Monetary Policy Mid-term

Continued tensions between the U.S. and Iran threaten to cause oil prices to increase further. How would an increase in oil prices affect the U.S. economy and what are the implications for monetary policy?

-Oil is an input for a vast number of goods that we consume everyday. An increase in oil prices forces business to reduce their supply as they compensate for higher production costs. -Given the IS-AS model, the effect of this is a upward shift of the AS curve where inflation is now higher and GDP is now lower. -The Fed will directly combat rising inflation by increasing the federal funds rate which reduces aggregate demand to bring inflation back to its original level.

According to Eggertsson and Woodford, what is the optimal monetary policy for a central bank to follow when the zero bound is a possibility? How does this policy differ from the Taylor rule?

-Optimal monetary policy should involve a commitment to a detailed course of action in regard to interest rates (like committing to keep them low for a specific amount of time) and inflation targeting such that expectations are grounded at some level. -Eggertson and Woodford also contend that quantitative easing (expanding the monetary base) does almost nothing to effect inflation. -The Taylor Rule only takes real-time data into account and does not deal with future expectations.

Output Gap and implications for monetary policy

-Output Gap=Actual GDP-Potential GDP -Potential GDP=level of GDP that occrurs when the economy is operating at full employment -Output gap can be used to determine if the Fed is fighting a recessionary gap or an inflationary gap and thus it can base its decisions about the federal funds rate on these gaps

How are economies in large countries other than the U.S. doing currently? Be as specific as you can

-Overall, the global economy is suffering from the looming trade war between China and the US and rising oil prices. The main consequence is that GDP growth in big economies is sluggish. -China: facing potentially very harmful trade war. GDP growth has fallen from 7.4% to 6.2% in the last 5 years. -Japan: slow growth with an average of .18% in last 6Q's. Posted negative growth in the last 6Q's twice. The Yen has steadily appreciated in recent years making Japanese goods less competitive in international markets. -Germany: relies heavily on exports, reduced demand for German cars has hampered GDP growth. The country has a high saving rate which implies lower levels of consumption and thus weaker contribution to GDP. Germany posted negative GDP growth in the most recent quarter at -.1% and the public is fearful of another negative quarter to follow = indicator of recession

Nearly eight years since the end of the recession, yet the expansion is slow. Why?

-Population growth is low and retirements are growing so workforce growth is weak -Productivity has increased at a slower rate than before the recession -Inflation is currently below its target rate as the Fed has tightened its policy since 2014

Referring to the New Keynesian IS curve or the term structure of interest rates, explain why monetary policy makers can stimulate output today by promising low interest rates in the future.

-Promising low interest rates in the future grounds expectations about interest rates and inflation rates and gives people the confidence to borrow money today and financial markets will be more likely to operate smoothly. -In the New Keynesian IS curve, promising low interest rates in the future will increase demand in the goods market and output in the short-term.

how can fed stimulate economy at the zero lower bound

-Quantitative easing

How would higher interest rates affect the Fed's holdings on Treasury bonds and MBS's?

-Risk of defaults would rise so the Fed would be at greater risk of incurring losses -The yield on Treasury bonds would increase, reducing the demand for Treasury bonds -The Fed can directly impact interest rates however, so it can mitigate potential losses

What is secular stagnation? What challenges does it pose for monetary policy?

-Secular stagnation is a condition when there is little economic growth in a market-based economy because the economy suffers from a chronic lack of demand. -In a healthy economy, when saving is greater than investment, interest rates fall and eventually saving equals investment. In an economy with secular stagnation, interest rates may be required to be negative in order to bring saving and investment back into equilibrium.

Two features of the structure of the Fed that are intended to guarantee its independence from the government:

-The Fed can implement policies that do not need approval from the President -The Fed's board of governors are appointed to 14 year terms that do not coincide with presidential terms

Why did the Federal Reserve not raise interest rates more rapidly during the housing bubble in the 2000's? Should it have?

