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Example research essay topic: Monetary Policy And The Economy - 2,043 words

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... duce consumers demand for cars and light trucks. Beyond these effects, consumption demand is lowered by a reduction in the value of household assets such as stocks, bonds, and landsat tends to result from higher long-term interest rates. The implications of changes in interest rates extend beyond domestic money and credit markets. Continuing with the example, when interest rates in the United States move higher in relation to those abroad, holding assets denominated in U. S.

dollars becomes more appealing, and the demand for dollars in foreign exchange markets increases. A result is upward pressure on the exchange value of the dollar. With flexible exchange rates (rates that fluctuate as the supply of and demand for national currencies vary), the dollar strengthens, the cost of imported goods to Americans de-cline's, and the price of U. S. -produced goods to people abroad rises. As a consequence, demands for U. S.

goods are reduced as Americans are induced to substitute goods from abroad for those produced in the United States and people abroad are induced to buy fewer American goods. Such changes in the demand for goods and services get translated into changes in total production and prices. Lessened demand resulting from higher interest rates and the stronger dollar tends to reduce production and thereby relieve pressures on resources. In an economy that is overheating, this relief will curb inflation. Production is the first to respond to monetary policy actions; prices and wages respond only later. There is considerable inertia in wages and prices, largely because much of the U.

S. economy is characterized by formal and informal contracts that limit changes in prices and wages in the short run and because inflation expectations, which influence how people set wages and prices, tend to be slow to adjust. In other words, because many wages and prices do not adjust promptly to a change in aggregate demand, sales and output slow initially in response to a slowing of aggregate demand. Over a longer period, however, inflation expectations are tempered, contracts are renegotiated, and other adjustments occur. As a consequence, price and wage levels adjust to the slower rate of expansion of aggregate demand, and the economy gravitates toward full employment of resources. Monetary policy is not the only force affecting output and prices.

Indeed, the economy frequently is buffeted by factors affecting aggregate demand for goods and services or aggregate supply. On the demand side, the government influences the economy through changes in tax and spending programs. Such fiscal policy actions receive a lot of public attention and typically can be anticipated well in advance. In fact, their effect on the economy may precede their implementation to the degree that some businesses and households may alter their spending in anticipation of the policy change. Also, forward-looking financial markets may build such fiscal events into the level and structure of interest rates and thus further influence spending decisions before the government action. Other changes in demand or supply can be totally unpredictable and can influence the economy in unforeseen ways.

Examples of such shocks on the demand side are changes in households propensity to consume and shifts in consumer and business confidence. Monetary policy in time can offset such shocks in private-sector demand but because of their nature, not as they occur. On the supply side, matters can be even more complicated. Natural disasters, disruptions in the supply of oil, and agricultural losses are examples of adverse supply shocks.

Because such events tend to raise prices and reduce output, monetary policy can attempt to counter the losses of output or the higher prices, but cannot completely offset both. In practice, monetary policymakers do not have up-to-the-minute, reliable information about the state of the economy and prices. Information is limited because of lags in the publication of data and because of later revisions in data. Also, policy-makers have a less-than-perfect understanding of the way the economy works, including the knowledge of when and to what extent policy actions will affect aggregate demand. The operation of the economy changes over time, and with it the response of the economy to policy measures.

These limitations add to uncertainties in the policy process and make determining the appropriate setting of monetary policy instruments more difficult. The central bank will have an easier time reaching its goals if the public understands them and believes the Federal Reserve will take the steps necessary to reach them. For example, a believable anti-inflation policy, implemented through a deceleration of aggregate demand, will more quickly lead the public to expect lower inflation, and such an expectation will itself help bring down inflation. In that case, workers will not feel the need to demand large wage increases to protect themselves against expected price hikes, and businesses will be less aggressive in raising their prices, knowing that doing otherwise would result in losses in sales.

In these circumstances, inflation will come down more or less in line with the slowing of aggregate demand, with much less slack emerging in resource markets than if workers and businesses continued to act as if inflation were not going to slow. The goals of monetary policy are spelled out in law. But how will the Federal Reserve know whether or not its current operations in the reserves market are consistent with those goals or whether it needs to be more restrictive or more accommodative? The actions taken in the reserves market affect the economy with considerable lags. If the Federal Reserve waits to adjust rates until it sees an undesirable change in employment or prices, it will be too late to achieve its objectives. Consequently, people have suggested that the Federal Reserve pay particularly close attention to guides to policy that are intermediate between operations in the reserves market and effects in the economy.

