Quiz 14: Monetary Policy


It is rightly said that unemployment is a more serious problem than inflation and it should be the focus of the Feds monetary policy. This is because unemployment in the economy slows down the real GDP of the economy. Therefore, appropriate steps should be undertaken by the Fed to correct the economy and to restore it to the level of full employment. By keeping the growth rate of the quantity of money in line with the growth rate of potential GDP, the Fed is expected to able to maintain full employment and keep the price level stable. Price stability is the key goal of Fed. It is the source of maximum employment and moderate long term interest rates. Price stability provides the best available environment for households, firms to make the saving, and investment decisions that bring economic growth. Thus, encourages the maximum sustainable growth rate of potential GDP. Price stability delivers moderate long term interest rates because the nominal interest rate reflects the inflation rate. The nominal interest rate equals the real interest rate plus the inflation rate. With stable prices, the nominal interest rate is close to the real interest rate and most of the time this rate is likely to be moderate. In the short run, the Fed faces a trade-off between inflation and interest rates and between inflation and real GDP, employment, and unemployment. Taking an action that is designed to lower the inflation rate and achieve stable prices might mean raising interest rates, which lowers employment and real GDP and increases the unemployment rate in the short run.

The Federal Reserve act makes the Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) responsible for the conduct of the monetary policy. The FOMC makes a monetary policy decision at eight scheduled meetings each year and communicates its decision with a brief explanation. Three weeks after an FOMC meeting the full minutes are published. Congress plays no role in making monetary policy decisions but the Federal Reserve act requires the Board of Governors to report on monetary policy to Congress. The Fed makes two reports each year, one in February and another in July. These reports and the Fed chairman's testimony before Congress along with the minutes of the FOMC communicate the Feds thinking on monetary policy to lawmakers and the public. The formal role of the President of the US is limited to appointing the members and the Chairman of the Board of Governors.

(a) Under the Federal Reserve Act, 2000, Fed was provided with the control to regulate the quantity of money supply in the economy such that in the long term, the employment level in the economy is maximized at stable prices. Fed has the responsibility to ensure that the long-run growth of the money supply in the economy remains aligned with the economy's long run potential of growth. In order to realize this responsibility, Fed shall raise interest rate to lower the inflation rate and lowers the interest rate to ensure that the economy grows out of recession. The Federal Reserve Act, 2000 provides such over-riding authority to base on the principle of Quantitative theory of money that states that when growth of money supply is kept in line with the growth of potential GDP, the full-employment level at price stability can be ensured in the economy. (b) Under the "Quantitative Easing" stance, Fed led to an increase of monetary base to an extent of trillions of dollars so as to ensure banks could increase the money supply in the economy to propel the investment and consumption demand in the economy that could revive the economy from the Global Financial crisis driven recession in US economy. Such aggressive stance of Fed is doubted to be a deliberate attempt where Fed were reckless to increase money supply without looking into the spiral effects that it could bring in some other macroeconomic variables without bringing a significant revival of the economy in terms of growth rate and employment level. At the fall of Q2, 2012 the economic growth remained at meager 1.5% with the consumption expenditure growth in the range of 1-2% only. The unemployment rate remained beyond the tolerable limit. Fed was doubted to have ignored the mandate of Federal Reserve Act of 2000. However, the massive increase in the monetary base by Fed resulting from "Quantitative easing" is reconciled with the Federal Reserve Act of 2000. Under this act, Fed enjoys an over-riding power to influence monetary and credit conditions to maximize employment, while ensuring stable prices and moderate long-term interest rates. Under this act, the Fed has also the freedom to use the traditional tools or specific new tools to deal with situation of immediate concern of the economy. Keeping alignment with the objective of monetary policy, the objective of "Quantitative Easing" was to ensure optimal employment with stable prices. Given the federal fund rate at near zero level and stable prices, raising employment level were at the priority of the Fed. It decided to lower down the gap between the short-term and long-term interest rate by deciding to finance buying of long term securities by selling securities of less than 3 years of maturity without any printing of the new money which is supposed to have inflationary impact. Fed also decided to not print new money as it would have eliminated any scope to maneuver federal fund rate as a part of future course of action. Federal fund rate at near zero level was already unable to propel investment demand in the economy. "Quantitative Easing" was expected to provide a boost to the long term investment demand in the economy and simultaneously increase the confidence of the households and the business, thereby stimulating the forces for speedy real GDP growth and lower unemployment. Thus, an attempt of Fed at "Quantitative Easing" was not in conflict with Federal Reserve Act, 2000 mandate for Fed.