Online Lesson

EconomicsMinute
A Case Study: The Federal Reserve System and Monetary Policy - August 9, 2005

Key Economic Concepts:

• Discount rate
• Federal Reserve structure
• Fiscal policy
• Interest rate
• Monetary policy
• Open market operations
• Reserve requirements

Description:

On August 9, the Federal Open Market Committee announced an increase in the target federal funds rate from 3.25 percent to 3.5 percent.

Date of Announcement May 3, 2005 Dates of Future Federal Reserve Open Market Committee Meetings June 29 and 30, 2005

Key Economic Indicators as of Octpber 7, 2005 Inflation CPI increased by .5% in July 2005 Unemployment 5.1 % in September 2005 Real GDP + 3.4% annual rate of increase 2nd quarter, 2005 Federal Reserve The Federal Reserve increased the target federal funds rate by .25% to 3.5%. (Click on an indicator above to be directed to most recent case study.)

Announcement

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 3 percent.

The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Recent data suggest that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices. Labor market conditions, however, apparently continue to improve gradually. Pressures on inflation have picked up in recent months and pricing power is more evident. Longer-term inflation expectations remain well contained.

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Roger W. Ferguson, Jr.; Richard W. Fisher; Edward M. Gramlich; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; Anthony M. Santomero; and Gary H. Stern.

In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.

The complete press release is available at: http://www.federalreserve.gov/boarddocs/press/monetary/2005/20050503/default.htm

Reasons for a Case Study on the Federal Open Market Committee (FOMC)

Following most Federal Open Market Committee announcements, newspapers across the country have front-page stories about the Federal Reserve actions to change interest rates and increase or decrease spending and employment in the U.S. economy. Attention increased when growth in spending and output slowed in the economy in late 2000 and 2001. The economy entered a recession in March of 2001 and came out of the recession in November of that year. We then began to grow but without a rise in employment (in fact, employment continued to fall). The Federal Reserve primary concern was to stimulate spending, production, and employment in the economy.

Once the economy began to grow, the focus shifted to reduction of the monetary stimulus and to potential inflation. The current announcement reflects confidence that economic conditions are good, some concern that growth may be slowing, and that attention should be paid to the possibility of increases in inflation in the future.

This case study is intended to guide students and teachers through an analysis of the recent and current actions of the Federal Reserve. An understanding of monetary policy in action is fundamental to developing a thorough understanding of macroeconomic policy, the U.S. economy, and financial markets.

Notes to Teachers

The material in this case study in italics is not included in the student version. This initial case study of the semester introduces relevant concepts and issues. Subsequent case studies following FOMC announcements will describe the announcement and add concepts and complexity throughout the semester. The announcement itself is included in the PowerPoint presentation.

Teachers should also note a possible discussion idea before students read the following “Guide to Announcement”. The idea is at the end of the case study.

You may wish to use the following larger versions of the graphs and tables from this lesson for overhead projection or handouts in class:

• PowerPoint (38 KB)
• PDF (24 KB)

Guide To Announcement

The first paragraph of the announcement summarizes the current monetary policy changes - this month it is the decision to increase the target for the federal funds rate to 3 percent. The increase is 25 basis points or ¼ of one percent. There are 100 basis points in each one percent of interest.

The Federal Reserve Board of Governors also sets the discount rate, through a technical process of approving requests from the twelve Federal Reserve Banks. The discount rate is discussed briefly in the final paragraph. It was also increased by 25 basis points, but to 4 percent.

In the second and third paragraphs, the Federal Reserve discusses the reasoning behind the decision. The second paragraph begins by stating that the “stance of monetary policy remains accommodative.” That means that the current policy is stimulative and encouraging increases in spending and production. The key difference in this announcement from the most recent announcement is that the committee states that “the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices”. That replaces a statement that “output evidently continues to grow at a solid pace despite the rise in energy prices”. The committee is sensitive to the possibility of slowing growth but as stated later is not yet so concerned that it will change its monetary policy direction.

The rest of the second paragraph states that the committee believes that while inflationary pressures are increased, expectations of increased inflation over time have not changed. The last part of the paragraph is the same as the last announcement.

The third paragraph is identical to the third paragraph in the previous announcement. The policy accommodation is the current stimulus. The committee continues to believe that it can be reduced. This means that it expects to continue to increase the target for the federal funds rate by ¼ of one percent. However, the last sentence simply means that if new data are reported and conditions change the committee will act appropriately.

The fourth paragraph describes the votes of the FOMC members on changing the target federal funds rate. In the past, there has been a lag between the announcement and the publication of this information in the minutes. The decision to include voting details, which was implemented in 2002, is one step in a FOMC trend toward releasing more information immediately following the meetings. In this instance, all members of the FOMC voted to increase the target for the federal funds rates by ¼ of one percent.

Data Trends

The economy entered a recession beginning in July of 1990 and ending in March of 1991. Figure 1 shows that the Federal Reserve reduced its target for the federal funds rate rather sharply from more than 8 percent to 3 percent. In 1994 and then again in 1999, the Federal Reserve increased the target federal funds rate in response to increased inflationary pressures. The Federal Reserve raised rates six times from June 1999 through May of 2000.

