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Chapter 5 Monetary Policy Outline Mechanics of Monetary Policy Monitoring Indicators of Economic Growth Monitoring Indicators of Inflation Implementing Monetary Policy Effects of a Stimulative Monetary Policy Impact on Interest Rates Why a Stimulative Monetary Policy Might Fail Effects of Restrictive Monetary Policy Tradeoff in Monetary Policy Impact of Other Forces on the Tradeoff Shifts in Monetary Policy over Time How Monetary Policy Responds to Fiscal Policy Proposals to Focus on Inflation Impact of Monetary Policy Impact in Financial Markets Impact on Financial Institutions Global Monetary Policy Impact of the Dollar Impact of Global Economic Conditions Transmission of Interest Rates Impact of the Greece Crisis on European Monetary Policy Key Concepts 1. Describe the common monetary policy used to correct a weak economy or high inflation. 2. Explain the tradeoff involved in the Fed’s use of a loose or tight monetary policy. 3. Explain how financial market participants would react to a particular monetary policy. 4. Explain how fiscal policy may influence the monetary policy. POINT/COUNTER-POINT: Can the Fed Prevent U.S. Recessions? POINT: Yes. The Fed has the power to reduce market interest rates, and can therefore encourage more borrowing and spending. In this way, it stimulates the economy. COUNTER-POINT: No. When the economy is weak, individuals and firms are unwilling to borrow regardless of the interest rate. Thus, the borrowing (by those who are qualified) and spending will not be influenced by the Fed’s actions. The Fed should not intervene, but rather let the economy work itself out of a recession. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: It is difficult to determine how long a recession would last if the Fed did not intervene. However, most people (especially the unemployed) would prefer that the Fed make an effort to stimulate the economy. There is some concern that a stimulative monetary policy may cause more inflation, but this is a risk that the Fed must take in order to cure a recession. Questions 1. Impact of Monetary Policy. How does the Fed’s monetary policy affect economic conditions? ANSWER: The Fed’s monetary policy can affect the supply of loanable funds available in financial markets and therefore may affect interest rates. It may also affect inflation (with a lag) and therefore affect the demand for loanable funds by influencing inflationary expectations. 2. Tradeoffs of Monetary Policy. Describe the economic tradeoff faced by the Fed in achieving its economic goals. ANSWER: In general, a stimulative monetary policy can increase economic growth and reduce unemployment, but may increase inflation. A restrictive monetary policy can keep inflationary pressure low but may cause low economic growth and higher unemployment. 3. Choice of Monetary Policy. When does the Fed use a stimulative monetary policy and when does it use a restrictive-monetary policy? What is a criticism of a stimulative monetary policy? What is the risk of using a monetary policy that is too restrictive? ANSWER: A stimulative monetary policy may be used to stimulate the economy, especially if inflation is not a concern. A restrictive monetary policy may be used to slow economic growth in order to reduce inflationary fears. A stimulative-monetary policy may result in higher inflation. The risk of a restrictive monetary policy is a potential slowdown in the economy. A restrictive monetary policy may result in higher interest rates, reduced borrowing, and reduced spending to an excessive degree. 4. Active Monetary Policy. Describe an active monetary policy. ANSWER: An active monetary policy reflects actions taken by the Fed to adjust money supply in order to affect economic conditions. 5. Passive Monetary Policy. Describe a passive monetary policy. ANSWER: A passive monetary policy means that the Fed does not attempt to adjust money supply in order to improve economic conditions. 6. Fed Control. Why may the Fed have difficulty in controlling the economy in the manner desired? Be specific. ANSWER: The Fed has difficulty in controlling the economy because it cannot always maintain money growth within its target boundaries. In addition, the impact of monetary growth on the economy may be different than what was anticipated. 7. Lagged Effects of Monetary Policy. Compare the recognition lag and the implementation lag. ANSWER: The recognition lag represents the time from when a problem exists until it is recognized by the Fed. It occurs because the economic statistics that are monitored to detect problems are only reported periodically. The implementation lag occurs when the Fed recognizes a problem but does not implement a policy to solve the problem until later. 