Chapter 5
Monetary Policy
Outline
Mechanics of Monetary Policy
Monitoring Indicators of Economic Growth
Monitoring Indicators of Inflation
Implementing Monetary Policy
Effects of a Stimulative Monetary Policy
Fed’s Focus on Long–term Debt Maturities
Why a Stimulative Monetary Policy Might Fail
Effects of Restrictive Monetary Policy
Summary of Monetary Policy Effects
Tradeoff in Monetary Policy
Impact of Other Forces on the Tradeoff
Shifts in Monetary Policy over Time
How Monetary Policy Responds to Fiscal Policy
Proposals to Focus on Inflation
Impact of Monetary Policy
Impact on Financial Markets
Impact on Financial Institutions
Global Monetary Policy
Impact of the Dollar
Impact of Global Economic Conditions
Transmission of Interest Rates
Impact of the Greece Crisis on European Monetary Policy
Chapter 5: Monetary Policy ❖ 2
Key Concepts
1. Describe the common monetary policy used to correct a weak economy or high inflation.
2. Explain the tradeoff involved in the Fed’s use of a loose or tight monetary policy.
3. Explain how financial market participants would react to a particular monetary policy.
4. Explain how fiscal policy may influence the monetary policy.
POINT/COUNTER-POINT:
Can the Fed Prevent U.S. Recessions?
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own
opinion.
is a risk that the Fed must take in order to cure a recession.
Questions
1. Impact of Monetary Policy. How does the Fed’s monetary policy affect economic conditions?
2. Tradeoffs of Monetary Policy. Describe the economic tradeoff faced by the Fed in achieving its
economic goals.
3. Choice of Monetary Policy. When does the Fed use a stimulative monetary policy and when does it
use a restrictive-monetary policy? What is a criticism of a stimulative monetary policy? What is the
risk of using a monetary policy that is too restrictive?
4. Active Monetary Policy. Describe an active monetary policy.
5. Passive Monetary Policy. Describe a passive monetary policy.
6. Fed Control. Why may the Fed have difficulty in controlling the economy in the manner desired? Be
specific.
7. Lagged Effects of Monetary Policy. Compare the recognition lag and the implementation lag.
8. Fed’s Control of Inflation. Assume that the Fed’s primary goal is to reduce inflation. How can it
achieve its goal? What is a possible adverse effect of such action by the Fed (even if it achieves this
goal)?
9. Monitoring Money Supply. Why do financial market participants closely monitor money supply
movements?
10. Monetary Policy During the Credit Crisis. Describe the Fed’s monetary policy response to the
credit crisis.
11. Impact of Money Supply Growth. Explain why an increase in the money supply can affect interest
rates in different ways. Include the potential impact of the money supply on the supply of and the
demand for loanable funds when answering this question.
12. Confounding Effects. What other factors might be considered by financial market participants who
are assessing whether an increase in money supply growth will affect inflation?
13. Fed Response to Fiscal Policy. Explain how the Fed’s monetary policy could depend on the fiscal
policy that is implemented. [
Advanced Questions
14. Interpreting the Fed’s Monetary Policy. When the Fed increases money supply to lower the federal
funds rate, do you think this will the cost of capital of U.S. companies be reduced? Explain how the
segmented markets theory regarding the term structure of interest rates (as explained in Chapter 3)
could influence the degree to which the Fed’s monetary policy affects long-term interest rates.
15. Monetary Policy Today. Assess the economic situation today. Is the administration more concerned
with reducing unemployment or inflation? Does the Fed have a similar opinion? If not, is the
administration publicly criticizing the Fed? Is the Fed publicly criticizing the administration? Explain.
16. Impact of Foreign Policies. Why might a foreign government’s policies be closely monitored by
investors in other countries, even if the investors plan no investments in that country? Explain how
monetary policy in one country can affect interest rates in other countries.
17. Monetary Policy During a War. Consider a discussion during FOMC meetings in which there is a
weak economy and a war, with potential major damage to oil wells. Explain why this possible effect
would have received much attention at the FOMC meetings. If this situation was perceived to be
highly likely at the time of the meetings, explain how it may have complicated the decision about
monetary policy at that time. Given the conditions stated in this question, would you suggest that the
Fed use a restrictive monetary policy, or a stimulative monetary policy? Support your decision
logically, and acknowledge any adverse effects of your decision.