In response to a slowing economy, from January 3 to December 11 of 2001, the Federal Reserve lowered the target federal funds rate 11 times from 6.50 percent to 1.75 percent (a total reduction of 4.75 percent). At that time that was the lowest target federal funds rate in forty years. As the economy did not seem to be responding rapidly the committee lowered the target twice more in November of 2002 and then again in June of 2003.

In response to increasing growth and the Federal Reserve's belief that it had provided sufficient stimulus, the Federal Reserve began a series of increases in the target in June of 2004. The target federal funds rate has been increased by ¼ of one percent at each meeting since.

(For more on changes in the rate of growth of real GDP, see the most recent GDP Case Study.)

Federal Open Market Committee (FOMC)

The primary function of the FOMC is to direct monetary policy for the U.S. economy. The FOMC meets about every six weeks. The next meeting is June 29 and 30, 2005. The seven Governors of the Federal Reserve Board and five of the twelve Presidents of the Federal Reserve Banks make up the committee. Governors are appointed by the U.S. President and confirmed by the U.S. Senate. The Boards of each Federal Reserve Bank select the presidents of the banks. The current committee is described in the fourth paragraph of the announcement. (There are only eleven members listed as there is currently one opening on the committee as a Governor is in the process of leaving and has not been replaced.)

Tools of the Federal Reserve

Open Market Operations

The Federal Reserve buys and sells bonds and by doing so, increases or decreases banks' reserves and their abilities to make loans. As banks increase or decrease loans, the nation's money supply changes. That, in turn, decreases or increases interest rates. Open market operations are the primary tool of the Federal Reserve. They are often used and are quite powerful. This is what the Federal Reserve actually does when it announces a new target federal funds rate. The federal funds rate is the interest rate banks charge one another in return for a loan of reserves. If the supply of reserves is reduced, that interest rate is likely to increase.

Banks earn profits by accepting deposits and lending some of those deposits to someone else. They sometimes charge fees for establishing and maintaining accounts and always charge borrowers an interest rate. Banks are required by the Federal Reserve System to hold reserves in the form of currency in their vaults or deposits with Federal Reserve System.

When the Federal Reserve sells a bond, an individual or institution buys the bond with a check on their account and gives the check to the Federal Reserve. The Federal Reserve removes an equal amount from the customer's bank's reserves. The bank, in turn, removes the same amount from the customer's account. Thus, the money supply shrinks.

Discount Rate

The discount rate is the interest rate the Federal Reserve charges banks if banks borrow reserves from the Federal Reserve itself. It is the only actual interest rate that the Federal Reserve sets. The target for the federal funds rate is set by the Federal Reserve, but the rate itself is determined in markets. Banks seldom borrow reserves from the Federal Reserve and tend to rely more on borrowing reserves from other banks when they are needed. The discount rate is often changed along with the target for the federal funds rate, but the change does not have a very important effect. In this announcement, the discount rate is increased by ¼ of one percent.

[Note: In January of 2003, the discount rate was changed to a level one-half of one percent above the target federal funds rate. The discount rate had normally been about one-half of a percent less than the target federal funds rate. Technical aspects of borrowing from the Fed were also changed at the same time. The basic functions of monetary policy were not changed.]

Reserve Requirements

Banks are required to hold a portion (either 10 or 3 percent of most deposits, depending upon the size of the bank) of some of their deposits in reserve. Reserves consist of the amount of currency that a bank holds in its vaults and its deposits at Federal Reserve banks. If banks have more reserves than they are required to have, they can increase their lending. If they have insufficient reserves, they have to curtail their lending or borrow reserves from the Federal Reserve or from another bank that may have extra, or what are called excess, reserves. The requirement is seldom changed, but it is potentially very powerful.

For more background on the Federal Reserve and resources to use in the classroom, go to http://www.federalreserve.gov/.

How does Monetary Policy Work?

Monetary policy works by affecting the amount of money that is circulating in the economy. The Federal Reserve can change the amount of money that banks are holding in reserves by buying or selling existing U.S. Treasury bonds. When the Federal Reserve buys a bond, the seller deposits the Federal Reserves' check in her bank account. As a bank's reserves increase, it has an increased ability to make more loans, which in turn will increase the amount of money in the economy.

Competition among banks forces interest rates down as banks compete with one another to make more loans. If businesses are able to borrow more to build new stores and factories and buy more computers, total investment spending increases. Consumer spending that partially depends upon levels of interest rates (automobile and appliances, for example) is also affected. Output will tend to follow and employment may also increase. Thus unemployment will fall. Prices may also increase.

When the Federal Reserve employs an expansionary monetary policy, it buys bonds in order to expand the money supply and simultaneously lower interest rates. Although gross domestic product and investment increase, this may also stimulate inflation. If growth in spending exceeds growth in capacity, inflationary pressures tend to emerge. If growth in spending is less than the growth in capacity, then the economy will not be producing as much as it could. As a result, unemployment may rise. (See the Unemployment Case Study for a more detailed discussion of employment and unemployment .)