-The Fed was attempting to stimulate the economy with low interest rates after the dotcom bubble burst in 2000 started a mild recession and the Fed only started raising the federal funds rate in 2004 -The government enacted a series of policies designed to promote home ownership and strict lending requirements were abandoned -The Fed simply did not detect such a massive failure in the housing and mortgage markets -If it has raised interest rates more rapidly before the bubble burst, it might have burst the bubble itself -Even with higher interest rates in place before the start of the housing bubble, the lack of regulation in the mortgage market and presence of moral hazards still could have made the bubble possible

What has the People's Bank of China been doing to the value of the yuan in the last couple of months, and why?

-The People's Bank of China has been depreciating the Yuan recently as a countermeasure for the effects of the trade war with the US. -By depreciating the Yuan, chinese goods will be cheaper for foreigners to buy which means chinese goods will remain relatively competitive in international markets, reducing the negative effects of a trade war.

List three things that make it inherently difficult for the Fed to consistently hit its targets for output and inflation:

-The US president may have different goals and promise different outcomes to the public than what the Fed intends and the Fed may choose to comply even if it doing so does not coincide with their current economic assessment -Poor choices by the public, including banks, can create unpredictable circumstances in the economy and make it difficult for the Fed to have perfect information when it acts -The Fed cannot control foreign economies and when foreign economies are struggling, US trade is directly affected and so is GDP

The U.S. had a current account deficit of $450 billion in 2017. Is this a problem? How has monetary policy affected the current account deficit in recent years?

-The largest implication of a growing CA deficit is that the debt within the deficit will eventually equal the value of an economy's GDP. -Since 2014, the Fed has steadily increased interest rates which appreciated the dollar, driving the CA into a further deficit -However, the US trade deficit (largest component of CA) has remained steady over recent years and the Fed recently reduced interest rates which will depreciate the dollar.

According to the CBO, the U.S. budget deficit increased from $666 billion in 2017 to $782 billion in 2018. Why? Should the increasing budget deficit affect monetary policy?

-The main reason is Trump's implementation of corporate tax cuts which directly reduces the funding that the government receives and thus increase the budget deficit. -Lower taxes encourage more investment, leading to increased aggregate demand which raises inflation. -Although deficits are typically a fiscal issue, for the Fed, this might mean that it has to raise the federal funds rate to combat higher inflation.

Why is high inflation harmful to an economy?

-The real value of income/wages is reduced People can't afford as many good (in real terms) so they save a greater portion of their income for the future and reduce their consumption, output falls -Businesses are uncertain about the value of their investments in the future, investment falls -Domestic financial markets become less desirable for foreign investors

Why has the stock market been so turbulent in the past year? What if anything should the Fed do about it?

-The stock market has been turbulent this year because of several uncertainties such as the trade war, decisions about the federal funds rate, and concerns that the current expansion may be coming to an end -Depending on the Fed's view of the stock market, they can have direct impacts on it by manipulating the federal funds rate.

The USD depreciates dramatically. Is the Fed obligated to respond? When should the Fed act to support the USD?

-The value of the USD is not actively managed by the Fed and the exchange rate is free floating so the Fed has no obligation -The Fed might act if the USD appreciates massively against the currencies of the US's biggest trading partners

Which indicators should the Fed monitor to track the labor market?

-Unemployment rate -Employment to population ratio -Gross job flow -Nonfarm payroll employment

If inflation is stable at 2 percent, but home price inflation is at 10 percent and accelerating, should the Fed tighten its policy?

-Yes. The housing market is key to detecting recessions and rising home price inflation indicates instability in the economy even if the PCE remains stable. -The Fed should respond by increasing the interest rate.

Why does health of foreign economies matter to the fed

-affects the investment the US recieves from abroad and trade -affect the valuation of the USD and our net exports

effects of an increase in the fed fund rate

-borrowing money now more expensive -higher borrowing costs cause business lay off workers -unemployment rises -reduced money supply and decreased spending results in a lower inflation

Feds most important goals

-max sustainable output -max sustainable employment -stable prices

Risks of expanding the balance sheet and exit strategies

-people know the Fed will protect banks when people default on their loans so the Fed picks up a vast number of risky assets -in taking unconventional steps like this, the conduct of monetary policy becomes less clear and the public is uncertain about what the expect -Risk of future inflation from increases money supply -exit strategy might be focusing on forward guidance

Should the Fed only target Inflation?

