Using the Iowa Electronic
Markets in Macroeconomics
Predicting Federal Reserve
Policy
Developed by:
Scott Simkins - North Carolina A&T State University
Vineeta Hingorani - Southern University at Baton Rouge
Jonathan Ikoba - Scott Community College
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEM
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Economic Policy and the Economy:
Policy Goals

Maintain low inflation
Maintain low unemployment rates
Promote steady economic growth
Maintain stable interest rates

How? Through monetary policy



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Economic Policy and the Economy:
Economic Growth with Low Inflation


By using its monetary policy tools, the
Federal Reserve strives to keep the
economy growing with low inflation.
To do this, it must offset “economic shocks”
that affect the economy.
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Economic Policy and the Economy:
Offsetting Shifts in AD



Event: increase in aggregate demand
Economic response
– price level rises and real GDP rises
Federal Reserve policy response:
– Raise interest rate to maintain price
stability
– Result: output back to original level, price
level remains stable
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Economic Policy and the Economy:
Offsetting Shifts in AD
1. Increase in AD
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Economic Policy and the Economy:
Offsetting Shifts in AD
1. Increase in AD
2. Federal Reserve Raises
Interest Rates
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Economic Policy and the Economy:
Offsetting Shifts in AD



Event: decrease in aggregate demand
Economic response
– price level falls and real GDP falls
Federal Reserve policy response:
– Reduce interest rate to maintain full
employment
– Result: output and price level back to
original level
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Economic Policy and the Economy:
Offsetting Shifts in AD
1. Decrease in AD
2. Federal Reserve Lowers
Interest Rates
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Economic Policy and the Economy:
Offsetting Shifts in SRAS



Event: decrease in aggregate supply
Economic response
– price level rises and real GDP falls
Federal Reserve policy response:
– Reduce interest rate to maintain full
employment
– Result: output returns to potential GDP
but price level rises further
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Economic Policy and the Economy:
Offsetting Shifts in SRAS
1. Decrease in SRAS
2. Federal Reserve lowers interest rate
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Economic Policy and the Economy:
Offsetting Shifts in SRAS



Event: decrease in aggregate supply
Economic response
– price level rises and real GDP falls
Federal Reserve policy response:
– Raise interest rate to maintain price
stability
– Result: price level returns to original level
but output falls further
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Economic Policy and the Economy:
Offsetting Shifts in SRAS
1. Decrease in SRAS
2. Federal Reserve raises interest rate
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Economic Policy and the Economy:
Self-regulating economy?



Event: increase in aggregate demand
Economic response
– price level rises and real GDP rises
Federal Reserve policy response:
– Do nothing
– Result: output returns to original level but
price level rises further
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Economic Policy and the Economy:
Self-Regulating Economy?
1. Increase in AD
2. Federal Reserve does nothing
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Economic Policy and the Economy:
Self-regulating economy?
Questions:
 What happens when AD falls and the
Federal Reserve responds by doing
nothing?
 What happens when SRAS falls and the
Federal Reserve responds by doing
nothing?
 Summary: when should the Federal Reserve
actively intervene in the economy?
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Economic Policy and the Economy:
The “New Economy”


In recent years, labor productivity has been
increasing, helping to keep inflation low and
generating economic growth.
What is the role of the Federal Reserve in
an economy experiencing significant
increases in productivity?
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Role of the Federal Reserve:
Policy Goals and Objectives




Maintain low inflation
Maintain low unemployment rates
Promote steady economic growth
Maintain stable interest rates
To meet its policy goals, the Federal
Reserve uses changes in the federal funds
rate as its primary monetary policy tool.
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Role of the Federal Reserve:
Policy Instrument: The Fed Funds Rate

The fed funds (interest) rate is determined in
the federal funds market

The Federal Reserve affects the supply of
reserves in the federal funds market through
open market operations, changes in the
discount rate, and changes in the reserve
requirement.
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Role of the Federal Reserve:
FOMC Meetings




FOMC consists of the Board of Governors of
the Federal Res. and 5 Fed. Reserve district
bank presidents
Led by Federal Reserve Chairman
(Greenspan)
Meets approximately every 6 weeks
Determines changes in monetary policy; in
particular, changes in the “target level” of the
federal funds rate.
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Role of the Federal Reserve:
Effects of Federal Reserve Policy




Changes in the fed funds rate affect a wide
variety of interest rates in the economy.
In turn, changes in interest rates affect
business and consumer spending.
Aggregate spending levels affect inflation,
unemployment, and output growth.
In addition, changes in interest rates also
affect stock market growth, which in turn can
affect consumer and business spending.
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Role of the Federal Reserve:
What can Fed Policy Do?


Some economists argue that the Fed’s goal
should simply be to keep inflation low; that in
the long run, real rather than monetary
factors, will determine output and
employment levels.
In reality, the Federal Reserve currently
looks at a wide variety of economic data
before implementing changes in monetary
policy.
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Predicting Federal Reserve Policy:
Summarizing Current Economic Conditions

Federal Reserve Beige Book
– Summary of economic conditions around the
country; published just prior to FOMC meetings
http://www.bog.frb.fed.us/FOMC/BeigeBook/2000/

Other Web sources
– The Dismal Scientist
http://www.dismal.com/
– BLS Economy at a Glance
http://stats.bls.gov/eag/eag.map.htm
– Economic Statistics Briefing Room
http://www.whitehouse.gov/fsbr/esbr.html
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Predicting Federal Reserve Policy:
Recent Federal Reserve Behavior



Main policy objective: keep inflation low
Over the past year (Aug., 1999 - August,
2000), Federal Reserve has been raising the
target fed funds rate due to concerns about
tight labor markets and future inflation.
Unemployment rate hit 30-year record low in
early 2000, productivity is increasing, and
output is rising, but inflation remains low.
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Predicting Federal Reserve Policy:
Forecasting Strategies

When predicting future Federal Reserve
policy, you must ask:
– What are the Fed’s objectives?
– What is current state of the economy?
– What must the Fed do to achieve its objectives,
given the current state of the economy?

