Federal Reserve
Monetary Policy and
the IEM
Background and Introduction
• Creation of the Federal Reserve System
• Policies of the Federal Reserve System
–Employment Act of 1946
–Humphrey-Hawkins Full Employment and Balanced
Growth Act of 1978
• Other Policy Guidelines of the Fed
–Natural Rate of Unemployment
–Moderate Inflation Rate
Employment Act of 1946
This act directed
policymakers to pursue
policies to achieve full
employment and
noninflationary growth
3
Humphrey-Hawkins
Full Employment &
Balanced Growth Act of 1978
This act required that
policymakers pursue
policies to achieve full
employment and
noninflationary economic
growth
4
Natural Rate of
Unemployment
An unemployment rate
which excludes cyclical
unemployment but includes
frictional and structural
unemployment (believed to
be about 4.5 percent)
5
Moderate Inflation
Many economists consider a rate of
inflation of about one to two percent
moderate and bearable, even though
some may prefer no inflation.
6
Macroeconomic Policy Goals
– Full Employment
– Stable Prices
– Satisfactory Balance of Payments
– Sustainable Economic Growth
7
Short Run Goals: Achieving these goals helps in
achieving the long run goal
Full
Employment
Stable
Prices
Satisfactory External Balance
compatible with full
employment and stable prices
Long Run Goal: Sustainable economic
growth determined by the growth and productivity
of labor and capital
8
Three Tools of
Monetary Policy
1. Reserve Requirement
• About 5 to 10% of
transactions accounts
• Non-interest bearing
• Seldom changed
• Set by Board of
Governors
9
Three Tools of
Monetary Policy
2. Discount Rate
• Interest rate
• Short-term (overnight)
loans
• Set by Federal Reserve
Banks / approved Board
of Governors
• Signal to markets
10
Three Tools of
Monetary Policy
3. Open Market Operations
• FOMC directive
• Affects Fed funds rate
• Purchase / sell Treasury
securities
• Federal Reserve / securities
dealers
• Implemented at Federal
Reserve Bank of New York
11
Federal Open Market
Committee (FOMC)
• Board of Governors
• Presidents of Reserve Banks
– Five presidents vote
– New York Federal
Reserve
Bank president
always votes
• Remaining presidents
alternate
voting membership
12
Concepts
–
–
–
–
–
–
Inflation
Deflation
Stagflation
Cost-Push Inflation
Demand-Pull Inflation
Stop-Go Policy Cycle
13
Inflation
A significant and persistent increase in
the price level.
14
Deflation
A drop in the overall price
level
15
Stagflation
A condition of concurrent
high unemployment
(stagnation) and inflation
16
Cost-Push Inflation
An inflation triggered by
increases in input prices
17
Demand-Pull Inflation
An inflation caused by high
levels of demand
18
Stop-Go Policy Cycle
Alternating implementation
of expansionary and
contractionary policies to
deal with downturn and
upturn in economic activities
19
Aggregate Demand
The total quantity of
commodities that are
demanded at various prices
20
Aggregate Supply
The total quantity of
commodities that are
supplied at various prices
21
Aggregate Demand and Aggregate Supply Curves
( Short-Run & Long-Run)
Price
Level
LRAS
SRAS
AD
Real GDP
22
Long-Run Aggregate Supply
Curve
The vertical line reflecting the
natural level of output that the
economy will produce in the long
run regardless of the price level.
(full employment is assumed)
23
Steady Noninflationary Growth
Price
Level
LRAS
LRAS’
•D
1.06
1.00
A
B
AD
AD'
$5,000
$5,200
Real GDP (billions)
24
Increase in price level due to increase in
aggregate demand with no Fed response
Price
Level
LRAS
SRAS'
C
SRAS
1.12
B
1.06
1.00
A
AD'
AD
$2,000 $2,400
Real GDP (billions)
25
Demand Fall-Induced Recession
Price
Level
LRAS
SRAS
SRAS'
A
1.00
.96
.92
B
C
AD'
Real GDP (in billions)
26
Phillips Curve
A curve showing an inverse
relationship between inflation
rate and unemployment rate
in the short run
27
The Phillips Curve
Inflation
O
Unemployment
28
Supply Shock
A change in technology or supply
of raw materials that shifts the
short-run aggregate supply curve
29
An Adverse Supply Shock as a Cause of Cost-Push
Inflation
LRAS
Price
Level
C
SRAS'
SRAS
B
A
AD'
AD
Real GDP
30
Accommodating Policy
Policymakers’ action to
increase aggregate
demand in response to a
negative supply shock
31