The Federal Reserve System and Monetary Policy
The Federal Reserve System and Monetary Policy
18.1 The Federal Reserve System
In most countries, a central bank manipulates the money supply.
Functions of a Central Bank
A central bank has many functions:
It serves as a "banker's bank," maintaining reserves for commercial banks.
It performs service functions for commercial banks:
Transferring funds.
Clearing checks.
It typically serves as the major bank for the central government.
It buys and sells foreign currencies and assists in international financial transactions.
It serves as a "lender of last resort" for banking institutions in financial distress.
It is concerned with the stability of the banking system and the money supply.
The central bank regulates private commercial banks, influencing the size of the money supply and the level of economic activity.
The central bank implements monetary policy, which, along with fiscal policy, directs the economy in accordance with macroeconomic goals.
Location of The Federal Reserve System
In most countries, the central bank is a single institution.
In the United States, the central bank is the Federal Reserve System, comprising 12 institutions across the country.
Each of the 12 banks has branches in key cities within its district.
The 12 banks act largely in unison on major policy issues, with effective control resting with the Board of Governors and the Federal Open Market Committee (FOMC) in Washington, D.C.
Each Federal Reserve bank has its own board of directors and can set its own policies to some extent.
The Chairman of the Federal Reserve Board of Governors is considered one of the most important economic policy makers in the country.
The Fed’s Relationship To The Federal Government
The Federal Reserve was created in 1913 due to the U.S. banking system's instability and lack of central direction.
Technically, the Fed is privately owned by member banks.
Membership is not required, and since 1980, requirements for member and nonmember banks are virtually the same.
The private ownership is essentially meaningless because the President of the United States appoints the Federal Reserve Board of Governors, which controls major policy decisions.
The Fed’s Ties To The Executive Branch
The Fed has historically had considerable independence from the executive and legislative branches.
The president appoints the seven members of the Board of Governors, subject to Senate approval, for 14-year terms.
Terms are staggered, with a new appointment every two years, making it difficult for a single president to appoint a majority of the board.
Board members have little fear of job loss due to presidential disapproval.
The Chair of the Federal Reserve Board, a member of the Board of Governors, serves a four-year term and effectively runs the system with the help of the presidents of the 12 regional banks.
Fed Operations
Key policy decisions are made by the Federal Open Market Committee (FOMC), comprising the seven members of the Board of Governors, the president of the New York Federal Reserve Bank, and four other Federal Reserve Bank presidents on a rotating basis.
The FOMC makes key decisions influencing the direction and size of changes in the money stock, and its regular meetings are considered very important.
18.2 How Does the Federal Reserve Change the Money Supply
The Federal Reserve Board of Governors and the FOMC are the primary decision-makers for monetary policy.
They decide whether to expand or contract the money supply to influence economic activity and inflation.
The Fed controls the money supply even though commercial banks create and destroy money through lending.
The Fed has three major methods to control the money supply:
Open market operations.
Changing reserve requirements.
Changing the discount rate.
Of these three tools, the Fed uses open market operations the most.
Open Market Operations
Open market operations involve the purchase and sale of government securities by the Federal Reserve System.
Decisions are made by the Federal Open Market Committee at its regular meetings.
Open market operations are the most important method the Fed uses to change the money supply:
It can be implemented quickly and cheaply.
It can be done quietly.
It is a powerful tool, as the impact is several times the initial transaction.
When the Fed buys bonds, it pays with a check from one of the 12 Federal Reserve banks.
The recipient deposits it, increasing the money supply.
The commercial bank gets cash reserves or a higher balance in their reserve account at the Federal Reserve Bank.
Example:
Bank One has no excess reserves, and a customer sells a bond for 10,000 to the Fed.
The customer deposits the check, and the Fed credits Bank One with 10,000 in reserves.
If the reserve requirement is 10 percent, Bank One needs new reserves of 1,000 (10,000 imes 0.10) and acquires 9,000 in new excess reserves (10,000 - 1,000).
Bank One can lend out the 9,000, creating new deposits.