Requires: constant monitoring of economic
activity in the economy
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Predicting Federal Reserve Policy:
An Example Using the IEM



Example: November, 1999 FedPolicy market
Daily IEM contract prices are used to illustrate the
relationship among economic conditions, Fed policy
objectives, and IEM contract prices
Contracts in this market and their associated payoff
rules are:
Contract Name
Contract Description / Liquidation Value Payoff Rules
FRup1199
FRsame1199
FRdown1199
$1.00 if the fed-funds rate target rises; $0 otherwise
$1.00 if the fed-funds rate target remains unchanged; $0 otherwise
$1.00 if the fed-funds rate target falls; $0 otherwise
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IEM FedPolicy Contract Prices - Nov. 1999
1.00
Contract Price ($)
0.80
0.60
FRup1199
0.40
0.20
FRsame1199
FRdown1199
25-Oct
26-Oct
27-Oct
28-Oct
29-Oct
30-Oct
31-Oct
1-Nov
2-Nov
3-Nov
4-Nov
5-Nov
6-Nov
7-Nov
8-Nov
9-Nov
10-Nov
11-Nov
12-Nov
13-Nov
14-Nov
15-Nov
16-Nov
0.00
Date
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IEM FedPolicy Contract Prices - Nov. 1999
1.00
Contract Price ($)
0.80
0.60
November 5
Employment Report Released Unemployment rate declines to 29year low but pressure on wages
remains tame.
The price of FRsame1199
rose with the new
economic information.
FRup1199
0.40
0.20
FRsame1199
FRdown1199
25-Oct
26-Oct
27-Oct
28-Oct
29-Oct
30-Oct
31-Oct
1-Nov
2-Nov
3-Nov
4-Nov
5-Nov
6-Nov
7-Nov
8-Nov
9-Nov
10-Nov
11-Nov
12-Nov
13-Nov
14-Nov
15-Nov
16-Nov
0.00
Date
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IEM FedPolicy Contract Prices - Nov. 1999
November 10
Producer Price Index Report
Released Overall producer prices fall by
0.1% but core rate of inflation
was up 0.3%, higher than
expected.
1.00
Contract Price ($)
0.80
0.60
FRup1199
Notice how the price of
FRsame1199 dropped with
the new economic
information.
0.40
0.20
FRsame1199
FRdown1199
25-Oct
26-Oct
27-Oct
28-Oct
29-Oct
30-Oct
31-Oct
1-Nov
2-Nov
3-Nov
4-Nov
5-Nov
6-Nov
7-Nov
8-Nov
9-Nov
10-Nov
11-Nov
12-Nov
13-Nov
14-Nov
15-Nov
16-Nov
0.00
Date
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IEM FedPolicy Contract Prices - Nov. 1999
1.00
Contract Price ($)
0.80
0.60
FRup1199
The FRsame1199 and FRup1199 contracts
remained near $.50 until the FOMC announced
its rate hike on Nov. 16
0.40
0.20
November 12
Mixed economic signals
makes predicting Fed
policy at upcoming FOMC
meeting a "tough call"
FRsame1199
FRdown1199
25-Oct
26-Oct
27-Oct
28-Oct
29-Oct
30-Oct
31-Oct
1-Nov
2-Nov
3-Nov
4-Nov
5-Nov
6-Nov
7-Nov
8-Nov
9-Nov
10-Nov
11-Nov
12-Nov
13-Nov
14-Nov
15-Nov
16-Nov
0.00
Date
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IEM FedPolicy Contract Prices - Nov. 1999
1.00
Contract Price ($)
0.80
0.60
November 5
Employment Report Released Unemployment rate declines to 29year low but pressure on wages
remains tame.
November 10
Producer Price Index Report
Released Overall producer prices fall by
0.1% but core rate of inflation
was up 0.3%, higher than
expected.
FRup1199
0.40
FRsame1199
November 12
Mixed economic signals
makes predicting Fed
policy at upcoming FOMC
meeting a "tough call"
25-Oct
26-Oct
27-Oct
28-Oct
29-Oct
30-Oct
31-Oct
1-Nov
2-Nov
3-Nov
4-Nov
5-Nov
6-Nov
7-Nov
8-Nov
9-Nov
10-Nov
11-Nov
12-Nov
13-Nov
14-Nov
15-Nov
16-Nov
0.20
IEM contract
prices respond as
FRdown1199
new economic information is
0.00
released. The contract prices
reflect the probability that the
Fed will change its policy
stance at the specified FOMC
Date
FALL
2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEM
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Predicting Federal Reserve Policy:
Summary

The FOMC uses changes in the federal
funds target rate to promote its policy goals
of low inflation, high employment, and
steady economic growth.

Accurately predicting Federal Reserve policy
changes requires (1) understanding Fed
monetary policy objectives, and (2) keeping
abreast of current economic conditions.
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Predicting Federal Reserve Policy:
Summary - continued

Contract prices in the IEM FedPolicy market
react quickly to new information about the
state of the economy.
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