8. Fed’s Control of Inflation. Assume that the Fed’s primary goal is to reduce inflation. How can it achieve its goal? What is a possible adverse effect of such action by the Fed (even if it achieves this goal)? ANSWER: To cure inflation, the Fed may use a restrictive monetary policy, which will reduce economic growth and inflationary pressure. A possible adverse effect is an increase in the unemployment rate. 9. Monitoring Money Supply. Why do financial market participants closely monitor money supply movements? ANSWER: Money supply movements can affect interest rates and other economic variables that influence security prices. Therefore, financial market participants can monitor money policy to develop forecasts of future security prices. Financial market participants may incorrectly forecast money supply movements, causing them to incorrectly forecast economic variables. Yet, even if they forecast money supply movements correctly, they may incorrectly anticipate the impact of money supply movements on economic variables. 10. Monetary Policy During the Credit Crisis. Describe the Fed’s monetary policy response to the credit crisis. The Fed used a stimulative monetary policy during the credit crisis because economic conditions were very weak. Specifically, the Fed’s policy resulted in lower interest rates in the U.S. 11. Impact of Money Supply Growth. Explain why an increase in the money supply can affect interest rates in different ways. Include the potential impact of the money supply on the supply of and the demand for loanable funds when answering this question. ANSWER: An increase in money supply increases the supply for loanable funds and therefore can place downward pressure on interest rates. Yet, it can also cause inflationary expectations, resulting in an increased demand for loanable funds and upward pressure on interest rates. 12. Confounding Effects. What other factors might be considered by financial market participants who are assessing whether an increase in money supply growth will affect inflation? ANSWER: Any factors that could offset or magnify the impact should be considered, such as expected oil prices, the strength or weakness of the dollar, and the strength of the economy. 13. Fed Response to Fiscal Policy. Explain how the Fed’s monetary policy could depend on the fiscal policy that is implemented. [ ANSWER: A fiscal policy that involves much government borrowing could place upward pressure on interest rates. If the Fed wants to keep interest rates low in order to stimulate the economy, it may need to use a loose monetary policy to offset the fiscal policy effect on interest rates. Advanced Questions 14. Interpreting the Fed’s Monetary Policy. When the Fed increases money supply to lower the federal funds rate, do you think this will the cost of capital of U.S. companies be reduced? Explain how the segmented markets theory regarding the term structure of interest rates (as explained in Chapter 3) could influence the degree to which the Fed’s monetary policy affects long-term interest rates. ANSWER: A change in the federal funds rate will likely cause a change in other short-term interest rates. However, it might not result in a change in long-term interest rates, because the direct impact is only on short-term rates. To the extent that maturity markets are segmented, the effect will be isolated on short-term rates. 15. Monetary Policy Today. Assess the economic situation today. Is the administration more concerned with reducing unemployment or inflation? Does the Fed have a similar opinion? If not, is the administration publicly criticizing the Fed? Is the Fed publicly criticizing the administration? Explain. ANSWER: Assessing the economic situation today, it appears that the administration is likely more concerned with reducing unemployment rather than inflation. Here's why: 1. Unemployment : While the economy has shown signs of recovery from the impacts of the COVID-19 pandemic, the unemployment rate remains elevated compared to pre-pandemic levels. The administration is likely focused on accelerating job growth, reducing unemployment, and facilitating a robust labor market recovery to ensure widespread economic opportunity and financial security for workers. 2. Inflation : While inflation has increased recently, reaching levels higher than in the previous years, the administration may view this inflationary pressure as transitory and largely driven by temporary factors such as supply chain disruptions, pent-up consumer demand, and base effects from the pandemic-induced downturn. Consequently, the administration may prioritize addressing unemployment over inflation concerns in the short term. Regarding the Federal Reserve's stance, it's important to note that the Fed operates independently of the administration and makes monetary policy decisions based on its dual mandate of maximizing employment and maintaining price stability. While the Fed shares the administration's goal of fostering full employment, its assessment of inflation and the appropriate policy response may differ. If there is a discrepancy between the administration's priorities and the Fed's assessment of economic conditions, it's possible that tensions could arise between the two entities. However, publicly criticizing each other is relatively uncommon and generally not conducive to maintaining market confidence and stability. The Fed may communicate its policy decisions and rationale to the public through statements, speeches, and press conferences, emphasizing its commitment to its mandate and data-driven approach to monetary policy. Similarly, while the administration may express its preferences and expectations regarding economic outcomes, direct criticism of the Fed's actions or decisions is typically avoided to preserve the central bank's independence and credibility. In summary, while the administration may be more concerned with reducing unemployment than inflation given the current economic situation, the Fed's assessment of economic conditions and its policy responses may differ. While differences in opinions may exist, open criticism between the administration and the Fed is generally avoided to maintain the integrity of both institutions and ensure effective policy coordination. 