The recipients of the loans will likely spend the money, leading to more new deposits and excess reserves in other banks.
The Fed's 10,000 bond purchase directly creates 10,000 in money and indirectly permits up to 90,000 in additional money to be created.
The money multiplier is the reciprocal of the reserve requirement; if the reserve requirement is 10 percent, then 1/0.10 = 10.
If the reserve requirement is 10 percent, a total of up to 100,000 in new money is potentially created by the purchase of one 10,000 bond by the Fed.
The process works in reverse when the Fed sells a bond.
The purchaser pays by check, lowering demand deposits.
Reserves of the bank fall.
If the bank had zero excess reserves, it will now have a reserve deficiency.
The bank must sell secondary reserves or reduce loan volume, leading to further destruction of deposits.
A multiple contraction of deposits will begin.
In a growing economy, an increase in the money supply is needed to maintain stable prices.
If the velocity of money (V) in the equation of exchange is fairly constant and real GDP (Q) is rising between 3 and 4 percent a year, then a 3 or 4 percent increase in M is consistent with stable prices.
In periods of rising prices, if V is fairly constant, the growth of M will likely exceed 3 percent to 4 percent annual growth.
The Reserve Requirement
The Fed can change the reserve requirements of member banks by altering the reserve ratio.
This can have an immediate impact on the ability of member banks to create money.
If the Fed lowers reserve requirements:
It creates excess reserves in the banking system.
The banking system can then expand deposits and the money stock by a multiple of this amount (1/required reserve ratio).
Relatively small reserve requirement changes can have a big impact on the potential supply of money by changing the money multiplier.
The power of the reserve requirement is both its advantage and its disadvantage.
Huge changes in required reserves and excess reserves have the potential to disrupt the economy.
Frequent changes in the reserve requirement would make it difficult for banks to plan.
The Fed changes reserve requirements rather infrequently, and when it does make changes, it is by very small amounts.
Changes in the reserve requirement are a sign that monetary policy has swung strongly in a new direction.
The Discount Rate
Banks having trouble meeting their reserve requirement can borrow funds directly from the Fed.
The interest rate the Fed charges on these borrowed reserves is called the discount rate.
If the Fed raises the discount rate:
It makes it more costly for banks to borrow funds from it to meet their reserve requirements.
The higher the interest rate banks have to pay on the borrowed funds, the lower the potential profits from any new loans made from borrowed reserves, and fewer new loans will be made and less money created.
If the Fed wants to contract the money supply, it will raise the discount rate, making it more costly for banks to borrow reserves.
If the Fed is promoting an expansion of money and credit, it will lower the discount rate, making it cheaper for banks to borrow reserves.
The discount rate changes fairly frequently, often several times a year.
The discount rate is a relatively unimportant tool because member banks do not rely heavily on the Fed for borrowed funds.
There seems to be some stigma among bankers about borrowing from the Fed; borrowing from the Fed is something most bankers believe should be reserved for real emergencies.
When banks have short-term needs for cash to meet reserve requirements, they are more likely to take a short-term loan from other banks in the federal funds market.
The discount rate's main significance is that changes in the rate signal the Fed's intentions with respect to monetary policy.
Discount rate changes are widely publicized, unlike open market operations.
How The Fed Reduces The Money Supply
The Fed can do three things if it wants to reduce the money supply:
Sell bonds (“buy” more from the economy).
Raise reserve requirements.
Raise the discount rate.
The Fed could also opt to use some combination of these three tools in its approach.
These moves would tend to decrease aggregate demand reducing nominal GDP, ideally through a decrease in P rather than Q.
These actions would be the monetary policy equivalent of a fiscal policy of raising taxes, lowering transfer payments, and/or lowering government purchases.
How The Fed Increases The Money Supply
If the Fed is concerned about underutilization of resources (e.g., unemployment), it would engage in precisely the opposite policies:
Buy bonds.
Lower reserve requirements.
Lower the discount rate.
The government could use some combination of these three approaches.