-some theorize that if the fed can successfully control inflation, the rest of the economy will balance itself out -However, the Fed can positively impact many other parts of the economy if it has more goals than just stable prices and a recession can still occur even when the inflation target is reached -if the fed started doing this today, people might feel less protected in the event of a recession and choose to save more for the future

How would an intensification of the trade war between the U.S. and China affect the macroeconomy? What would be the implications for monetary policy?

-An intensification of the trade war would likely result in both countries establishing the tariffs that they have promised to impose on each other. The US would suffer heavy declines in exports as ---China is its largest trading partner, increasing the CA deficit and lowering GDP growth in the long run. -US corporations that do business with China would suffer heavy losses These tariffs would raise the prices of imports coming into the US, forcing inflation to increase. The Fed would have to combat rising inflation by increasing the federal funds rate.

Why do banks hold reserve balances at the Federal Reserve (name three reasons)?

-Banks have a reserve requirement and choose to hold this cash at the Fed because this is the safest place to hold cash in the US (bank robbers?) -Banks receive interest on the reserves that they hold at the Fed -Holding reserves at the Fed has less monetary risk than any other institution so Banks face no default risk by holding funds there

What was the rationale for changing the commitment to a low interest rate in 2012?

-Changing the commitment to a more specific outline gave the public a more transparent idea of where the Fed would set interest rates -This better grounded interest rate and inflation rate expectations, known as forward guidance

The Feds impact on inflation expectations

-Commiting to a low interest rate now can cause people to expect a higher inflation rate in the future -If people expect inflation in the future, they will demand higher wages today which can raise the actual inflation rate -People will consume more before expected inflation sets in, raising the actual inflation rate

The pace of economic recovery has increased in the past year or two. Why?

-Corporate tax cuts introduced in 2017 have helped businesses increase their profit margins, contributing to more reinvestment into the economy and higher growth -Unemployment has fallen as more workers enter the labor-force, contributing to higher output -Consumer sentiment is at historically high levels and consumer expenditure has risen steadily

Fiscal vs Monetary Policy

-Fiscal= involves taxes and government spending and directly affects output by changing these things -directly affects income which then affects the demand for money, interest rates, and financial markets which has implications on monetary policy -monetary=involves controlling money supply, interest rates, and inflation rates

What is forward guidance and how does it affect interest rates and the economy?

-Forward guidance is a commitment from the Fed to a detailed plan for future interest rates -It is used to ground inflation expectations and usually involves a commitment to a low interest rate for a number of years -It introduces business and consumer confidence into a struggling economy, increasing loans, consumption, GDP

Despite the economy's long recovery since 2009, housing starts are as low as they've been since the early 1990's. Why?

-Home prices have grown since the 2007 recession at a rate greater than the rate of income growth. -Since 2014, the Fed has steadily raised the federal funds rate, making mortgages for house purchasing more expensive. -Overall, this means that on average, people do not have the money needed to purchase a new home. For this reason, builders don't have a strong incentive to build new homes.

How can economists estimate expected inflation using Treasury yields?

-If investors think that the Fed has set the federal funds rate too low, they anticipate more inflation in the future. -Because inflation eats into investment returns, investors will demand short-term bonds over long-term bonds to avoid higher future inflation. -Because short-term bonds are now in high demand, they do not require as high of a return so the yield on short-term bonds drops and the yield on long-term bonds rises (steep yield curve)

Why would the Fed want to raise inflation expectations when short term interest rates are near zero?

-If short term interest rates are already near zero, it indicates that people are buying short term bonds because they are pessimistic about the future due to high inflation expectations -Given this, the Fed would not want to raise inflation expectations higher

Why is inflation "forward-looking" in the New Keynesian model (i.e. how does price-setting work in that model)?

-In the New Keynesian Model, price setting is assumed to be sticky, meaning that prices and wages do not adjust instantaneously to changes in other economic factors. -The new Keynesian Phillips curve says that this period's inflation depends on current output and the expectations of next period's inflation, this is why it is "forward-looking."

