11.4 Review and Practice

Summary

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.

Concept Problems

  1. Suppose the Fed were required to conduct monetary policy so as to hold the unemployment rate below 4%, the goal specified in the Humphrey–Hawkins Act. What implications would this have for the economy?
  2. The statutes of the recently established European Central Bank (ECB) 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?
  3. Do you think the Fed should be given a clearer legislative mandate concerning macroeconomic goals? If so, what should it be?
  4. Referring to the Case in Point on targeting, what difference does it make whether the target is the inflation rate of the past year or the expected inflation rate over the next year?

  5. In a speech in January 1995,[1] 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?

  6. In a speech in August 1999 (Greenspan, 1999),[2] 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?

  7. Suppose we observed an economy in which changes in the money supply produce no changes whatever in nominal GDP. What could we conclude about velocity?
  8. Suppose price levels 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?
  9. 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 GDP. Now what happens in terms of the variables in the equation of exchange?
  10. 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.

  11. 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.

  12. 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.

  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 GDP, and the price level. Illustrate your analysis graphically.
  15. Trace the impact of a contractionary monetary policy on bond prices, interest rates, investment, the exchange rate, net exports, real GDP, and the price level. Illustrate your analysis graphically.

Numerical Problems

  1. 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
    1. Compute the velocity for each year.
    2. Compute the fraction of nominal GDP that was being held as money.
    3. What is your conclusion about the stability of velocity in this five-year period?
  2. 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
    1. Compute the velocity for each year.
    2. Compute the fraction of nominal GDP that was being held as money.
    3. What is your conclusion about the stability of velocity in this five-year period?
  3. 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.
    1. Compute the M1 velocity for these years. (Nominal GDP for these years is shown in problem 1.)
    2. If you were going to use a money target, would M1 or M2 have been preferable during the 1990s? Explain your reasoning.
  4. 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
    1. Compute the M1 velocity for these years. (Nominal GDP for these years is shown in problem 2.)
    2. If you were going to use a money target, would M1 or M2 have been preferable during the 2000s? Explain your reasoning.
  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.
    1. Using the equation of exchange, compute the price level in each year.
    2. Compute the inflation rate for each year.
    3. Explain why inflation varies, even though the money supply rises by $100 each year.
    4. If the central bank wanted to keep inflation at zero, what should it have done to the money supply each year?
    5. If the central bank wanted to keep inflation at 10% each year, what money supply should it have targeted in each year?
  6. 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?
    1. 0%
    2. 1%
    3. 2%
  7. 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?
    1. 4%
    2. 5%
    3. 6%
  8. Suppose that a country whose money supply grew by about 20% a year over the long run had an annual inflation rate of about 20% and that a country whose money supply grew by about 50% a year had an annual inflation rate of about 50%. Explain this finding in terms of the equation of exchange.
  1. Speech by Alan Greenspan before the Board of Directors of the National Association of Home Builders, January 28, 1995. ↵
  2. 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. ↵

License

Icon for the Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License

Principles of Macroeconomics Copyright © 2016 by University of Minnesota is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted.

Share This Book