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Chapter 35 – Monetary Policy, GDP, and the Price Level
Chapter 35 - Monetary Policy, GDP, and the Price Level
McConnell Brue Flynn 23e
1. What is the difference between quantitative tightening and quantitative easing? Why did the Fed feel that it was necessary to start using quantitative easing for the first time during the financial crisis? LO35.2
Answer: The main difference between the two is quantitative tightening raises long-term interest rates while quantitative easing lowers them.
The Fed felt it necessary to start using quantitative easing during the financial crisis because short-run interest rates were nearly zero and up against the zero lower bound below which further reductions in short-term rates were likely to become counterproductive. Faced with that situation, the Fed began to lower longer-term interest rates as a way of achieving additional economic stimulus without having to risk lowering short-term interest rates below the zero lower bound.
2. Which policy would be the most helpful in lowering long-term interest rates? LO35.2 a. numerical neutrality b. quantitative easing c. raising the administered rates d. lowering the federal funds target range
Answer: b. quantitative easing
Feedback: Quantitative easing was developed by the Fed as a strategy to reduce
longer-term interest rates. Option a, numerical neutrality, is just a made-up term. Option c is incorrect because raising the administered rates will raise short-term interest rates but likely have zero effect on longer-term rates (or maybe might even raise them a bit, which would be the opposite of what is wanted here). Answer d is wrong because lowering the federal funds target range would lower short-term rates but probably not do much to lower long-term rates (as was discussed at the end of Chapter 34).
PROBLEMS
1. Draw two separate demand-and-supply diagrams that illustrate, respectively, bond
purchases and bond sales by the Fed. In each figure, the price of bonds is the vertical axis variable while the quantity of bonds demanded or supplied is the horizontal axis variable. In each of the two figures, show the initial equilibrium before the Fed action and the new equilibrium after the Fed has (1) increased the demand for bonds in the
first figure and (2) increased the supply of bonds in the second figure. Note which way the equilibrium bond price moves in each figure, and then use the fact that “bond prices and interest rates move inversely” to infer in which direction interest rates move in each situation. LO35.1
Answer: Refer to the graphs below. In the graph on the right, the Fed has taken action to increase the demand for government bonds. The Fed could do this by announcing their intent to make a significant purchase of bonds. This action would cause the demand curve to shift rightward to D’ which would cause the equilibrium price to rise from P* to P’ as shown.
In the graph on the left, the Fed has taken action to increase the supply government bonds. The Fed could do this by selling a significant amount of bonds. This action would cause the supply curve to shift rightward to S’ which would cause the equilibrium price to fall from P* to P’ as shown.
Since bond prices and interest rates move in opposite direction, we could infer that an increase in bond price to P’ as shown in the graph on the left would be followed by a decrease in interest rates. Similarly, decrease in bond price as shown in the graph on the right would be followed by a increase in interest rates.
2. Examine the nearby dual-mandate bullseye chart that shows where the U.S. economy was exactly one year before the covid-19 lockdowns began. Write a brief essay of just a paragraph or two explaining how an FOMC member might have reacted to this information, including whether the Fed was getting mixed signals and what policies they might have recommended to move the red dot toward the center of the bullseye. LO35.3
Answer: An FOMC member in March 2019 would have seen that the current unemployment and inflation data were giving them mixed signals. On the one hand, inflation was the 2-percent inflation target, suggesting that a restrictive monetary policy might be useful (reduce money supply so that interest rate rises and reduce I and AD). On the other hand, the unemployment rate was more than the 3.5 percent unemployment target that prevailed back then, suggesting that the economy was having recession and that an expansionary monetary policy might be useful.
However, it should be noted that difference between the actual rates and the targeted rates for both inflation and unemployment were quite small. Thus, an FOMC member would likely not have been very motivated to make any changes given that both gaps were small, and both were indicating opposite policy stances.