Should the Fed raise the federal funds rate to a relatively high level now while the economy is growing so that it will have more "ammunition" when a recession comes in the future?

-Increasing the federal funds rate now will give the Fed more room from the zero lower bound in the event of a recession and thus more "ammunition" but this doesn't mean that this policy is an optimal choice. -Given that the inflation rate is currently below the 2% target, increasing the federal funds rate will suppress the inflation rate even further below the target. -Also, the Fed has other means of combating recessions including forward guidance and quantitative easing.

Would our economy benefit today if the inflation rate was higher than its current level of 2 percent?

-Inflation can be good for the economy when it isn't running at full capacity (when actual GDP is less than potential GDP) because this implies that an economy has unused labor and allowing inflation to grow helps increase production. -Inflation can be interpreted as more money entering the economy (increase in money supply) which stimulates spending and increase aggregate demand. -Today, actual GDP is higher than potential GDP, implying rising inflation. Given this, the economy is past full employment with upward pressure on the inflation rate. If it were higher than 2 percent, the Fed would be fighting an even greater inflation rate than the current level.

How does the Large Scale Asset Purchase program boost economic growth?

-LSAP's reduce the supply of securities like mortgages, driving up their price and lowering their yield -The overall effect is a lower yield on mortgages and other long-term securities which makes borrowing more affordable to businesses and consumers -This boosts economic growth

Summarize some of the evidence on the effect that large scale asset purchases have on bond yields.

-LSAPs (quantitative easing) encourage banks to make more loans as central bank purchases of securities reduce the supply of mortgages and -Treasury bonds and public banks must find new assets elsewhere, like loans. -The effect of this is an increase in the money supply, lowering interest rates and thus the yield on bonds. -If a central bank publicly commits to quantitative easing, people expect the money supply to increase and interest rates to fall. This can push the yield on bonds down even more as long term bond yields are usually formed around future expectations.

What is Hyman Minsky's "financial instability hypothesis"?

-Minsky: financial crises are endemic in capitalism because periods of economic prosperity encourage borrowers and lenders to be progressively reckless. This excess optimism creates financial bubbles which later burst. -Therefore, capitalism is prone to move from periods of financial stability to instability. This is a type of market failure and needs government regulation. -Solutions to this problem include reserve requirements, monetary contribution to a stability fund during expansions, strict lending requirements, lender of last resort

Monetary Policy and Financial Stability

-Monetary policy cannot achieve financial stability -The effects of monetary changes on the stability of financial markets is indirect and usually small -Financial instability may cause higher unemployment to which the Fed will respond

How might economic crises in emerging markets affect the US economy?

-Multiple crises in emerging markets could set off a domino effect across the global economy and into the US -As a result of economic crises, these countries may become poor trading partners, experience severe inflation and a devaluation of their currency, or default on their debt -The greatest risk would be any outstanding loans that the US government has made to emerging markets who now are at risk of defaulting on their loans -This would increase the US current account deficit and put the government in greater debt

NAIRU and its implcations

-NAIRU is the amount of unemployment required to prevent excessive inflation -some workers are more skilled than other and when the unemployment rate is less than NAIRU, it implies that there are employed unskilled workers in the economy who make more money than they produce -it represents the level of employment that supports stable inflation

Growth rate of potential GDP, the natural rate of interest, and the neutral federal funds rate over the next decade? How are these concepts related?

-Natural rate of unemployment → Potential GDP → Natural rate of interest → Neutral federal funds rate -The Fed predicts that the growth rate of potential GDP will be around 4.5% for the next decade -The Fed predicts that the neutral federal funds rate will remain around 2.5 - 3.5% for the coming years -When the current level of unemployment is equal to the natural level of unemployment, then the economy's actual GDP is equal to its potential GDP and the output gap is 0. -At this point, the inflation rate is constant. The natural rate of interest is the rate

What is the portfolio balance theory as it applies to bond yields?