These moves would tend to increase aggregate demand, raising nominal GDP, ideally through an increase in Q (in the context of the equation of exchange) rather than P.
Equivalent expansionary fiscal policy actions would be to reduce taxes, increase transfer payments, and/or increase government purchases.
How Else Can The Fed Influence Economic Activity?
The Fed's control of the money supply is largely exercised through the three methods outlined above, but it can influence the level and direction of economic activity in numerous less important ways as well.
The Fed can attempt to influence banks through moral suasion.
If the Fed thinks the money supply and credit is growing too fast, it might urge bank presidents to be more selective in making loans and maintain some excess reserves.
During business contractions, the Fed may urge bankers to lend more freely, hoping to promote an increase in the supply of money.
The Fed also has at its command some selective regulatory authority over specific types of economic activity.
Federal Reserve Board of Governors establishes margin requirements for the purchase of common stock.
The Fed specifies the proportion of the purchase price of stock that a purchaser must pay in cash.
Congress believes that the Fed can limit speculative market dealings in securities and reduce instability in securities markets.
In the last few decades, the Federal Reserve regulatory authority has been extended into new areas.
Beginning in 1969, the Fed began enforcing provisions of the Truth in Lending Act, which requires lenders to state actual interest rate charges when making loans.
In the mid‑1970s, the Fed began enforcing provisions of the Equal Lending Opportunity Act, designed to eliminate discrimination against loan applicants.
18.3 Money, Interest Rates, and Aggregate Demand
The Federal Reserve's policies with respect to the supply of money has a direct impact on short-run real interest rates, and accordingly, on the components of aggregate demand.
The money market is the market where money demand and money supply determine the equilibrium nominal interest rate.
The Money Market
When the Fed acts to change the money supply by changing one of its policy variables, it alters the money market equilibrium.
People have three basic motives for holding money instead of other assets:
Transactions purposes.
Precautionary reasons.
Asset purposes.
Transaction Purposes
The primary reason that money is demanded is for transaction purposes—to facilitate exchange.
The higher a person’s income, the more transactions that person is likely to make.
The greater will be GDP; and the greater will be the demand for money for transaction purposes, other things being equal.
Precautionary Reasons
People like to have money on hand for precautionary reasons.
If unexpected medical or other expenses require an unusual outlay of cash, people want to be prepared.
The extent to which an individual holds cash for precautionary reasons depends partly on that person’s income and partly on the opportunity cost of holding money, which is determined by market rates of interest.
The higher the market interest rates, the higher the opportunity cost of holding money; and so people will hold less of their financial wealth as money.
Asset Purposes
Money has a trait—liquidity—that makes it a desirable asset.
Other things being equal, people prefer assets that are more liquid to those that are less liquid.
That is, people want to be able to easily convert some of their money into goods and services.
For this reason, most people wish to have some of their portfolio in the form of money.
At higher interest rates on other assets, the amount of money desired for this purpose will be smaller, because the opportunity cost of holding money will have risen.
The Demand For Money And The Nominal Interest Rate
The quantity of money demanded varies inversely with the rate of interest.
When interest rates are higher, the opportunity cost in terms of the interest income on alternative assets forgone of holding monetary assets is higher, and persons will want to hold less money for each of these reasons.
At the same time, the demand for money, particularly for transactions purposes, is highly dependent on income levels because the transactions volume varies directly with income.
And lastly, the demand for money depends on the price level.
If the price level increases, buyers will need more money to purchase their goods and services.
Or if the price level falls, buyers will need less money to purchase their goods and services.
At lower interest rates, the quantity of money demanded is greater.
An increase in income will lead to an increase in the demand for money, depicted by a rightward shift in the money demand (MD) curve.
Why Is The Supply Of Money Relatively Inelastic?
The supply of money is largely governed by the regulatory policies of the central bank.
Whether interest rates are 4 percent or 14 percent, banks seeking to maximize profits will increase lending as long as they have reserves above their desired level because even a 4 percent return on loans provides more profit than maintaining those assets in non interest-bearing cash or reserve accounts at the Fed.
