Part of the Fed’s 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 inflation rate below 2% to 3%. 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 contractionary 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 Fed’s policy decisions have on macroeconomic 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 GDP.
We saw in this chapter that the money supply is related to the level of nominal GDP by the equation of exchange. A crucial issue in that relationship is the stability of the velocity of money and of real GDP. If the velocity of money were constant, nominal GDP could change only if the money supply changed, and a change in the money supply would produce an equal percentage change in nominal GDP. If velocity were constant and real GDP 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 macroeconomic behavior in the short run. Nonetheless, policy makers must be mindful of these long-run relationships as they formulate policies for the short run.
In a speech in January 1995,Speech by Alan Greenspan before the Board of Directors of the National Association of Home Builders, January 28, 1995. Federal Reserve Chairman Alan Greenspan 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 anti-inflation, contractionary 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 cannot foresee all the events that might occur as the river is being navigated. A year ago, the Fed began its turn (a shift toward an expansionary monetary policy), and it was successful.”
Mr. Greenspan 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,Alan Greenspan, “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. Mr. Greenspan was famous for his convoluted speech, which listeners often found difficult to understand. CBS correspondent Andrea Mitchell, to whom Mr. Greenspan 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. Mr. Greenspan said,
We no longer have the luxury to look primarily to the flow of goods and services, as conventionally estimated, when evaluating the macroeconomic environment in which monetary policy must function. There are important—but extremely difficult—questions surrounding the behavior of asset prices and the implications of this behavior for the decisions of households and businesses.
The asset price that Mr. Greenspan was referring to was the U.S. stock market, which had been rising sharply in the weeks and months preceding this speech. Inflation and unemployment were both low at that time. What issues concerning the conduct of monetary policy was Mr. Greenspan raising?
The text notes that prior to August 1997 (when it began specifying a target value for the federal funds rate), the FOMC 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 FOMC 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 5–6, 1995 | February 3–4, 1994 |
| December 19, 1995 | January 31–February 1, 1995 |
| January 30–31, 1996 | March 25, 1997 |
Recent minutes of the FOMC 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 meetings in 2008 at which the Fed changed the target for the federal funds rate are shown below.
| January 30, 2008 | March 18, 2008 |
| October 8, 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.
Here are annual values for M2 and for nominal GDP (all figures are in billions of dollars) for the mid-1990s.
| Year | M2 | Nominal GDP |
|---|---|---|
| 1993 | 3,482.0 | $6,657.4 |
| 1994 | 3,498.1 | 7,072.2 |
| 1995 | 3,642.1 | 7,397.7 |
| 1996 | 3,820.5 | 7,816.9 |
| 1997 | 4,034.1 | 8,304.3 |
Here are annual values for M2 and for nominal GDP (all figures are in billions of dollars) for the mid-2000s.
| Year | M2 | Nominal GDP |
|---|---|---|
| 2003 | 6,055.5 | $10,960.8 |
| 2004 | 6,400.7 | 11,685.9 |
| 2005 | 6,659.7 | 12,421.9 |
| 2006 | 7,012.3 | 13,178.4 |
| 2007 | 7,404.3 | 13,807.5 |
The following data show M1 for the years 1993 to 1997, respectively (all figures are in billions of dollars): 1,129.6; 1,150.7; 1,127.4; 1,081.3; 1,072.5.
The following data show M1 for the years 2003 to 2007, respectively (all figures are in billions of dollars): 1,306.1; 1,376.3; 1,374.5; 1,366.5; 1,366.5
Assume a hypothetical economy in which the velocity is constant at 2 and real GDP is always at a constant potential of $4,000. Suppose the money supply is $1,000 in the first year, $1,100 in the second year, $1,200 in the third year, and $1,300 in the fourth year.
Suppose the velocity of money is constant and potential output grows by 3% per year. By what percentage should the money supply grow in order to achieve the following inflation rate targets?
Suppose the velocity of money is constant and potential output grows by 5% per year. For each of the following money supply growth rates, what will the inflation rate be?