16. Impact of Foreign Policies. Why might a foreign government’s policies be closely monitored by investors in other countries, even if the investors plan no investments in that country? Explain how monetary policy in one country can affect interest rates in other countries. ANSWER: Country economies have become highly integrated over time, so that one country’s economy can affect others. Thus, a foreign country’s government policies may affect its own economy, which in turn affects other economies and therefore security prices. If the monetary policy in one country (such as the U.S.) places upward pressure on the country’s interest rates, investors from other countries may shift their funds there to capitalize on the high interest rates. This results in a reduced supply of funds in the foreign countries. Given the degree of integration between countries, the higher interest rates in one country can place upward pressure on interest rates of other countries as well. 17. Monetary Policy During a War. Consider a discussion during FOMC meetings in which there is a weak economy and a war, with potential major damage to oil wells. Explain why this possible effect would have received much attention at the FOMC meetings. If this situation was perceived to be highly likely at the time of the meetings, explain how it may have complicated the decision about monetary policy at that time. Given the conditions stated in this question, would you suggest that the Fed use a restrictive monetary policy, or a stimulative monetary policy? Support your decision logically, and acknowledge any adverse effects of your decision. ANSWER: Normally a weak economy will cause FOMC members to push for a loose money policy that is intended to reduce interest rates, encourage more borrowing (and spending), and stimulate the U.S. economy. However, if oil wells were damaged, there could be an oil shortage. Under these conditions, oil prices would rise and inflation would likely rise as well. The Fed usually does not want to use a loose money policy in a period when there is high inflation. Thus, it has a dilemma of either adding fuel to the higher inflation with a loose monetary policy or leaving the money supply as is, which offers no cure for the slow economy. The student’s decisions will likely be: (1) leave the monetary policy as is, which offers no cure for the economy, or (2) use a loose money policy that could stimulate the economy but cause more inflation. The key is that they recognize the tradeoff. 18. Economic Indicators. Stock market conditions serve as a leading economic indicator. Assuming the U.S. economy is in a recession, what are the implications of this indicator? Why might this indicator be inaccurate? ANSWER: If stock prices are a leading economic indicator, then the stock market will move up before the economy begins to recover from a recession. An improvement in the stock market may signal that the economy is about to recover. This indicator may be inaccurate because the investors who push stock prices higher may have had unrealistic expectations. 19. How the Fed Should Respond to Prevailing Conditions. Consider the existing economic conditions, including inflation and economic growth. Do you think the Fed should increase interest rates, reduce interest rates, or leave interest rates at their present levels? Offer some logic to support your answer. ANSWER: The appropriate response for the Federal Reserve (the Fed) to prevailing economic conditions, including inflation and economic growth, depends on various factors and requires careful consideration. Let's assess the situation and explore the potential courses of action: 1. Inflation : If inflationary pressures are rising significantly and persistently above the Fed's target level, it may indicate overheating in the economy. In such a scenario, the Fed may consider increasing interest rates to cool down inflationary pressures and prevent the economy from overheating. Higher interest rates can reduce borrowing and spending, thereby dampening demand and easing inflationary pressures. 2. Economic Growth : If economic growth is robust and sustainable, with indicators such as low unemployment, strong consumer spending, and healthy business investment, the Fed may opt to gradually increase interest rates to prevent the economy from overheating and to maintain price stability. By raising interest rates, the Fed can moderate economic growth to a more sustainable pace and prevent imbalances from building up in the economy. 