6. Fed Sees Both Unemployment, Prices on Rise The Federal Reserve sees worse eco

Question

6. Fed Sees Both Unemployment, Prices on Rise

The Federal Reserve sees worse economic problems ahead. . . . But even so, the Fed may be reluctant to cut interest rates any further than it already has. . . . The Fed lowered its economic growth forecast for the year. At the same time, it reaised its projections for inflation and unemployment. . . . The Fed raised its unemployment forecast . . . to between 5.5 percent and 5.7 percent . . . [and] now expects personal consumption expenditures to rise between 3.1 percent and 3.4 percent in 2008 . . [and] expects steeper "core" inflation. . . . In an effort to keep the country from falling into recession and to deal with the credit crisis, the Fed has cut its key federal funds rate seven times since September. This short-term interest rate is now 2 percent, down from 5.25 percent at the start of the Fed's easing campaign. . . . Some believe the Fed cuts since last September helped fuel inflation, especially the sharp run-up in oil prices, because the rate cuts have led to a weakening of the dollar. Along those lines, the two Fed members who voted against the last rate cut . . . argued during the meeting that the Fed cuts were hurting the economy more than heping it. CNN, May 21, 2008

a. Explain the inteded effect of the Fed cutting the target federal funds rate from 5.25 percent to 2 percent and illustrate your explanation with an appropriate graphical analysis.

b. Explain how this monetary policy may have "helped fuel inflation, especially the sharp run-up in oil prices."

c. What is core inflation and why does the Fed tend to focus on that measurement of inflation more heavily than overall inflation?

d. Explain the dilemma that the Fed is facing when making decisions in the face of rising unemployment and rising inflation.

Explanation / Answer

1.The increase in reserves lowers the federal funds rate, from 5.25 percent to 2 percent in the figure.

2.The increase in reserves also increases the monetary base so that the quantity of money increases. In Figure   , the supply of money increases from MS0 to MS1.

3.The increase in the quantity of money lowers the interest rate, to 4 percent in the figure.

4. Figure shows the increase in loanable funds as the shift in the supply of loanable funds curve from SLF0 to SLF1. The increase in the supply of loanable funds lowers the real interest rate, to 3 percent in the figure, and increases the quantity of loanable funds, to $2.5 trillion in the figure.

5.The fall in the interest rate also lowers the U.S. exchange rate.

6.Finally the fall in the real interest rate, the increase in supply of loanable funds, the fall in the exchange rate, and the increase in bank loans all increase aggregate expenditure and aggregate demand.

7.Figure shows the increase in aggregate demand with the rightward shift of the aggregate demand curve from AD0 to AD1. The increase in aggregate demand increases real GDP, from $12.0 trillion to $12.2 trillion in the figure, and raises the price level, in the figure from 120 to 122

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1.The fall in the exchange rate makes U.S. imports more expensive. Oil is one of the products imported into the United States

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c. What is core inflation and why does the Fed tend to focus on that measurement of inflation more heavily than overall inflation?

1.Core inflation is the inflation rate calculated using the core personal consumption expenditure (PCE) deflator is the PCE 224 MONETARY POLICY deflator excluding food and fuel prices. The prices of food and fuel are generally quite volatile.

2.Because of the added volatility they can make the direction of the inflation rate more difficult to determine. The core inflation rate is a better indicator of the overall direction of the inflation rate and so is a better indicator of what monetary policy should be used.

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d. Explain the dilemma that the Fed is facing when making decisions in the face of rising unemployment and rising inflation.

1.Rising unemployment calls for expansionary monetary policy, that is, a cut in the interest rate, to lower the unemployment rate.

2.This policy, however, raises the inflation rate. Rising inflation calls for a contractionary monetary policy, that is, a hike in the interest rate, to lower the inflation rate.

3.This policy, however, raises the unemployment rate. So if the Fed combats unemployment, it worsens the inflation problem. But if the Fed combats inflation, it worsens the unemployment problem.

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