- In a world with two assets, one is monetary (stock) and one is real (house), portfolio equilibrium is achieved when the nominal interest rate equals the real interest rate plus expected inflation - When people expect higher inflation in the future, they buy more real assets - When people expect deflation they buy more monetary assets - If expected inflation rises, demand for bonds drops and their yield rises

What does the Fed mean by "normalize" monetary policy?

- In response to 2007 crisis, Fed lowered interest rates to nearly zero and made unusually large purchases of securities through LSAPs - "Normalization" refers to the Fed's plan to return short-term interest rates and the Fed's holdings of securities to normal levels

What is the Federal Reserve's main monetary policy instrument today? If the Fed wants to raise interest rates, precisely how does it accomplish this?

- Main monetary policy instrument today is the federal funds rate, the interest rate that banks charge each other for overnight loans - If the Fed wants to raise interest rates, it will lower the money supply through open market transactions. - If the cost of borrowing for banks increases, they will increase the interest rate they charge to businesses and consumers looking to borrow

Relationship between the price-earnings ration on stocks and the interest rate

- P/E ratios and interest rates are inversely related - When a central bank lowers interest rate allowing inflation to grow (assuming it was too low) there is a greater opportunity for higher real earning growth so investors are willing to pay more for company earnings, driving up the P/E ratio

What is the Bagehot rule and who is it named for?

- The Bagehot rule is named for a central bank and states that it should serve as a lender of last resort - A lender of last resort ensures liquidity in financial markets by lending in times of crisis to prevent economic disruption from one bank to another due to a lack of liquidity - A central bank may be forced to act as lender of last resort when people suddenly want to liquidate their assets and bank deposits

What does the Taylor Principle say the Fed needs to do if inflation expectations rise by one percent?

- The Taylor Rule does not account for expectations of inflation so it fails to recommend any changes to the interest rate if expected inflation rates change. - Taylor Rule only incorporates actual inflation and inflation target

Congress is considering legislation that would require the Federal Reserve to adhere fairly strictly to the Taylor rule. Is this a good idea?

- The Taylor rule approximates how the central bank should change the nominal interest rate in regard to changes in inflation, output, or other economic conditions. - In particular, the rule describes how, for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point. - The Taylor rule does not account for expectations about inflation rates and interest rates which have been shown to be crucial aspects for forming optimal monetary policies.

What is the zero lower bound? Is the lower bound really zero or can it be negative?

- The ZLB is the level at which interest rates equal zero - It represents an expansionary policy tool where a central bank lowers short-term interest rates to zero - Some central banks have set negative interest rates

What is an "inverted yield curve" and why is it considered to be a good predictor of recession?

- The curve inverts when the yield on short-term bonds exceeds the yield on long-term bonds - This might happen when investors anticipate risk in the future (often due to higher inflation expectations) so they demand short-term bonds over long-term bonds - This means people anticipate a poor economy in the future and is thus an indicator of a potential recession

Relationship between long-term and short-term bonds and expectations theory of the term structure

- The expectations theory states that the yields on financial assets of different maturities are related primarily by market expectations of future yields - Investors prefer short-term bonds to long-term bonds unless long-term bonds have a risk premium to justify the risk of holding until maturity

What is the natural rate of interest? What has happened to it in recent years?

- The real rate of interest that equates savings and investment at full employment - Determined by the loanable funds model - It has been declining in recent years due to low investment demand and high savings - Low investment demand (price of capital goods and capital expenditure falling) - High savings in countries like Germany, China, Korea, Japan

What is meant by the "term structure of interest rates" and the "yield curve"?

- The term structure of interest rates is the relationship between interest rates or bond yields and different terms or maturities.

What is the Financial Stability Oversight Council and what does it do?

- Was formed to monitor risks to the U.S. financial sector from the issues of large banks or financial holding companies that could derail the economy - Identify risks in financial sector and increase discipline in communicating the message that no institution is "too big to fail"

How could raising the inflation target to 4% benefit the economy?

- When financial markets anticipate more inflation, nominal interest rates generally increase - The Fed has more room to cut them at times when the economy slows - Reduces the likelihood that short-term interest rates would fall to zero and help the Fed avoid the ZLB

What would the government need to do to make it possible to have negative nominal interest rates?