The supply of money is effectively almost perfectly inelastic with respect to interest rates over their plausible range.
Therefore, we draw the money supply (MS) curve as vertical, other things equal, with changes in Fed policies acting to shift the money supply curve.
The Money Market
Equilibrium in the money market is found by combining the money demand and money supply curves.
Money market equilibrium occurs at that nominal interest rate where the quantity of money demanded equals the quantity of money supplied.
Equilibrium occurs at the point where the quantity of money demanded by the public is equal to the quantity of the money supplied by the banking system, given the policies adopted by the Fed.
People respond to this shortage by increasing their holdings of money by reducing their holdings of bonds or other interest-bearing assets.
People respond to this surplus by decreasing their holdings of money by increasing their holdings of bonds or other interest-bearing assets.
When the price level rises, people demand more money and the money demand curve shifts to the right.
The increase in the demand for money causes the interest rate to rise.
The increase in interest leads to a reduction in RGDP demanded.
How Do Income Changes Affect the Equilibrium Position?
Rising national income will increase the demand for money; therefore shifting the demand for money to the right, leading to a new higher equilibrium interest rate.
How Would an Increase in Money Supply Affect Equilibrium Interest Rates and Aggregate Demand?
An increase in the money supply will shift the money supply to the right, lowering the nominal interest rate equilibrium.
The increase in the money supply causes the interest rate to fall in the short run.
At lower interest rates, households and businesses invest more and buy more goods and services, shifting the aggregate demand curve to the right.
Does the Fed Target the Money Supply or Interest Rates?
Some economists believe the Fed should try to control the money supply.
Others believe the Fed should try to control the interest rate.
The Fed cannot do both—it must pick one or the other.
Suppose the demand for money increases.
If the Fed tries to keep the interest rate steady while money demand increases, it must increase the growth in money supply.
If it tries to keep the growth of money supply steady while money demand increases, the interest rate will fall.
The problem with targeting the money supply is that the demand for money fluctuates considerably in the short run.
Focusing on the growth in the money supply when the demand for money is changing unpredictably will lead to large fluctuations in the interest rate, which can seriously disrupt the investment climate.
Keeping interest rates in check would also create problems.
When the economy grows, the demand for money also grows, so the Fed would have to increase the money supply to keep interest rates from rising.
If the economy was in a recession, the Fed would have to contract the money supply.
This would lead to the wrong policy prescription.
Expanding the money supply during a boom would eventually lead to inflation.
Contracting the money supply during a recession would worsen the recession.
Which Interest Rate Does The Fed Target?
The federal funds rate is the interest rate the Fed has targeted since about 1965.
At the close of the meetings of the Federal Open Market Committee (FOMC), the Fed will usually announce whether the federal funds rate will be increased, decreased, or left alone.
Summary of Fed Tools for Monetary Policy
Monetary policy actions can be conveyed through either the money supply or the interest rate.
A contractionary policy can be thought of as a decrease in the money supply or an increase in the interest rate.
An expansionary policy can be thought of as an increase in the money supply or a decrease in the interest rate.
Why is the interest rate used for monetary policy?
Many economists believe the primary effects of monetary policy are felt through the interest rate.
The money supply is difficult to accurately measure.
Changes in the demand for money can complicate money supply targets.
People are more familiar with changes in interest rates than changes in the money supply.
Does the Fed Influence the Real Interest Rate in the Short Run?
Many economists believe that in the short run, the Fed can control the nominal interest rate and the real interest rate.
The real interest rate is equal to the nominal interest rate minus the expected inflation rate.
Real Interest Rate = Nominal Interest Rate - Expected Inflation Rate
So a change in the nominal interest rate tends to change the real interest rate by the same amount since the expected inflation rate is slow to change in the short run.
That is, if the expected inflation rate does not change, the relationship between the nominal and real interest rates is a direct relationship.
However, in the long run, years after the inflation rate has adjusted, the equilibrium real interest rate is determined by the intersection of the saving supply and investment demand curve.
