Chapter 5
Monetary Policy
Outline
Input Used to Determine Monetary Policy
Monitoring Indicators of Economic Growth
Monitoring Indicators of Inflation
Implementing a Stimulative Monetary Policy
How a Stimulative Monetary Policy Reduces Interest Rates
Implementing a Restrictive Monetary Policy
Comparing a Restrictive Versus Stimulative Monetary Policy
Tradeoff in Monetary Policy
Monitoring the Impact of Monetary Policy
Impact on Financial Markets
Global Monetary Policy
Impact of the Dollar
Transmission of Interest Rates
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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 stimulative or restrictive monetary policy.
POINT/COUNTER-POINT:
Can the Fed Prevent U.S. Recessions?
POINT: Yes. The Fed has the power to reduce market interest rates and can use such adjustments to
ANSWER: It is difficult to determine how long a recession would last if the Fed did not intervene.
However, most people (especially the unemployed) would prefer that the Fed make an effort to stimulate
the economy. There is some concern that a stimulative monetary policy may cause more inflation, but this
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?
ANSWER: The Fed’s monetary policy can affect the supply of loanable funds available in financial
2. Tradeoffs of Monetary Policy. Describe the economic tradeoff faced by the Fed in achieving its
economic goals.
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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?
ANSWER: A stimulative monetary policy may be used to stimulate the economy, especially if
4. Active Monetary Policy. Describe an active monetary policy.
ANSWER: An active monetary policy reflects actions taken by the Fed to adjust money supply in
5. Passive Monetary Policy. Describe a passive monetary policy.
6. Fed Control. Why might the Fed have difficulty in controlling the economy in the manner desired?
Be specific.
ANSWER: The Fed has difficulty in controlling the economy because it cannot always maintain
7. Lagged Effects of Monetary Policy. Compare the recognition lag and the implementation lag.
ANSWER: The recognition lag represents the time from when a problem exists until it is recognized
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)?
ANSWER: To cure inflation, the Fed may use a restrictive monetary policy, which will reduce
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9. Monitoring Money Supply. Why do financial market participants closely monitor money supply
movements?
ANSWER: Money supply movements can affect interest rates and other economic variables that
10. Monetary Policy During the Credit Crisis. Describe the Fed’s monetary policy response to the
credit crisis that began in 2008.
The Fed used a stimulative monetary policy during the credit crisis because economic conditions
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. Which factors might be considered by financial market participants who are
assessing whether an increase in money supply growth will affect inflation?
ANSWER: Any factors that could offset or magnify the impact should be considered, such as
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.
ANSWER: A change in the federal funds rate will likely cause a change in other short–term interest
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15. Monetary Policy Today. Assess the economic situation today. Is the current presidential
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.
ANSWER: This question allows students to understand how the goals of the administration and the
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.
ANSWER: Country economies have become highly integrated over time, so that one country’s
economy can affect others. Thus, a foreign country’s government policies may affect its own
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
that is intended to reduce interest rates, encourage more borrowing (and spending), and stimulate the
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
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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.
ANSWER: This question is open-ended. It requires students to apply the concepts that were presented
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?
ANSWER: The Fed would likely not change the target. It probably raised interest rates at the last
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?
ANSWER: The Fed influences interest rates, which affects the cost of borrowing, and this affects the
ability of consumers to purchase a home. If interest rates are too high, some consumers are unable to
Chapter 5: Monetary Policy ❖ 7
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.
ANSWER: Even though the federal funds rate is the interest rate that is targeted by the Fed, other
interest rates are affected as well because they are also affected by supply and demand for funds in
24. Monetary Policy During Credit Crisis. During the credit crisis of 2008, 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?
ANSWER: The Fed was successful at reducing interest rates. However, under very bad economic
conditions, many potential business projects may not be feasible even at the lower cost of borrowing,
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.
ANSWER: A credit crunch implies that banks are very careful in their credit analysis of potential
borrowers and are restricting the amount of credit they will provide. The ability of the Fed to
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 money. Even if banks are willing to lend such funds, why might such a
presumption about the willingness of firms to borrow be wrong? What are the consequences if the
presumption is wrong?
ANSWER: The presumption about firms borrowing may be wrong because in a weak economy, firms
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?
Chapter 5: Monetary Policy ❖ 8
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?
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
28. Impact of Monetary Policy on Cost of Capital Explain the effects of a stimulative monetary policy
on a firm’s cost of capital.
ANSWER: A stimulative monetary policy is normally intended to reduce interest rates. Since lower
29. Effectiveness of Monetary Policy Which circumstances might cause a stimulative monetary policy
to be ineffective?
ANSWER: The ability of the Fed to stimulate the economy is partially influenced by the willingness
of depository institutions to lend funds. Even if the Fed increases the level of bank funds during a
Chapter 5: Monetary Policy ❖ 9
CRITICAL THINKING QUESTION
Fed’s Exposure to Political Agendas. The Fed attempts to use monetary policy to control the level
of inflation and economic growth in the United States. Write a short essay on how the
government’s fiscal policy can make the Fed’s role more difficult. Specifically, assume that the
administration plans to implement a new program that will expand the government benefits
provided to most people in the country. The new program will likely increase the budget deficit.
Discuss the impact of this policy on interest rates and explain how this makes the Fed’s role
more challenging.
ANSWER
The Fed might be concerned that the government’s excessive spending will increase the budget deficit,
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.”
The Fed would like to focus on expectations of the future rather than on historical data. Gold
prices are perceived to reflect expectations of future inflation. Conversely, recent historical data
may not necessarily represent economic conditions in the future.
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
Chapter 5: Monetary Policy ❖ 10
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.
a. Given the situation, is the Fed likely to adjust monetary policy? If so, how?
The Fed would likely use a more restrictive monetary policy in order to reduce inflation. While
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?
This gives the Fed one more reason for using a more restrictive monetary policy, because it
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.
The increased borrowing by the Treasury may place upward pressure on interest rates.
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
Carson’s future performance will not be as strong as expected, because the Fed’s actions will
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?
A tight (restrictive) monetary policy could reduce economic growth, and therefore reduce the
aggregate demand for products and services. Firms like Carson Company would perform worse
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.
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