# Economics: Theory Through Applications, v. 1.0 (2 Volume Set)

by Russell Cooper and A. Andrew John

## 25.7 End-of-Chapter Material

### In Conclusion

A driving analogy is sometimes used to illustrate the problems of the Fed. In the best of all worlds, we would drive a car in perfect weather along straight, wide, dry roads. We would look out crystal clear windows with complete knowledge of exactly where we are on the road and what driving conditions are like up ahead. Then, with complete control over the car, we could adjust speed and direction to reach our destination.

This is not the right picture for monetary policy. Instead, the windshield is very dirty, obscuring current conditions and making predictions almost impossible. Although the driver is well trained, the connection between the tools of the car and its direction and speed is haphazard.

Suppose the driver sees a steep downhill in the distance that requires some slowing down. Putting on the brakes will eventually slow the car down, but the delay is hard to predict. Making matters worse, by the time the car slows, the road may be going uphill again.

More precisely, the first challenge for the Fed is determining the current state of the economy. The Fed must rely on economic data to determine the current state of the economy. This is not easy; data often arrive with lags and with measurement error. Furthermore, the data often provide conflicting signals about the current state of the economy.

The second challenge for the Fed is that the transmission mechanism is not cast in stone. Reducing real interest rates by, say, one percentage point does not create the same response in spending at all times. Instead, the links in the monetary transmission mechanism change over time and depend on numerous other variables in the economy. Understanding these links remains a key area of research in economics and is also a challenge for those responsible for the conduct of monetary policy.

### Exercises

1. Have you ever noticed that banks are often housed in big imposing buildings? Why do you think this is the case?
2. Consider a Taylor rule given by

real interest rate = −(1/2) × (output gap) + (1/2) × (inflation rate − 4 percent).
1. Describe this rule in words. What is the target inflation rate in this rule?
2. If the inflation rate is 6 percent and the GDP gap is −2 percent, what should the real interest rate be? What nominal interest rate should the Fed set?
3. (Advanced) Draw a version of Figure 25.15 "The Taylor Rule" where you show how to relate the target interest rate to the output gap. Explain in words what it means to move along the curve. What shifts the curve you have drawn?
4. What would happen if the Fed set the discount rate below the rate of return on government bonds?
5. Do open-market operations have to be in the form of the Fed buying and selling government debt? Could an open-market operation occur with the Fed buying the stock of a company?
6. Explain why an increase in interest rates reduces the demand for durable goods.
7. Suppose the relationship between investment and interest rates is investment = 100 − 4 × real interest rate and suppose the multiplier is 2. If the interest rate decreases by one percentage point, what happens to real GDP (assuming no change in the price level)?
8. Give two reasons why it is difficult to conduct monetary policy.
9. Suppose the central bank in country A is more worried about inflation than the output gap, but the opposite is true in country B. What differences in the Taylor rule would you expect to see in the two countries? Must it be the case that country A has a lower target inflation rate than country B?
10. Explain why a positive output gap does not necessarily lead to decreasing prices.

Economics Detective

1. Find the most recent announcement of the Federal Open Market Committee (FOMC). How does it differ from the one from February 2, 2005? Who is currently on the FOMC?
2. Use the site http://www.hsh.com/calc-payment.html to calculate how your monthly payment would change as you vary the interest rate charged on a car loan for a \$30,000 car. This will give you a sense of how actions of the Fed would affect your monthly payments on a loan.
3. Find the names of five other central banks in the world economy. Find some information about their history (when were they established, for example), their design (are they independent?), and their operating procedures.
4. Find the web page for the Board of Governors of the Federal Reserve System and read about the tools of monetary policy. Based on your reading, (a) how often does the FOMC meet, and (b) how is its membership determined?
5. If you live in the United States, find the web page for the regional Fed closest to you. Try to find its most recent report on local economic conditions. Do you agree with this assessment of the local economy? What can you learn about the president of the regional Fed? What about the director of research, who is the staff member most likely to give advice to the president of the regional Fed about monetary policy?
6. Using your web research skills, find a discussion of Fed policy during times of high oil prices. How did the Fed resolve the tensions between increasing rates to combat inflation and decreasing rates to deal with unemployment? Try to find data on (real) oil prices and the federal funds rate. Did these two economic variables move together during periods of high oil prices?
7. In March 2008, the Fed opened the discount window to add liquidity into the financial system. Find the policy statements associated with this action and describe exactly what the Fed did.
8. Get data on the US economy to see how well the Taylor rule,

real interest rate = −(1/2) × (output gap) + (1/2) × (inflation rate − 4 percent),

fits the facts for the past five years.

9. Find an occasion when the Fed has changed reserve requirements. Did it also make other policy adjustments at the same time?