When the Federal Reserve adopts a restrictive monetary policy it sells bonds in order to reduce the money supply and this results in higher interest rates. A restrictive monetary policy will decrease inflationary pressures, but it may also decrease investment and real gross domestic product. (See the Inflation Case Study for a more detailed discussion of inflation.)

Comparison of Monetary and Fiscal Policy

The FOMC was reacting to a slowing economy throughout 2001 and then once in 2002 and once in 2003. While the monetary policy was not sufficient to prevent a recession, it surely made the recession milder than it would have been otherwise and likely contributed to the recession ending sooner.

Fiscal policy, the taxing and spending policies of the federal government, also has the potential to influence economic conditions. Throughout 2003, there were debates in Congress about what to do with spending and taxes in order to stimulate spending. Taxes were lowered and spending increased. This debate is one of the key differences between fiscal and monetary policy. Fiscal policy is much more difficult to implement. However, fiscal policy, once adopted, will be likely to have a faster effect on spending. Monetary policy decisions are much easier to institute and more responsive to economic conditions, but take longer to actually have an effect.

Creation of the Federal Open Market Committee

The seven members of the Board of Governors are appointed by the President and confirmed by the Senate to serve 14-year terms of office. Members may serve only one full term, but a member who has been appointed to complete an unexpired term may be reappointed to a full term. The President designates, and the Senate confirms, two members of the Board to be Chairman and Vice Chairman, for four-year terms.

Only one member of the Board may be selected from any one of the twelve Federal Reserve Districts. In making appointments, the President is directed by law to select a "fair representation of the financial, agricultural, industrial, and commercial interests and geographical divisions of the country." These aspects of selection are intended to ensure representation of regional interests and the interests of various sectors of the public.

The seven Board members constitute a majority of the 12-member Federal Open Market Committee (FOMC), the group that makes the key decisions affecting the cost and availability of money and credit in the economy. The other five members of the FOMC are Reserve Bank presidents, one of whom is the president of the Federal Reserve Bank of New York. The other Bank presidents serve one-year terms on a rotating basis. By statute the FOMC determines its own organization, and by tradition it elects the Chairman of the Board of Governors as its Chairman and the President of the New York Bank as its Vice Chairman. (http://www.federalreserve.gov/pubs/frseries/frseri.htm)

Click here for an online activity.

Discussion question

Why does the Federal Reserve increase the target for the federal funds rate even before there is inflation?

[Answer to Question: There are a number of possible answers. The primary answer is that it takes time for monetary policy to work. If the Federal Reserve waited until inflation appeared a tightening of monetary policy would only begin to have an effect on spending nine to fifteen months later. By that time inflation might be a much more serious problem. A second answer is that if inflation begins and expectations of further inflation are created, the inflation may be much more difficult to solve. Thus, reducing inflationary pressures quickly means that a serious problem is much less likely to occur.]

Teachers: Suggested activity for discussion

Go to the Federal Reserve website and print off the March 22 announcement. Ask students to compare the two announcements and identify the important differences. These differences are briefly discussed above. This activity might be done before students read the case study.

Possible questions –

What are the changes?

What does the change in the second sentence of the second paragraph mean?

Has there been a change in monetary policy?

Sources of Additional Activities

Advanced Placement Economics: Macroeconomics. (National Council on Economic Education)

UNIT FOUR: Money, Monetary Policy, and Economic Stability
UNIT FIVE: Monetary and Fiscal Combinations: Economic Policy in the Real World

Entrepreneurship in the US Economy--Teacher Resource Manual

LESSON 10: The Nature of Consumer Demand
LESSON 11: What Causes Change in Consumer Demand?
LESSON 19: Financing the Entrepreneurial Enterprise
LESSON 32: Government Policies, the Economy, and the Entrepreneur

On Reserve: A Resource for Economic Educators from the Federal Reserve Bank of Chicago. Number 28, April 1994: Basics to Bank on

Economics USA: A Resource Guide for Teachers

LESSON 11: The Federal Reserve: Does Money Matter?
LESSON 12: Monetary Policy: How Well Does It Work?
LESSON 13: Stabilization Policy: Are We Still in Control?

Handbook of Economic Lesson Plans for High School Teachers

LESSON EIGHTEEN: The Federal Reserve System
LESSON NINETEEN: Making Monetary Policy: The Tools of the Federal Reserve System

Focus: High School Economics

20. Money, Interest, and Monetary Policy

All are available in Virtual Economics, An Interactive Center for Economic Education (National Council on Economic Education) or directly through the National Council on Economic Education.

Case Study Index: The Federal Reserve System and Monetary Policy Following is a list of past case studies: 8/9/2005 6/30/2005 5/3/2005 2/2/2005 5/4/2004 1/27/2004 12/09/2003 10/28/2003 9/16/2003 6/25/2003 5/7/2003 1/29/2003 11/6/2002 9/24/2002 5/7/2002 3/19/2002 1/30/2002 12/11/2001 11/6/2001 10/2/2001 5/15/2001

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