Policymaking is much easier when the state of the economy is easily observable t
ID: 2699656 • Letter: P
Question
Policymaking is much easier when the state 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 percent, whereas if the economy is in a recession , the federal funds rate is ideally set at 2 percent. If monetary policy makers know the state of the economy when they set policy, then policymaking is easy- set the fed funds rate at 6 percent when in expansion and at 2 percent when in a 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 percent chance the economy is still in an expansion (and thus a 10 percent 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 percent chance that it is still in a recession (and a 25 percent chance 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 funds 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 conducts conventional monetary policy by targeting the federal funds rate, the rate that banks charge each other for overnight loans of their reserves held with the Fed. The Federal Reserve can directly influence this rate because its transactions with private market banks affect the total supply of bank reserves. Banks are required to hold a minimum level of reserves against their deposits, and banks may borrow reserves to meet those requirements or to make additional loans to customers. Monetary policy affects the real economy because the level of the federal funds rate sets the opportunity cost for additional funds for banks. The cost of these funds then influences the level of interest rates that banks charge customers for loans, as well as the level of other market interest rates. Higher interest rates (all other things the same) raise the cost of borrowing and tend to reduce loan and investment activity, whereas lower interest rates (all other things the same) reduce the cost of borrowing and tend to increase loan and investment activity. Federal Reserve monetary policy aims to achieve its statutory goals of low inflation and maximum employment. This dual mandate has been often characterized as a balancing act