Policymaking is much easier when the stae of the economy is easily observable th
ID: 1237707 • Letter: P
Question
Policymaking is much easier when the stae of the economy is easily observable than when there is uncertainty about how the economy is doing, as this problem illustrates. Suppose that the economy is either in an expansion or a recession. Suppose that in an expansion, monetary policy ideally sets the interest rate on federal funds (loans between banks) at 6%, whereas if the economy is in a recession, the federal funds rate is ideally set at 2%. If monetary policymarkers know the state of the economy when they set policy, then policymaking is easy set the fed funds rate at 6% when in expansion and at 2% when in recession. Suppose, however, that policymakers cannot easily observe the current state of the economy. They know only what the state of the economy was three months ago. Suppose that if the economy was in an expansion three months ago, there is a 90% chance the economy is still in an expansion (and thus a 10% chance that it is now in a recession.) And suppose that if the economy was in a recession three months ago, there is a 75% chance that it is still in recession (and a 25% that it is now in an expansion.) Given these probabilities, what would you guess is the right setting for the federal funds rate if the economy was in a recession three months ago? What is the right setting for the federal rate if the economy was in an expansion three months ago? (Note: To answer these questions, you must make an assumption about the ideal federal funds rate when you do not know what the state of the economy is you may make any reasonable assumption you want, but you must justify it.)
Explanation / Answer
The Federal Reserve Act specifies that the FOMC should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." At each meeting, the FOMC closely examines a number of indicators of current and prospective economic developments. Then, cognizant that its actions affect economic activity with a lag, it must decide whether to alter the federal funds rate. A decrease in the federal funds interest rate stimulates economic growth, but an excessively high level of economic activity can cause inflation pressures to build to a point that ultimately undermines the sustainability of an economic expansion. An increase in the federal funds interest rate will curb economic growth and help contain inflation pressures, and thus can promote the sustainability of an economic expansion, but too large an increase could retard economic growth too much. The Committee's actions on interest rates are undertaken to achieve the maximum rate of economic growth consistent with price stability and moderate long-term interest rates. Two consecutive quarters of decline in real GDP is commonly taken to be a recession. The National Bureau of Economic Research, a private organization, effectively decides when recessions occur, however, and the actual dating process is determined by judgment rather than a formal rule. Most of the recessions identified by our procedures do consist of two or more quarters of declining real GDP, but not all of them. According to current data for 2001, the present recession falls into the general pattern, with three consecutive quarters of decline. Our procedure differs from the two-quarter rule in a number of ways. First, we consider the depth as well as the duration of the decline in economic activity. Recall that our definition includes the phrase, "a significant decline in economic activity." Second, we use a broader array of indicators than just real GDP. One reason for this is that the GDP data are subject to considerable revision. Third, we use monthly indicators to arrive at a monthly chronology. The NBER considers real GDP to be the single measure that comes closest to capturing what it means by "aggregate economic activity." The committee therefore places considerable weight on real GDP and other output measures. Following the precedents established in many decades of maintaining its business cycle chronology, however, the committee considers a wide range of indicators of economic activity. There is no fixed rule for how the different indicators are weighted.