The Iowa Electronic Markets
Federal Reserve Monetary
Policy and the IEM
Test Questions:
I.
Essay Questions:
a. What is the Fed? Why does it appear to have such a great influence on the
economy?
b. What are the four tools to achieve monetary policy?
c. How does an increase in the Federal Funds Rate indicate a tighter monetary
policy?
d. How does your experience with the FedPolicy Market help you understand
the impact of economic conditions (inflation, unemployment and stock prices)
on the fluctuations and the volatility of the financial markets?
e. Discuss whether an adverse aggregate supply shock can cause inflation.
f. The economy has just experienced an n increase in aggregate demand. What
should the Fed do?
g. The economy has just experienced an n decrease in aggregate demand.
What should the Fed do?
h. Will the Fed have less power to affect the economy in the future?
i.
Is a financial crisis more likely to occur when the economy is experiencing
inflation or deflation?
j.
What are the goals of monetary policy?
Answers:
a. What is the Fed? Why does it appear to have such a great influence on
the economy?
The Fed is the central bank of the nation and it has a significant power due to
its function of implementing monetary policy. The Fed can change the
amount of liquidity in the financial system. By changing the interest rate, it can
change the amount of investment expenditures by businesses and the
consumption of consumers. These changes impact the amount of real GDP
and the price level in the economy.
b. What are the four tools to achieve monetary policy?
When the Fed sells securities (Open Market Operations), it takes
reserves (liquidity) out of the system and hence with fewer reserves in the
banks, fewer loans will be made. When the Fed decreases the Discount
Rate, the member banks can borrow more reserves from the Fed and
hence can increase credit to their customers. If the Fed increases the
Required Reserve Ratio, the banks are required to set aside more
required reserves and have less money to lend. The change in the
Federal Funds Rate as a short-term interest rate is important in changing
the ability of banks to borrow on a short-term basis.
c. How does an increase in the Federal Funds Rate indicate a tighter
monetary policy?
An increase in the targeted Federal Funds Rate is a sign of the decision of
the Fed to tighten the money supply. This is because many banks borrow
reserves from the Federal Funds Market on a short-term basis to enhance
their ability to provide more credit on a continuous basis to businesses.
d. How does your experience with the FedPolicy market help you
understand the impact of economic conditions (inflation, unemployment
and stock prices) on the fluctuations and the volatility of the financial
markets?
Comparing the Federal Funds Rate, Inflation Rate, and Unemployment
data over some period of time, one can observe that higher Federal Funds
Rates are established to either slow down the rate of the inflation or to
ease the tightness in the labor market. One of the assignments of this
class required the comparison of historical data on the unemployment rate
and the Federal Funds Rate.
e. Discuss whether an adverse aggregate supply shock can cause
inflation?
An adverse supply shock causes real output and employment to fall while
prices will rise, an accommodating policy will reduce the recession but
may aggravate the inflation. Cost-push inflation may result when the
general price level rises due to increases in the prices of inputs.
f. The economy has just experienced an increase in aggregate demand.
What should the Fed do?
An increase in aggregate demand may create demand-pull inflation and
increase in output beyond the natural level. The Fed may follow a laissezfaire policy and let the economy return to long-run equilibrium at higher
prices and the natural level of output. The Fed may also implement a
contractionary monetary policy to control increases in the price level.
Raising the Federal Funds Rate does this.
g. The economy has just experienced a decrease in aggregate demand.
What should the Fed do?
A decrease in aggregate demand may create unintended increases in
inventories. Businesses may cut production, employment, and prices,
which may lead to a recession. The Fed response depends on its current
policy objectives. It may choose to do nothing, in which case price
expectations will decrease, the price level will decrease, and the short-run
aggregate supply curve will shift to the right. Long-run equilibrium will be
achieved at the full employment output level and a lower price level. On
the other hand, if the Fed responds by expansionary monetary policy,
aggregate demand will shift to the right and the economy will return to its
pre-recession equilibrium.
h. Will the Fed have less power to affect the economy in the future?
If the share of intermediation by the banking system decreases, then the
control over the banks declines. Also global economic forces may
become stronger and hence, the Fed’s power may decline in the future.
i. Is a financial crisis more likely to occur when the economy is
experiencing inflation or deflation?
Financial crisis is defined as a critical reversal in the financial markets
reflected by sharp declines in asset prices and the default of business
firms in their financial obligations. In periods of inflation, financial crisis
could result in the Fed raising interest rates and thus restricting business
output; individuals may become less creditworthy thus bringing more risky
borrowers into the credit markets. In periods of deflation, consumers and
businesses alike would have difficulty meeting their financial obligations. If
one party defaults, this often sets off a chain reaction. The drop in
incomes, high rate of unemployment, increases in inventories, and layoffs
can also exacerbate the problem. Unanticipated declines in the overall
level of prices can intensify the risk of a financial crisis.
j. What are the goals of monetary policy?
Price stability, full employment, and satisfactory balance of payments are
the short-term goals of monetary policy. Sustainable economic growth is
the long-term goal of monetary policy.