Among those frequently mentioned are monetary and credit aggregates, interest rates, and the foreign exchange value of the dollar. Some suggest that one or the other of these measures be used as an intermediate target that is, one with a specific formal objective. Others suggest that they be used less formally as indicators of the longer-term effects of monetary policy on the economy, to be judged in conjunction with a variety of other financial and economic information. The Humphrey Hawkins Act has something to say about the guides for monetary policy: It specifies that each February the Federal Reserve must announce publicly its objectives for growth in money and credit and that at midyear it must review its objectives and revise them if appropriate. This provision of the act was based on the presumption of a reasonably stable relation between growth of money and credit, on the one hand, and the goals of monetary policy, on the other relation that could be fruitfully exploited in achieving those goals. Control over the money stock, it was thought, could in effect anchor the price level in much the same way that the former gold standard was thought to have anchored the price level.

Nonetheless, the law foresaw that revision might be appropriate should, for example, the relation between the monetary or credit aggregates and the economy the velocity of money or credit change unpredictably (see the box for a description of the content of the monetary and credit aggregates). In these circumstances, adherence to the initial objectives for money or credit growth would lead to an undesirable outcome for output or prices. The Federal Reserve is not required to achieve its announced objectives for these financial aggregates, but if it does not, it must ex-plain the reasons to Congress and the public. The usefulness of the monetary aggregates for indicating the state of the economy and for stabilizing the level of prices has been called into question by frequent departures of their velocities from historical patterns. As can be seen in chart 2. 1, the velocity of M 2 had until recently been fairly stable over long periods, although it did vary over shorter periods in ways related to the interest-rate cycle.

In the early 1990 s, the velocity of M 2 departed from this pattern and drifted upward. This upward drift occurred even as market interest rates were moving down, a change that should have added to the attractiveness of deposits in M 2 and lowered its velocity. Such departures from historical experience have made forecasting velocity, and thus the rate of monetary growth needed to achieve economic objectives, more difficult. Many observers believe that the recent unusual monetary behavior is due to the growing variety of new financial assets offered to the public, such as new kinds of mutual funds and mutual fund services, and to changes in the way people manage their financial portfolios. Some analysts expect that rapid financial change will continue and will further undermine the value of the monetary aggregates as guides to policy. Others expect the process to settle down as people complete their shifts of investment-type balances to assets outside M 2.

In this view, once the shift is fairly complete, M 2 perhaps measured somewhat differently will again behave in a reliable way and can again be used effectively as a guide for monetary policy. Interest rates have frequently been proposed as a guide to policy. Surely, some argue, changes in the provision of reserves by the Federal Reserve can influence interest rates, and changes in interest rates affect various spending decisions. Moreover, information on interest rates is available on a real-time basis.

Arguing against giving interest rates a key role in guiding monetary policy is the uncertainty about what level or path of interest rates is consistent with the more basic goals. The appropriate level or path will vary with the stance of fiscal policy, changes in pat-terns of business and household spending, the productivity of capital, and economic developments abroad. It is difficult not only to gauge the strength of these various forces at any time but also to translate them into an appropriate level of interest rates. More-over, real interest rates that is, interest rates net of expected inflation drive spending decisions.

Expected inflation is not readily measured; thus, assessing what the level of real interest rates hap-pens to be is difficult. However, failing to account for inflation expectations can result in misleading signals coming from nominal interest rates. For example, if the public expected more inflation, nominal interest rates would tend to rise, as investors sought protection for the greater loss of purchasing power, and might lead to the belief that monetary policy had become tighter and more dis inflationary when, in fact, just the reverse had occurred. Alternatively, the yield corvette difference between the interest rate on longer-term securities and the interest rate on short-term instruments has been proposed. Whereas short-term interest rates are strongly influenced by current reserve provisions of the central bank, longer-term rates are influenced by expectations of future short-term rates and thus by the longer-term effects of monetary policy on inflation and output. For example, a steep positive yield curve (that is, long-term rates far above short-term rates) may be a signal that participants in the bond market believe that monetary policy has become too expansive and thus, without a monetary policy correction, more inflationary.

Such a curve would be telling the central bank to provide fewer reserves. Conversely, an inverted yield curve (short-term rates above long-term rates) may be an indication that policy is restrictive, perhaps overly so. However, various other influences, such as uncertainty about the course of interest rates, affect long-term interest rates. Thus, a steepening of the yield curve may indicate not that the thrust of monetary policy is too expansive, but that market participants have become more uncertain about the outlook for interest rates. In other words, liquidity premiums embodied in long-term interest rates may have risen. More generally, interest rates can vary for a variety of reasons, especially over short periods, and the Federal Reserve must exercise considerable caution in interpreting and re-acting to their fluctuations.

Exchange rate movements are an important channel through which monetary policy affects the economy, and they tend to respond promptly to a change in the provision of reserves and in interest rates. Information on exchange rates, like that on interest rates, is available almost continuously throughout each day. Bibliography:


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Research essay sample on Monetary Policy And The Economy

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