Mechanics of Monetary Policy
Monitoring Indicators of Economic Growth
Gross domestic product (GDP) measures total value of goods and services produced during a specific period, is measured each month.
Most direct indicator of economic growth
High production indicates strong economic growth and can result in an increased demand for labor (lower unemployment)
National income- total income earned by firms and individual employees
Unemployment rate
Measures only the number and not the type of jobs that are being filled
i.e. new, low paying jobs may have a substantial reduction in unemployment during a period of weak economic growth
Does not necessarily indicate the degree of economic growth
Index of Leading Economic Indicators
Published by Conference Board
Independent, not for profit, membership organization whose stated goal is to create and disseminate knowledge about management and the marketplace to help businesses strengthen their performance and better serve society
Conducts research, convenes conferences, makes forecasts, assess trends, and publishes information and analyses
Leading economic indicators are used to predict future economic activity
Three consecutive monthly changes in the same direction suggest turning point
Coincident economic indicators tend to reach their peaks and troughs at the same time as business cycles
Lagging economic indicators tend to rise or fall a few months after business cycles
Look at pg. 98
Monitoring Indicators of Inflation
Producer and consumer price index
Producer price index
Prices at wholesale level
Consumer price index
Prices at retail (paid by the consumer)
Lag time of 1 month after period being measured
Due to time required to compile price information for the indexes
Other inflation indicators
Wage rates
Oil prices
Price of gold
Sometimes indicators of economic growth are used to indicate inflation
Demand pull inflation- when excessive spending pulls up prices
Investors anticipate that the Fed will have to increase interest rates in order to reduce the inflationary momentum
Implementing the proper monetary policy
Demand curve is downward sloping because many potential borrowers would borrow a larger quantity of funds at lower interest rates
Supply curve of loanable funds is upward sloping because suppliers of funds tend to supply a larger amount of funds when the interest rate is higher.
Correcting a weak economy
FOMC may decide that a stimulative monetary policy should be implemented to increase the level of spending by households and businesses.
Open market operations to increase the money supply
Intended to reduce interest rates and encourage more borrowing and spending
Fed buys securities
Correcting high inflation
FOMC can implement a restrictive (tight money) policy by using open market operations to reduce money supply growth
Fed can sell some of its holdings of treasury securities in the secondary market
Setting a target for the federal funds rate
Fed focuses its control over the federal funds rate; this is the interest rate at which depository institutions lend to each other for very short-term periods (one day)
Directly affected by changes to supply or money in the banking system
Limitations of Monetary Policy
Impact of a credit crunch
When banks do not lend out additional funds even when they have a surplus
Economy will not stimulated
Lagged effects of monetary policy
Recognition lag- time between when problem arises and the time it is recognized
Implementation lag- lag from the time a serious problem is recognized until the time the Fed implements a policy to resolve the problem
Impact lag- until the policy has its full impact on the economy
Impact of a stimulative policy on expected inflation
When a stimulative monetary policy is used, the effect of an increase in money supply growth may be disrupted owing to an increase in inflationary expectations
Theory of rational expectations
An increase