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Chapter 26: Problem 2

For more than 20 years, the Fed has used the federal funds rate as its monetary policy target. Why doesn't the Fed target the money supply at the same time?

Short Answer

Expert verified
The Fed targets the federal funds rate instead of the money supply because it allows them to more directly and precisely influence short-term interest rates, which are crucial for overall economic activity. While controlling the money supply impacts inflation directly, it's less effective for addressing short-term economic changes and more challenging to implement accurately due to the complexity of global financial markets.

Step by step solution

01

Understand Federal Reserve’s monetary policies

The Federal Reserve (Fed) has two main monetary policies: adjusting the money supply and manipulating the federal funds rate. Adjusting the money supply – the total amount of money in circulation in a country – is directly linked to inflation. The Fed can increase the money supply to stimulate the economy or decrease it to curb inflation. On the other hand, the federal funds rate is the interest rate banks charge each other for overnight loans. The Fed can influence this rate to stimulate financial activity or slow it down.
02

Relate the monetary policies to the Fed’s goals

The Fed has two main goals: maintaining price stability and promoting maximum employment. Both adjusting the money supply and manipulating the federal funds rate can help achieve these goals but in different ways. Money supply manipulation affects inflation directly, while federal funds rate manipulation affects the lending and borrowing between banks, thereby indirectly influencing economic activity and inflation.
03

Explain why the Fed targets the federal funds rate

The federal funds rate provides a more direct mechanism for influencing short-term interest rates, which are crucial for the overall economic activity. By targeting the federal funds rate, the Fed can fine-tune economic conditions with more precision.
04

Explain why the Fed does not target the money supply

While the control of money supply directly impacts inflation, it is less effective in regulating short-term Economic changes due to lags in policy implementation and the time it takes for money supply changes to affect the economy. Moreover, given the complexity and global nature of financial markets, it is difficult for the Fed to accurately control the money supply. Hence the Fed focuses on the federal funds rate as its primary monetary policy target.

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Most popular questions from this chapter

Draw a demand and supply graph showing equilibriur in the money market. Suppose the Fed wants to lower th equilibrium interest rate. Show on the graph how the Fe would traditionally accomplish this objective.

What is quantitative easing? Why have central banks used this policy?

A column in the Wall Street journal referred to policy actions aimed at "fulfilling both sides of the Fed's dual mandate." a. Who gave the Fed a dual mandate? b. Does the Fed's dual mandate require it to attain a zero percent unemployment rate? Briefly explain. c. Does the Fed's dual mandate require it to attain a zero percent inflation rate? Briefly explain.

(Related to the Don't Let This Happen to You on page 918 ) Briefly explain whether you agree with the following statement: "The Fed has an easy job. Say it wants to increase real GDP by \(\$ 200\) billion. All it has to do is increase the money supply by that amount."

The European Central Bank (ECB) issued the following statement after its June 2017 meeting on monetary policy: Regarding non-standard monetary policy measures, the Governing Council confirms that the net asset purchases, at the current monthly pace of \(€ 60\) billion, are intended to run until the end of December \(2017,\) or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. a. What is this nonstandard monetary policy of net asset purchases called? What other central banks have used it? b. Based on this statement, do you expect that the inflation rate is above or below the ECB's inflation target? Briefly explain.
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