ANSWER: Normally a weak economy will cause FOMC members to push for a loose money policy
18. Economic Indicators. Stock market conditions serve as a leading economic indicator. Assuming the
U.S. economy is in a recession, what are the implications of this indicator? Why might this indicator
be inaccurate?
ANSWER: If stock prices are a leading economic indicator, then the stock market will move up
19. How the Fed Should Respond to Prevailing Conditions. Consider the existing economic
conditions, including inflation and economic growth. Do you think the Fed should increase interest
rates, reduce interest rates, or leave interest rates at their present levels? Offer some logic to support
your answer.
20. Impact of Inflation Targeting by the Fed. Assume that the Fed adopts an inflation-targeting
strategy. If oil prices rise abruptly by 15 percent in response to an oil shortage, describe how the
Fed’s monetary policy would be affected by this situation. Do you think the inflation-targeting
strategy would be more or less effective in this case than if the Fed balances its inflation concerns
with unemployment concerns? Explain.
ANSWER: If the Fed uses an inflation targeting strategy, it will need to use a tight (restrictive)
21. Predicting the Fed’s Actions. Assume the following conditions. The last time the FOMC met, it
decided to raise interest rates. At that time economic growth was very strong, and inflation was
relatively high. Since the last meeting, economic growth has weakened, and the unemployment rate
will likely rise by one percentage point over the quarter. The FOMC’s next meeting is tomorrow. Do
you think the FOMC will revise its targeted federal funds rate? If so, how?
22. The Fed’s Impact on the Housing Market. In periods when home prices declined substantially,
some homeowners blamed the Fed. In other periods when home prices increased, homeowners gave
credit to the Fed. How can the Fed have such a large impact on home prices? How could news of a
substantial increase in the general inflation level affect the Fed’s monetary policy and thereby affect
home prices?
23. Targeted Federal Funds Rate. The Fed uses a targeted federal funds rate when implementing
monetary policy. However, the Fed’s main purpose in its monetary policy is typically to have an
impact on the aggregate demand for products and services. Reconcile the Fed’s targeted federal funds
rate with its goal of having an impact on the overall economy.
24. Monetary Policy During Credit Crisis. During the credit crisis, the Fed used a stimulative monetary
policy. Why do you think the total amount of loans to households and businesses did not increase as
much as the Fed had hoped? Are the lending institutions to blame for the relatively small increase in
the total amount of loans extended to households and businesses?
25. Stimulative Monetary Policy During a Credit Crunch. Explain why a stimulative
monetary policy might not be effective during a weak economy in which there is a credit crunch.
26. Response of Firms to a Stimulative Monetary Policy In a weak economy, the Fed commonly
implements a stimulative monetary policy to lower interest rates, and presumes that firms will be
more willing to borrow. Even if banks are willing to lend, why might such a presumption about the
willingness of firms to borrow be wrong? What are the consequences if the presumption is wrong?
27. Fed Policy Focused on Long-term Interest Rates Why might the Fed want to focus its efforts on
reducing long-term interest rates rather than short-term interest rates during a weak economy?
Explain how it might use a monetary policy focused on influencing long-term interest rates. Why
might such a policy also affect short-term interest rates in the same direction?
Chapter 5: Monetary Policy ❖ 8
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ANSWER: Firms incur a cost of debt that is highly influenced by the long-term Treasury rates, not
the short-term Treasury rates. If the Fed wants to encourage them to borrow more funds, it may want
to focus on lowering long-term interest rates.
To achieve this goal, it may need to use a stimulative policy that is focused on reducing the long-term
Treasury yields. The long-term loan rates are based on the long-term Treasury rate plus a risk
premium.
Money flows between short-term and long-term Treasury markets, which means that it is difficult for
the Fed to have one type of impact in the long-term market that is different than the short-term
market.
28. Impact of Monetary Policy on Cost of Capital Explain the effects of a stimulative monetary policy
on a firm’s cost of capital.
29. Effectiveness of Monetary Policy What circumstances might cause a stimulative monetary policy to
be ineffective?
30. Impact of ECB Response to Greece Crisis How did the debt repayment problems in Greece affect
creditors from other countries in Europe? How did the ECB’s stimulative monetary policy affect the
Greek crisis?
Chapter 5: Monetary Policy ❖ 9
CRITICAL THINKING QUESTION
Fed’s Role Prior to Credit Crisis. The Fed attempts to use monetary policy to control the level of
inflation and economic growth in the U.S. Write a short essay on the Fed’s role during the housing bubble
that occurred in the 2004-2006 period just before the credit crisis. Do you think the Fed could have
controlled housing prices in some way that would have prevented the housing bubble and the credit
crisis? In your essay, offer your insight on the underlying reason for the abrupt increase in home prices in
the 2004-2006 period.