- With a negative rate, the interest received on holding reserves at the Fed is flipped. Banks now pay the Fed to hold their money - Banks now charge their customers to hold their savings - Public seeks assets with positive returns, like long-term bonds - To compete, banks would likely lower interest they charge on loans to incentivize borrowing - Consumers will substitute saving for consumption

What is the Taylor Rule?

- is a proposed guideline for how central banks should alter interest rates in response to changes in economic conditions -It contends that a one percent increase in the inflation rate should prompt the central bank to increase interest rates by more than one percent -It takes target inflation, actual inflation, full employment, actual employment, potential GDP, and actual GDP into account to calculate a proposed interest rate

Who serves on the Federal Open Market Committee?

-12 total members -7 are from the board of governors -4 are the Fed's Bank Presidents -The last is the President of Fed's Bank in New York

Fed's LSAP programs after 2007 recession

-4 programs that primarily included purchase of MBS, US Treasury bonds and government agency debt - Amount in MBS = $2.25 trillion - Amount in treasury bonds = $2.6 trillion - Amount in agency debt = $200 billion

What is a "credit spread" (e.g. the Baa-Aaa spread) and what information does it give about macroeconomic conditions?

-A credit spread is the difference in yield between a U.S. Treasury bond (Aaa) and another debt security of the same maturity but different credit quality (Baa). -Widening credit spreads indicate growing concern about the ability of corporate (and other private) borrowers to service their debt. Narrowing credit spreads indicate improving private creditworthiness. -In a recession, the credit spread widens. Today, the credit spread is relatively narrow.

What is moral hazard? How is it relevant to the Fed's actions during the 2007-8 financial crisis?

-A moral hazard is the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity. -A moral hazard may mean a party has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles. -Certain actions on the parts of lenders/banks could qualify as moral hazards in the 2007 crisis. -Mortgage brokers working for banks may have been encouraged to make as many loans as possible with the incentive of earning a higher commissions. -Borrowers who began struggling to . Some homeowners may have seen this as an incentive to walk away, as their financial burden would be lessened by abandoning their property instead of repaying their loan.

What is the difference between outright purchases and sales of government securities by the Fed and a repurchase agreement (repo)?

-A repo is when someone sells government securities to an investor and agrees to buy them back the next day at a slightly higher price -A repo is the most efficient short-term loan with an agreed maturity date whereas typical open market transactions are more flexible and can last much longer periods of time -The interest rate on repo's is generally very close to the federal funds rate

Relationship between the real interest rate and the nominal interest rate

- Real interest rate = nominal interest rate - inflation rate

What is the Federal Reserve's "dual mandate"? Where does it come from?

-stable prices and maximum employment -Federal Reserve Act in November 1977

What does it mean to say that the Federal Reserve System is "independent within the government"?

The Fed is an independent government agency as it is part of the government but makes its own decisions Congress decides what the Fed's goals are (dual-mandate) but the Fed can decide how to achieve those goals

What is the time inconsistency problem?

- A situation in which a decision-maker's preferences change over time in such a way that a preference can become inconsistent at another point in time - Suppose firms and workers have formed their expectations about inflation and built these expectations into contract. - Central bank has an incentive to pursue an expansionary monetary policy to boost output in the short run, driving up wages and prices, resulting in higher inflation - Solution can be to set explicit policy rules and form credibility and reputation for making the right long-run choices

What is the efficient markets hypothesis?

- An investment theory whereby stock prices reflect all information and consistent risk-adjusted excess return generation is impossible. - Stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices - The only way an investor can possibly obtain higher returns than the overall market provides is by purchasing riskier investments

What is the Lucas Critique?

- Argues that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data - It showed that the various empirical equations estimated in previous economic models were from periods where people had particular expectations about government policy - Once these expectations *changed*, then the empirical equations must account for these changes otherwise the models are useless for predicting the results of different fiscal and monetary policies - Essentially the past is not an accurate predictor of the future

Trump has criticized the Fed's recent interest rate increases and has urged the Fed to go slow in raising rates. Is this appropriate? Possible dangers?

