Question

Ch.20

1.

1. Premature to rule out an interest rate increase this year In the current state of the economy, it would be worse for the Fed to raise rates too soon than moving slightly too late and adjusting by raising rates more quickly Source: Wall Street Journal, August 1, 2016

What are some of the problems that could arise if the Fed raises interest rates too soon or too late

2. Suppose that inflation is rising toward 5 percent a year, and the Fed, Congress, and the White House are discussing ways of containing inflation without damaging employment and output. The President wants to cut aggregate demand but to do so in a way that will give the best chance of keeping investment high to encourage long-term economic growth. Explain the Fed’s best action for meeting the President’s objectives.

text: Essential Foundations of Economics, Bade & Parkin, 8th ed. 2018, Pearson

Answer 1

1) Monetary policies work with a sometimes "long and variable lag" central banks would project future paths of their respective economies, so if their objectives were to be met in the near medium term sooner than projected, they would start tightening their monetary policy - raising rates to increase short-term funding cost, so higher borrowing cost would gradually take effect in the real economy and cool growth. That way by the time "medium term" comes, the central bank would not be at risk of "overshooting" its objectives.

In other words, central bankers are like the train engines of traditional locomotives - they would lower rates (shoveling slow-burning coal into the engine) when they project the economy (locomotive) slowing down in the future. Because coal (a proxy for interest rates) does not release its energy instantaneously (just like lower interest rates does not instantly manifest into more lending, thus an increase in money supply), shoveling coal into the engine by the time the locomotive has already stopped would be too late. Similarly, if central bankers see the locomotive at risk of exceeding speed limit and risk danger, the central bankers would start to apply brakes (raising rates) long before the locomotive slams into a slow moving train a mile ahead (because raising rates then would be too late).

When the U.S. Federal Reserve raises the federal funds rate, the cost of borrowing goes up too, and this increase starts a series of cascading effects. In essence, banks raise their interest rates for consumers and businesses, and it costs more to buy a home or finance a company. In turn, the economy slows down as people spend less. However, this also keeps the cost of goods stable and curtails inflation. It serves as a signal that economic growth in the United States is expected to be firm as well.

Decreasing rates has the opposite effect, as money supply generally increases, consumption increases and consequently money supply will increase. It is done when inflation is seen as too low, for example during the financial crisis. It will generally lower the exchange rate or put downward pressure as foreign investors remove money from the capital account and look for higher returns. That is the theory anyway. As we have seen that in extraordinary times there are limits to the effect of monetary policy controlled by rates alone. The global nature of the last financial crisis saw a race to the bottom in terms of rates as it area tried to effectively devalue and loosen policy.

2) In a situation like this Fed will start raising rates generally as it causes rates to rise throughout the banking system and may also affect the government rate of borrowing. It will quell inflation, as by increasing the cost of borrowing it reduces consumption, company surpluses (i.e. dividends) as cost of borrowing increases and generally reduces the supply of money in the system. It will also tend to support or increase the exchange rate in a country as it will tend to increase the flow of money into the capital account from foreign investors.

Inflation could generally be controlled by the Fed through the main policy tools:

Monetary policy – Setting interest rates. Higher interest rates reduce demand, leading to lower economic growth and lower inflation. In a period of rapid economic growth, demand in the economy could be growing faster than its capacity can grow to meet it. This leads to inflationary pressures as firms respond to shortages by putting up the price. We can term this demand-pull inflation. Therefore, reducing the growth of aggregate demand (AD) should reduce inflationary pressures. The Central bank could increase interest rates. Higher rates make borrowing more expensive and saving more attractive. This should lead to lower growth in consumer spending and investment. See more on higher interest rates A higher interest rate should also lead to higher exchange rate, which helps to reduce inflationary pressure by :

Making imports cheaper.

Reducing demand for exports and

Increasing incentive for exporters to cut costs.

As part of monetary policy, many countries have an inflation target. The argument is that if people believe the inflation target is credible, then it will help to lower inflation expectations. If inflation expectations are low, it becomes easier to control inflation.Countries have also made Central Bank independent in setting monetary policy. The argument is that an independent Central Bank will be free from political pressures to set low-interest rates before an election.

Control of money supply – Monetarists argue there is a close link between the money supply and inflation, therefore controlling money supply can control inflation.

Supply-side policies – policies to increase competitiveness and efficiency of the economy, putting downward pressure on long-term costs.

Fiscal policy – a higher rate of income tax could reduce spending and inflationary pressures. The government can increase taxes (such as income tax and VAT) and cut spending. This improves the budget situation and helps to reduce demand in the economy. Both these policies reduce inflation by reducing the growth of Aggregate Demand. If economic growth is rapid, reducing growth of AD can reduce inflationary pressures without causing a recession.

Monetarism seeks to control inflation through controlling the money supply. Monetarists believe there is a strong link between the money supply and inflation. If you can control the growth of the money supply, then you should be able to bring inflation under control. Monetarists would stress policies such as:

• Higher interest rates (tightening monetary policy)
• Reducing budget deficit (deflationary fiscal policy)
• Control of money being created by government.   

this is how fed or govenment can deal with the situation of higher inflation without disturbing the groiwth of economy.