Answers to Review Questions

1.What are the ultimate targets of monetary policy?

The ultimate targets of monetary policy include stable prices, sustainable real gross domestic product growth, full employment, and satisfactory external balances.

2.What is an intermediate target? Why does the Fed use intermediate targets instead of focusing on the ultimate targets? What is an operating target?

An intermediate target is a measurable variable that lies between the operating target that the Fed uses in the implementation of monetary policy and the ultimate goals.

The intermediate target should be highly correlated with the ultimate target and amenable to control by the Fed. If the Fed uses such an intermediate target to guide its open market operations, it will have a greater success rate in achieving its ultimate goals. Intermediate targets enhance the probability of achieving the ultimate goals.

3.What is the recognition lag? The policy lag? The impact lag?

The recognition lag is the time elapsed between when a change occurs in the economy’s performance and when policy makers recognize that a change has occurred.

The policy lag is the time elapsed between when policy makers recognize that a change in the economy's performance has occurred and when policy makers decide on and implement an adjustment policy.

An impact lag is the time elapsed between when adjustment policy is implemented and when the economy responds to the policy.

4.How would the recognition, policy, and impact lags differ with regard to monetary and fiscal policy? What role does uncertainty play?

The recognition lag should be the same for both monetary and fiscal policy. The policy lag is generally thought to be shorter for monetary policy. The FOMC is capable of making changes faster than Congress. The impact lag of monetary policy may also be shorter. Changes in interest rates may be able to impact economic activity faster than changes in government spending or taxes. For example, a government spending program on a new highway may take several years to implement.

Uncertainty plays a key role in assessing policy. Economic forecasts generally contain large errors, and impacts lags are difficult to measure. Also, incoming data may be contradictory. These factors create uncertainty in policymaking, so policymakers tend to be cautious in adjusting policy.

5.Are current incoming economic data or forecasts more important in guiding monetary policy? Why?

Current economic data is more important than forecasts in guiding monetary policy.

The proportionately large forecasting errors have created a lack of confidence in forecasts; hence, policy makers rely more heavily on current economic data than forecasts.

6.When is it most difficult to interpret incoming data? (Hint: Consider the case in which retail sales are weak, but new orders for capital goods are strong, etc.)

It is more difficult to interpret incoming data when the collection of different individual series of data reveals conflicting results.

7.What is policy regret? What are some of the strategies that the Fed could use to minimize policy regret?

Policy regret is a situation in which policy actions based on available data would not have been taken if more accurate data revisions had been available. The Fed could make more gradual changes in policy to reduce the effect of data uncertainty on policy recommendations. The Fed could also base policy actions on data that are less responsive to highly uncertain information or the Fed could respond to data that have been averaged over several time periods.

8.Why can short-term goals sometimes differ from long-term goals?

Short‑term goals can differ from long‑term goals. For example, if the economy is very far from the long-term goals, then an adjustment that would result in a movement to the long-term goals in the short term may not be possible. Thus, the short‑term goals depend on how far the economy is from the long‑term goals and what can politically be feasible in the short term.

8.What is an irregular variance? How does it affect Fed behavior?

Irregular variance is a random fluctuation in any data series that makes any single month movement less reliable as a policy indicator then if a trend continues for several month. Irregular variance affects the behavior of Fed because it causes the Fed to wait for two to three months of data to interpret cyclical or trend movements of the economy rather than relying on month‑to‑month data only.

10.What are some common intermediate targets that the Fed has used to guide policy in recent years? Give two criteria for intermediate targets.

The Fed used the M2 and DNFD aggregates as intermediate targets in the late 1980s and early 1990s. Since the early 1990s, the Fed has used the level of interest rates as intermediate targets.

An intermediate target must be highly correlated with the ultimate goals of policy. An intermediate target must also be amenable to control by the Fed.

11.Why can’t the Fed target both an interest rate and a monetary aggregate simultaneously?

The Fed cannot target both an interest rate and a monetary aggregate simultaneous if there are changes in the demand for money due to changes in aggregate demand. If the Fed maintains an interest rate target if the face of a change in the demand for money, it will have to let the supply of money adjust and hence it will miss its money supply target. If the Fed maintains the money supply target in the fact of a change in the demand for money it will have to let the interest rate change and hence miss the interest rate target.

12.Assume the Fed is targeting the money supply and the demand for money falls. Explain why interest rates will fall.

If the Fed is targeting the money supply and the demand for money falls, there will be an excess supply of money available at the current interest rate. The interest rate will fall until a new equilibrium is achieved where the quantity supplied and the quantity demanded of money are equal.

13.Assume the Fed is targeting an interest rate and the demand for money increases. Explain why the money supply will increase.

If there is an increase in the demand for money, given a fixed money supply, the interest rate will rise. To keep the interest rate from rising and missing the targeted rate, the money supply has to increase.

14.“The Fed should do everything it can to eliminate inflation.” Do you agree? Explain.

Without ignoring or jeopardizing other goals, the Fed should do everything it can to eliminate inflation. Sometimes, it may not be possible to reduce inflation without severe and politically unacceptable consequences for employment. Such a situation may result from a severe adverse supply shock causing both high unemployment and high inflation. In this case, attempts to eliminate inflation may lead to unacceptable increases in already high unemployment.

15.Can using an interest rate as an intermediate target ever have an inflationary bias? Explain.

Using interest rates as an intermediate target can have an inflationary effect. If an increase in the demand for money occurs, the Fed would have to increase the money supply to maintain a target interest rate. The increase in money supply could lead to inflation.

Answers to Analytical Questions

16.Find the minutes of the most recent FOMC meeting, either at the library or on the Internet. (Since the FOMC meets about every six weeks, minutes appear in 8 of the 12 monthly issues of the Federal Reserve Bulletin.) Summarize the policy directive.

The answer to this question will depend on when students take this class.

17.Assume that the Fed is targeting an interest rate and aggregate demand drops. Show graphically why the Fed will have to reduce the supply of money to maintain the interest rate target.

If the Fed targets the interest rate at X, equilibrium occurs at point A. A drop in aggregate demand causes the demand for money to fall. If the demand for money drops from D to DI because of a drop in aggregate demand, market forces will be pushing the interest rate down towards the new equilibrium point B. To maintain the interest rate at X, the Fed must reduce the money supply from MS to MS1. At the new money supply, the equilibrium is point C and interest rate is X.

18.Use a graph to explain why the Fed cannot target both an interest rate and a monetary aggregate at the same time, assuming that there is a drop in aggregate demand.

A drop in aggregate demand causes the demand for money to fall. The Fed cannot for maintain both an interest rate and money supply target in the face of changes in demand. For example, if the original money supply and interest rate targets are determined by point A, if there is a drop in demand for money, and if the Fed maintains the money supply target, then the interest rate will fall to that determined by point B and the Fed will miss its interest rate target. On the other hand, in the face of a drop in demand, if the Fed maintains the interest rate target as determined by point A, then it will have to allow the money supply to fall to MS1. In either case, maintaining one target causes the Fed to miss the other target. Therefore, the Fed cannot target both an interest rate and an aggregate at the same time.