Monetary policy is an important tool used by the Federal Reserve Open Market Committee to control inflation and unemployment rates in the economy. However, there is disagreement over the extent to which monetary policy can be used to bring the economy back to equilibrium following a supply or demand shock. In Business Week, Joshua Zumbrun, Aki Ito, and Catarina Saraiva discuss the Federal Reserve’s recent decision to cautiously adjust monetary policy by gradually reducing open market operations on a trial basis. This action is significant because it serves to both highlight and challenge the important role that monetary policy plays in stimulating aggregate demand, boosting GDP, and reducing unemployment.
This case study pertains to a Business Week article published May 1, 2013, on Ben Bernanke’s recent decision to reduce the Federal Reserve’s purchase of bonds during the fourth quarter from the amount of $85 billion dollars to $50 billion dollars (Zumbrun, Ito, and Saraiva). The rationale behind this strategy is that the Federal Reserve would like to signal that the economy is heading towards recovery, yet it is reluctant to trigger higher inflation rates by reducing its purchasing activities too drastically (Zumbrun et al.). If this policy is successful, the Federal Reserve plans to make an additional cut of $30 billion (Zumbrum et al.). This move is significant because it marks the first time that the Federal Reserve has engaged in a conditional reduction open market operations so that it can assess the impact of its operations (Zumbrum et al.). Economic analysts have mixed assessments on the merits of Bernanke’s decisions.
The main criticism is that the Federal Reserve’s prediction of recovery is premature. As a May 3 jobs report released by the labor department revealed, there was little change in unemployment from the previous month, and the rate was stagnant at 7.6 percent (Zumbrum et al.). While Department statistics establish that 148,000 jobs were added to the economy, an independent study determines that private employers only added 119,000 jobs to the economy since September (Zumbrum et al.). Further, the Institute for Supply Management reported that the factory index fell to 50.7 in April from a previous figure of 51.3, with 50 being the base for determining contraction (Zumbrum et al.). Additionally, critics note that the proposed reductions that the Federal Reserve wished to make will have little impact on the economy overall (Zumbrum et al.). In order to assess these criticisms, it is important to understand the role that monetary policy plays in influencing both the aggregate money supply and unemployment.
As David Gordon notes, there are several tools that the Federal Reserve can use to influence the economy. These tools are collectively referred to as monetary policy and consist of measures taken by the Federal Reserve to target the aggregate money supply or interest rates. First, the Federal Reserve can use the discount rate, which is the interest rate that it charges banks to borrow funds (Gordon 533). However, as Gordon notes, this is a minor tool that is rarely used to impact the amount of currency in circulation (533). Second, the Federal Reserve can require reserve ratios to contract or expand the money supply by adjusting the percentage of reserve currency that financial institutions are required to keep (535). However, Gordon also notes that this tool has not been in use since the 1990s because financial institutions have largely been conservative in their lending practices (535). Thus, there is less of a need to actively regulate the reserves-ratios kept by banks.
Of the policy tools available, open market operations are the most significant. As Gordon notes, open market operations are conducted by the Federal Open Markets Committee (FOMC), which meets every six weeks in order to determine what operations it should take for the following six-week period (535). While the FOMC can also set the federal funds rate in order to influence the money supply, it primarily relies on open market operations to influence the aggregate money supply (535). By selling and purchasing United States Treasury securities, the FOMC can determine how much money is introduced to or subtracted from the economy (535). When the FOMC makes an open market purchase to buy bonds from the general public, it increases the money supply as it exchanges securities for money (535). However, when the FOMC sells bonds, it decreases the money supply and it causes a contraction in the aggregate supply as the public transfers money to the Federal Reserve in exchange for securities (535). When conducted in the correct manner, monetary policy should have the effect of stabilizing inflation and keeping unemployment rates stable (Svensson 293). Thus, economists are particularly interested in the decisions that the FOMC makes at its regular meetings.
There is one final policy option that the FOMC has at its disposal that is worth noting. In 2006, the Financial Services Regulatory Relief Act enables the Federal Reserve to pay financial institutions interest rates on demand deposits (536). The benefit of this action is that it enables the Federal Reserve to pay a higher interest rate on deposits than the rates for securities at low risk to the financial institutions (536). It is believed that this option could become a powerful tool because it provides a greater incentive for financial institutions to increase their deposits, which will help contract the money supply (536). This option is noteworthy because it presents a strong alternative to open market operations.
