a few errors which may slightly distract the reader.
Below Expectations - Fails to display basic comprehension of syntax or mechanics, such as spelling and grammar. Written work contains major errors which distract the reader.
Non-Performance - The assignment is either nonexistent or lacks the components described in the instructions.
Written Communication: APA Formatting
Total: 0.50
Distinguished - Accurately uses APA formatting consistently throughout the paper, title page, and reference page.
Proficient - Exhibits APA formatting throughout the paper. However, layout contains a few minor errors.
Basic – Exhibits limited knowledge of APA formatting throughout the paper. However, layout does not meet all APA requirements.
Below Expectations - Fails to exhibit basic knowledge of APA formatting. There are frequent errors, making the layout difficult to distinguish as APA.
Non-Performance - The assignment is either nonexistent or lacks the components described in the instructions.
Written Communication: Page Requirement
Total: 0.50
Distinguished - The length of the paper is equivalent to the required number of correctly formatted pages.
Proficient - The length of the paper is nearly equivalent to the required number of correctly formatted pages.
Basic - The length of the paper is equivalent to at least three quarters of the required number of correctly formatted pages.
Below Expectations - The length of the paper is equivalent to at least one half of the required number of correctly formatted pages.
Non-Performance - The assignment is either nonexistent or lacks the components described in the instructions.
Written Communication: Resource Requirement
Total: 0.50
Distinguished - Uses more than the required number of scholarly sources, providing compelling evidence to support ideas. All sources on the reference page are used and cited correctly within the body of the assignment.
Proficient - Uses the required number of scholarly sources to support ideas. All sources on the reference page are used and cited correctly within the body of the assignment.
Basic - Uses less than the required number of sources to support ideas. Some sources may not be scholarly. Most sources on the reference page are used within the body of the assignment. Citations may not be formatted correctly.
Below Expectations - Uses an inadequate number of sources that provide little or no support for ideas. Sources used may not be scholarly. Most sources on the reference page are not used within the body of the assignment. Citations are not formatted correctly.
Non-Performance - The assignment is either nonexistent or lacks the components described in the instructions.
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