- Could be appropriate if the trade war with China continues - Lowering the interest rate will devalue the dollar and help keep American goods competitive in international markets - Potential danger is the threat of inflation if the public does not believe that the Fed will continue raising rates - The Fed could also be underestimating potential output / overestimating the natural rate of unemployment, therefore keeping interest rates too high - Low interest rates could push the economy to full employment

What is meant by "credibility" and why is it important that the Fed's monetary policy be credible?

- Credibility means that a central bank is credible if people believe it will do what it says - Credibility can be defined and measured as the extent to which inflation expectations are anchored on a specific target - A high degree of credibility is desired because it means expected inflation is close to the target and there is a shorter time lag between monetary policy and its effects - Credibility is gained through transparency - Transparency means giving the public insights into the central bank's decision and decision making process so that they are not surprised by decisions

Difference between "forward looking" and "history dependent" forward guidance

- Forward looking: The type of guidance the Fed used after the 2007 recession. Policies are aimed at maintain a low level of interest for some period of time and indicate how the Fed will change the interest rate for the first time, but no indication of how they might change it afterwards. The length of this period can be ambiguous and policies that are forward looking can change when current economic conditions change - History dependent: Based on the idea that the Fed should commit to an interest rate target for some time based on a single rule. Many argue that this rule should be the Fed's commitment to a low interest rate will remain in place until the general price level reaches some pre-announced price level

How does the Taylor Rule differ from the monetary policy rule recommended by Milton Friedman and monetarist economists?

- Friedman: the central bank should set the nominal interest rate at 0% by setting a deflationary target equal to the real interest rate on government bonds.

How close is the economy currently to full employment? What data speaks most strongly on this question?

- Full employment is achieved when actual GDP = potential GDP - Today, actual GDP > potential GDP, implying we have exceeded full employment - Very low unemployment rate shows this

Suppose the U.S. and China agree to end the trade war. What would this entail, how would it affect the U.S. economy, and what are the implications for monetary policy?

1.Both countries would likely abandon the tariffs that they intend to set on the eachothers goods. 2.Good news for US, goods will remain competitive in China and thus US corporations that do business in China remain as profitable as they already are. 3.Chinese goods are no longer more expensive for Americans and imports return to their original level. 4.US corporations that do business with China no longer have to account for additional costs from Chinese tariffs so the prices of their goods in China do not change. The same goes for chinese goods in the US which no longer face upward pressure on their selling price. This means inflation returns to its original level and the Fed's hand is not forced to adjust interest rates.

If economic conditions suggest that the federal funds rate needs to be increased, how exactly does the Fed go about doing this?

1.The Fed manipulates the money supply through open market transactions of government backed securities 2.To increase the federal funds rate, the Fed will decrease the money supply by selling government securities, implying that a public bank is buying them 3.The public bank has used some of its reserves to purchase that security and now wishes to replenish its reserves 4.The bank will call some of its loans by an amount equal to its loss in reserves 5.The holder of that loan will then write a check from another bank for the amount of the call 6.This bank now faces a loss in reserves as well and so it will conduct the same operation as the first bank 7.In the end, the money supply decreases by an amount equal to the sale of the government security divided by the reserve ratio

Why is deflation so dangerous? Explain using the IS-AS model when the economy is at the zero lower bound.

1.When deflation occurs, it implies income and consumption are low which can typically lead to poor output and low or even negative growth 2.It can be particularly dangerous because it is cyclical and can lead to even more deflation as businesses lay-off workers from reduced demand, increasing unemployment, lowering demand even further, leading to more unemployment, lower output, and so on 3.In the IS-AS, the AS shifts down as a result of immediate unexpected deflation and inflation is now lower. 4.This eventually leads to a decline in business revenue. Business lower their wages and lay-off portions of their workforce, decreasing demand in the good market down, shifting the IS to the left where output is now lower.

What was the "Treasury Accord" of 1951?

The "Accord" in 1951 formalized Federal Reserve independent to pursue monetary policy separate from government financing objective