18.4 Expansionary and Contractionary Monetary Policy
An expansionary monetary policy to combat a recessionary gap results in lower interest rates leading to greater investment demand.
When interest rates fall, total expenditures rise, resulting in greater RDGD growth, at a higher price level.
During the recession, the Fed aggressively lowered the federal funds rate to stimulate aggregate demand when it was faced with a recessionary gap.
Contractionary Monetary Policy in an Inflationary Gap
An contractionary monetary policy during an inflationary gap in the economy, may see the Fed engaging in an open market sale of bonds.
This decreases the money supply, and increases the rate of interest, leading to a decrease in the quantity of investment demanded.
A decrease in investment spending causes a reduction in aggregate expenditures, shifting the AD curve leftward.
This results in lower RGDP and a lower price level, where RGDP equals the potential level of output.
Monetary Policy in the Open Economy
When the Fed buys bonds on the open market, money supply increases and interest rates fall.
With lower domestic interest rates, domestic investors will invest funds in foreign markets, exchanging dollars for foreign currency, which leads to a depreciation of the dollar.
The depreciation of the dollar makes the U.S. market more attractive to foreign buyers and foreign markets relatively less attractive to domestic buyers.
This increases the net exports which in turn increases RGDP in the short run.
If Fed pursues a contractionary monetary policy, net exports will decrease and subsequently RGDP will decrease in the short run.
18.5 Money and Inflation
For many centuries, scholars have known that there is a positive relationship between the money supply, the price level, the growth in the money supply, and the inflation rate.
The Inflation Rate and the Growth in the Money Supply
One of the major reasons that the control of the money supply is so important is that, in the long run, the amount of money in circulation and the overall price level are closely linked.
The Equation of Exchange
In the early part of this century, economists noted a useful relationship that helps our understanding of the role of money in the national economy.
The relationship, called the equation of exchange, can be presented as: M imes V = P imes Q
Where:
M is the money supply, however defined (M1 or M2).
V is the velocity of money.
P is the average prices of final goods and services.
Q is the physical quantity of final goods and services produced in a given period (usually one year).
V, the velocity of money, refers to the "turnover" rate, or the intensity with which money is used.
V represents the average number of times that a dollar is used in purchasing final goods or services in a one-year period.
If individuals are hoarding their money, velocity will be low.
If individuals are writing lots of checks on their checking accounts and spending currency as fast as they receive it, velocity will tend to be high.
The expression P imes Q represents the dollar value of all final goods and services sold in a country in a given year.
But that is the definition of nominal gross domestic product (GDP).
Thus, the average level of prices (P) times the physical quantity of final goods and services (Q) equals nominal GDP.
The quantity equation of money could also be expressed as: V = \frac{Nominal GDP}{M}
MV = Nominal GDP
The total output of goods in a year divided by the amount of money is the same thing as the average number of times a dollar is used in final goods transactions in a year.
The magnitude of V will depend on the definition of money that is used.
The average dollar of money turns over a few times in the course of a year, with the precise number depending on the definition of money.
The Quantity Theory of Money and Prices
The equation of exchange becomes the quantity theory of money if we make certain assumptions.
If velocity (V) and real GDP (Q) both remain constant, then a 10 percent increase in the money supply will lead to a 10 percent increase in the price level.
That is, the money supply and the price level change by the same proportion.
Using the growth version of the quantity equation, we can transform the equation of exchange to:
Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level (inflation rate) + Growth rate of real output
This makes it easy to see the effect of the money supply on the inflation rate.
Inflation rate = Growth rate of the money supply-Growth rate of real GDP
If money supply grows at a faster rate than real GDP, then there will be inflation.
If money supply grows at a slower rate than real GDP, then there will be deflation.
If money supply grows at the same rate as real GDP, the price level will be stable.
Economists once considered the velocity of money a given.
We now know that it is not constant, but it often moves in a fairly predictable pattern.
Thus, the connection between money supply and GDP is still fairly predictable.
