Monetary Policy and the Fed
Read this chapter to understand in more detail the monetary policy tools, process, and impacts on the U.S. economy. Review specific monetary policies and their effects from our recent history.
Summary
Part of the Fed's power stems from the fact that it has
no legislative mandate to seek particular goals. That leaves the Fed
free to set its own goals. In recent years, its primary goal has seemed
to be the maintenance of an inflation rate below 2% to 3%. Given success
in meeting that goal, the Fed has used its tools to stimulate the
economy to close recessionary gaps. Once the Fed has made a choice to
undertake an expansionary or contractionary policy, we can trace the
impact of that policy on the economy.
There are a number of
problems in the use of monetary policy. These include various types of
lags, the issue of the choice of targets in conducting monetary policy,
political pressures placed on the process of policy setting, and
uncertainty as to how great an impact the Fed's policy decisions have on
macroeconomic variables. We highlighted the difficulties for monetary
policy if the economy is in or near a liquidity trap and discussed the
use of quantitative easing and credit easing in such situations. If
people have rational expectations and respond to those expectations in
their wage and price choices, then changes in monetary policy may have
no effect on real GDP.
We saw in this chapter that the money
supply is related to the level of nominal GDP by the equation of
exchange. A crucial issue in that relationship is the stability of the
velocity of money and of real GDP. If the velocity of money were
constant, nominal GDP could change only if the money supply changed, and
a change in the money supply would produce an equal percentage change
in nominal GDP. If velocity were constant and real GDP were at its
potential level, then the price level would change by about the same
percentage as the money supply. While these predictions seem to hold up
in the long run, there is less support for them when we look at
macroeconomic behavior in the short run. Nonetheless, policy makers must
be mindful of these long-run relationships as they formulate policies
for the short run.