ANSWER
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “Lately, the Fed’s policies are driven by gold prices and other indicators of the future rather than
by recent economic data.”
b. “The Fed cannot boost money growth at this time because of the weak dollar.”
c. “The Fed’s fine-tuning may distort the economic picture.”
Managing in Financial Markets
As a manager of a firm, you are concerned about a potential increase in interest rates, which would reduce
the demand for your firm’s products. The Fed is scheduled to meet in one week to assess the economic
conditions and set monetary policy. Economic growth has been high, but inflation has also increased from
3 percent to 5 percent (annualized) over the last four months. The level of unemployment is so low so that
it cannot possibly go much lower.
Chapter 5: Monetary Policy ❖ 10
a. Given the situation, is the Fed likely to adjust monetary policy? If so, how?
b. Recently, the Fed has allowed the money supply to expand beyond its long-term target range.
Does this affect your expectation of what the Fed will decide at its upcoming meeting?
c. Suppose that the Fed has just learned that the Treasury will need to borrow a larger amount of
funds than originally expected. Explain how this information may affect the degree to which the
Fed changes the monetary policy.
Flow of Funds Exercise
Anticipating Fed Actions
Recall that Carson Company has obtained substantial loans from finance companies and commercial
banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months.
Because of its expectations of a strong U.S. economy, Carson plans to grow in the future by expanding its
business and through acquisitions. It expects that it will need substantial long-term financing and plans to
borrow additional funds either through loans or by issuing bonds. The company also considers issuing
stock to raise funds in the next year.
An economic report recently highlighted the strong growth in the economy, which has led to nearly full
employment. In addition, the report estimated that the annualized inflation rate increased to 5 percent, up
from 2 percent last month. The factors that caused the higher inflation (shortages of products and
shortages of labor) are expected to continue.
a. How will the Fed’s monetary policy change based on the report?
b. How will the likely change in the Fed’s monetary policy affect Carson’s future performance?
Could it affect Carson’s plans for future expansion?
Chapter 5: Monetary Policy ❖ 11
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Carson’s future performance will not be as strong as expected, because the Fed’s actions will
likely result in higher interest rates, which will increase the cost of borrowing. In addition, the
Fed’s actions will slow economic growth, which could reduce the demand for Carson’s products,
and will reduce Carson’s sales.
If higher interest rates occur and slow down economic growth, Carson may not expand as much
as it had planned because the demand for its products could be less than what it had expected.
c. Explain how a tight monetary policy could affect the amount of funds borrowed at financial
institutions by deficit units such as Carson Company. How might it affect the credit risk of these
deficit units? How might it affect the performance of financial institutions that provide credit to
such deficit units as Carson Company?
Solution to Integrative Problem for Part 2
Fed Watching
1. There is no perfect answer to this question, but some factors deserve to be considered. The Fed may
prefer to stimulate the economy, but the dilemma involves inflationary pressure. At the present time,
the economy is almost at full employment, even though the GDP has declined slightly in the last two
quarters. Inflation is assumed to be 5 percent prior to the expectation of a large increase in oil prices.
Therefore, the expected inflation will now exceed 5 percent. The past inflation occurred in the
presence of a strong dollar. If the dollar weakens at all (which could happen if U.S. oil prices rise),
there would be additional pressure on U.S. inflation. Overall, there would be much concern that
stimulating the economy could cause further inflationary pressure. While the Fed does not necessarily
desire a decline in GDP, it may not be as concerned about that as inflation. Thus, the Fed is not likely
to use a stimulative policy yet. If economic conditions get worse, it may need to reconsider.
2. If the Fed does not stimulate the economy, the economy will decline further, which would normally
reduce interest rates. It was assumed that changes in economic growth tend to have a greater impact
on interest rates than the impact of inflation. Thus, the upward pressure of increased inflationary
expectations on interest rates should be offset by the downward pressure caused by a slow economy.
Overall, there does not seem to be any urgency to dump bonds.
The future values of stocks may be dependent on whether the Fed uses a stimulative monetary policy.
Following the logic of the answer to the preceding question, the Fed is not likely to use a monetary
policy. Based on this logic, there is no reason to switch to stocks.