Historically, the velocity of money has been quite stable over a long period of time, particularly using the M2 definition.
However, velocity is less stable when measured using the M1 definition and over shorter periods of time.
For example, an increase in velocity can occur with anticipated inflation.
When individuals expect inflation, they will spend their money more quickly.
They don't want to be caught with money that is going to be worth less in the future.
Also, an increase in the interest rates will cause people to hold less money because people want to hold less money when the opportunity cost of holding money increases.
This, in turn, means that the velocity of money increases.
Hyperinflation
The inflation rate tends to rise more in periods of rapid monetary expansion than in periods of slower growth in the money supply.
The relationship is particularly strong with hyperinflation.
The cause of hyperinflation is simply excessive money growth.
18.6 Problems in Implementing Monetary and Fiscal Policy
The lag problem inherent in adopting fiscal policy changes are much less acute for monetary policy, largely because the decisions are not slowed by the same budgetary process.
The FOMC of the Fed, for example, can act quickly and even secretly to buy or sell government bonds, the key day-to-day operating tool of monetary policy.
Problems in Conducting Monetary Policy
However the length and variability of the impact lag before its effects on output and employment are felt is still significant and the time before the full price-level effects are felt is even longer and more variable.
According to the Federal Reserve Bank of San Francisco, the major effects of a change in policy:
On growth in the overall production of goods and services usually are felt within three months to two years, and;
The effects on inflation tend to involve even longer lags, perhaps one to three years, or more.
How Do Commercial Banks Implement The Fed’s Monetary Policies?
One limitation of monetary policy is that it ultimately must be carried out through the commercial banking system.
The Central Bank can change the environment in which banks act, but the banks themselves must take the steps necessary to increase or decrease the supply of money.
Usually, when the Fed is trying to constrain monetary expansion, there is no difficulty in getting banks to make appropriate responses.
Banks must meet their reserve requirements, and if the Fed raises bank reserve requirements, sells bonds, and/or raises the discount rate, banks must obtain the necessary cash or reserve deposits at the Fed to meet their reserve requirements.
In response, they will call in loans that are due for collection, sell secondary reserves, and so on, to obtain the necessary reserves.
In the process of contracting loans, they lower the supply of money.
When the Federal Reserve wants to induce monetary expansion, however, it can provide banks with excess reserves (e.g., by lowering reserve requirements or buying government bonds), but it cannot force the banks to make loans, thereby creating new money.
Ordinarily, of course, banks want to convert their excess reserves to work earning interest income by making loans.
But in a deep recession or depression, banks might be hesitant to make enough loans to put all those reserves to work, fearing that they will not be repaid.
Their pessimism might lead them to perceive that the risks of making loans to many normally creditworthy borrowers outweigh any potential interest earnings.
Banks maintaining excess reserves rather than loaning them out was, in fact, one of the monetary policy problems that arose in the Great Depression.
Banks That Are Not Part Of The Federal Reserve System And Policy Implementation
A second problem with monetary policy relates to the fact that the Fed can control deposit expansion at member banks, but it has no control over global and nonbank institutions that also issue credit (loan money) but are not subject to reserve requirement limitations, like pension funds and insurance companies.
While the Fed may be able to predict the impact of its monetary policies on member bank loans, the actions of global and nonbanking institutions can serve to partially offset the impact of monetary policies adopted by the Fed on the money and loanable funds markets.
There is a real question of how precisely the Fed can control the short-run real interest rates through its monetary policy instruments.
Fiscal And Monetary Coordination Problems
Another possible problem that arises out of existing institutional policy making arrangements is the coordination of fiscal and monetary policy.
Fiscal policy decisions are made by Congress and the president, and monetary policymaking by the Federal Reserve System.
A macroeconomic problem arises if the federal government's fiscal decision makers differ on policy objectives or targets with the Fed's monetary decision makers.
For example, the Fed may be more concerned about keeping inflation low, while fiscal policymakers may be more concerned about keeping unemployment low.