One criticism of monetary policy that should be noted is that many speculate that non-monetary explanations can cause economic trends. For example, former FOMC chairman Arthur Burns noted that inflation during the 1970s was caused by the high unemployment rates and could not be offset by monetary policy tools (Hetzel 274). Further, Alan Greenspan asserted that increased political support for price stability, globalization, and drastic increases in productivity are the factors that contributed to overall stability while he was chairman of the Federal Reserve (274). Additionally, economist Charles Evans asserts that high productivity and factors that prevent job mobility offer alternative explanations to economic growth or stagnation (Evans 155). As these factors reveal, there are limitations to the efficacy of monetary policy in impacting the economy that must be taken into consideration.
In order to assess the efficacy of monetary policy, it is important to understand how the aggregate demand curve and aggregate supply curve work. According to economists Paul Krugman and Robin Weils, “the aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, firms, the government, and the rest of the world” (316). The aggregate price level is located on the vertical axis of the curve while real GDP is located on the horizontal access (316). Further, there is a negative relationship between price levels and GDP; as the price levels increase, GDP decreases (316). As the economists explain, when the Federal Reserve engages in open market operations, it influences the price levels by increasing or decreasing the amount of money that is available to spend. Through this model, it can be seen that Bernanke’s plan to gradually decrease the purchase of bonds would also lead to a gradual decrease of money that is being infused into the economy, which would, in turn, lead an increase in the aggregate price level and decrease real GDP. Because of the risk of raising the price levels when the economy is already lagging, Bernanke’s plan to gradually increase GDP is well advised.
The second framework for evaluating the Federal Reserve’s policy is the aggregate supply curve. As Kruger and Weils note, the aggregate supply curve demonstrates “the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy” (324). As the economists note, the economy is considered to be in equilibrium when the aggregate supply is equal to aggregate demand (334). While aggressive monetary policy through open market buying might help alleviate demand shocks by expanding the aggregate money supply, which in turn can increase demand, it also presents the risk of causing inflation if demand outstrips supply. Thus, it is advisable for the Federal Reserve to begin the process of slowly reducing its open market purchases. Yet conversely, if the money supply decreases drastically, it poses the risk of causing interest rates to rise, which will accelerate the contraction of the money supply and cause demand to lag behind supply. Because supply shocks more difficult to remedy, it is also advisable for the Federal Reserve to slowly cut back its open market operations rather than make the reductions at once.
There are other considerations that support the Federal Reserve’s caution in altering its open operations policies. First, as was previously discussed, the impact of monetary policy is not always predictable. Other variables that extend outside of monetary policy operations can explain contractions and expansions in the economy. Thus, it is beneficial for the Federal Reserve to make modest cuts in its purchasing activities. Second, if the amount by which the Federal Reserve opts to decrease the money supply is not enough, it has the option of imposing interest rates on demand deposits, a newer tool that can have more significant effects on the economy overall. Thus, Bernanke’s decision to conditionally cut back the purchase of bonds is a sound use of monetary policy that can serve to boost security in the economy while making adjustments in supply that are needed to prevent long-term inflation.
Evans, Charles L. "Labor Markets and Monetary Policy." Business Economics 45.3 (2010): 152-7. ProQuest. Web. 22 Nov. 2013.
Gordon, David. "The Federal Reserve Bank's New Monetary Policy Tool." Journal of Business & Economics Research (Online) 10.9 (2012): 533. ProQuest. Web. 22 Nov. 2013.
Krugman, Paul, and Robin Wells. Microeconomics. 2nd ed. New York: Worth Publishers, 2009.
Svensson, Lars E. O., Randall S. Kroszner, and David Wessel. "Practical Monetary Policy: Examples from Sweden and the United States/Comments and Discussion." Brookings Papers on Economic Activity (2011): 289-352. ProQuest. Web. 22 Nov. 2013.
Zumbrun, Joshua, Aki Ito, and Catarina Saraiva. “Fed Seen Slowing Stimulus with QE Cut by End of this Year.” Business Week. 01 May 2013. Web. 22 Nov. 2013.