Alleviating Coordination Problems
In recognition of potential macroeconomic policy coordination problems, the Chairman of the Federal Reserve Board participates in meetings with top economic advisers of the president.
An attempt to reach a consensus on the appropriate policy responses, both monetary and fiscal is made.
There is often some disagreement, and the Fed occasionally works to partly offset or even neutralize the effects of fiscal policies that it views as inappropriate.
Some people believe that monetary policy should be more directly controlled by the president and Congress, so that all macroeconomic policy will be determined more directly by the political process.
It is argued that such a move would enhance coordination considerably.
Others argue that it is dangerous to turn over control of the nation's money stock to politicians, rather than allowing decisions to be made by technically competent administrators who are focused more on price stability and more insulated from political pressures from the public and from special interest groups.
The timing of fiscal policy and monetary policy is crucial.
Because of the significant lags before the fiscal and monetary policy has its impact, the increase in aggregate demand may occur at the wrong time.
Suppose the economy is currently suffering from low levels of output and high rates of unemployment.
In response, policymakers decide to increase government purchases and implement a tax cut, or alternatively they could have increased the money supply.
But from the time when the policymakers recognize the problem to the time when the policies have a chance to work themselves through the economy, business and consumer confidence both increase, increasing RGDP and employment.
When the fiscal policy takes hold, the policies will have the undesired effect of causing inflation, with little permanent effect on output and employment.
Input owners requiring higher input prices, will result in a new long-run equilibrium.
Imperfect Information
In order to know how much to stimulate the economy, policymakers must know the size of the multiplier and by how much RGDP should increase.
But some economists disagree on the natural rate of real output (RGDPNR), and it may be difficult to know where RGDP is at any given moment in time; government estimates are approximations and are often corrected at a later period.
The government must also know the exact MPC.
If the estimate is too low, the multiplier will be less than it should be and the stimulus will be too small.
If the estimate of MPC is too high, the multiplier will be more than it should be and the stimulus will be too large.
Overall Problems With Monetary and Fiscal Policy
Much of macroeconomic policy in this country is driven by the idea that the federal government can counteract economic fluctuations
Stimulating the economy when it is weak.
Increased government purchases;
Tax cuts.
Transfer payment increases;
Easy money.
Restraining it when it is overheating.
But policy makers must adopt the right policies in the right amounts at the right time for such “stabilization” to do more good than harm.
And for government policy makers to do this, they need far more accurate and timely information than experts can give them.
First, economists must know not only which way the economy is heading, but also how rapidly.
However, no one knows exactly what the economy will do, no matter how sophisticated the econometric models used.
Even if economists could provide completely accurate economic forecasts of what will happen if macroeconomic policies are unchanged, they could not be certain of how to best promote stable economic growth.
If economists knew, for example, that the economy was going to dip into another recession in six months, they would then need to know exactly how much each possible policy would spur activity in order to keep the economy stable.
But such precision is unattainable, given the complex forecasting problems faced.
Further, economists aren’t always sure what effect a policy will have on the economy.
It is widely assumed that an increase in government purchases quicken economic growth.
Increasing government purchases increases the budget deficit, which could send a frightening signal to the bond markets.
The result can be to drive up interest rates and choke off economic activity.
Even when policy makers know which direction to nudge the economy, they can’t be sure which policy levers to pull, or how hard to pull them, to fine tune the economy to stable economic growth.
A third crucial consideration is how long it will take a policy before it has its effect on the economy.
Even when increased government purchases or expansionary monetary policy does give the economy a boost, no one knows precisely how long it will take to do so.
The boost may come very quickly, or many months (or even years) in the future, when it may add inflationary pressures to an economy that is already overheating, rather than helping the economy recover from a recession.
Macroeconomic policy making is like driving down a twisting road in a car with an unpredictable lag and degree of response in the steering mechanism.
If you turn the wheel to the right, the car will eventually veer to the right, but you don’t know exactly when or how much.
There are severe practical difficulties in trying to fine-tune the economy.
Even the best forecasting models and methods are far from perfect