3. Present Conditions : Given the existing economic conditions, where inflation has increased but economic growth may not yet be at risk of overheating, the Fed may choose to leave interest rates at their present levels for the time being. This approach allows the Fed to monitor developments in the economy more closely and assess whether inflationary pressures are transitory or if they pose a sustained risk to price stability. 4. Forward Guidance : In addition to adjusting interest rates, the Fed may provide forward guidance to communicate its policy intentions and expectations for future interest rate movements. Clear communication from the Fed can help shape market expectations and guide economic behavior, providing stability and predictability to financial markets. In summary, the appropriate response for the Fed to prevailing economic conditions involves carefully balancing the objectives of maintaining price stability and promoting maximum employment. While rising inflation may warrant eventual interest rate increases to prevent overheating, the Fed should assess the sustainability of economic growth and the persistence of inflationary pressures before taking action. Leaving interest rates at their present levels while closely monitoring developments in the economy allows the Fed to maintain flexibility and respond effectively to evolving economic conditions. 20. Impact of Inflation Targeting by the Fed. Assume that the Fed adopts an inflation-targeting strategy. If oil prices rise abruptly by 15 percent in response to an oil shortage, describe how the Fed’s monetary policy would be affected by this situation. Do you think the inflation-targeting strategy would be more or less effective in this case than if the Fed balances its inflation concerns with unemployment concerns? Explain. ANSWER: If the Fed uses an inflation targeting strategy, it will need to use a tight (restrictive) monetary policy in response to the oil price shock so that it can attempt to slow economic growth and reduce pressure on inflation. However, in this situation, the inflation is caused by an oil shortage, not by an excessive demand for products. Therefore, the policy will not necessarily cure the oil price shock, and could also cause a recession. 21. Predicting the Fed’s Actions. Assume the following conditions. The last time the FOMC met, it decided to raise interest rates. At that time economic growth was very strong, and inflation was relatively high. Since the last meeting, economic growth has weakened, and the unemployment rate will likely rise by one percentage point over the quarter. The FOMC’s next meeting is tomorrow. Do you think the FOMC will revise its targeted federal funds rate? If so, how? ANSWER: The Fed would likely not change the target. It probably raised interest rates at the last meeting in order to reduce inflation. It realizes that the use of a restrictive monetary policy may reduce economic growth, so it will not feel the need to correct a slowdown in the economy in this situation. 22. The Fed’s Impact on the Housing Market. In periods when home prices declined substantially, some homeowners blamed the Fed. In other periods when home prices increased, homeowners gave credit to the Fed. How can the Fed have such a large impact on home prices? How could news of a substantial increase in the general inflation level affect the Fed’s monetary policy and thereby affect home prices? ANSWER: The Fed influences interest rates, which affects the cost of borrowing, and this affects the ability of consumers to purchase a home. If interest rates are too high, some consumers are unable to afford the type of home they wish to purchase, because they can not afford the monthly payments on the mortgage. A sudden increase in inflation could prompt the Fed to use a restrictive monetary policy to slow economic growth, whereby interest rates are increased. The higher interest rates could reduce consumer demand for homes and may reduce home prices. In addition, if the Fed slows economic growth, this could also reduce demand for homes and home prices. 23. Targeted Federal Funds Rate. The Fed uses a targeted federal funds rate when implementing monetary policy. However, the Fed's main purpose in its monetary policy is typically to have an impact on the aggregate demand for products and services. Reconcile the Fed's targeted federal funds rate with its goal of having an impact on the overall economy. ANSWER Even though the federal funds rate is the interest rate that is targeted by the Fed, other interest rates are affected as well because they are also affected by supply and demand for funds in the banking system. When depository institutions experience an increase in supply of funds due to the Fed's stimulative monetary policy, they have more funds than they need, and reduce the deposit rate that they are willing to offer on new bank deposits. They also reduce their rates on loans in order to attract more potential borrowers so that they can make use of the funds that they have available. The lower loan rates cause a higher demand for loanable funds by households and businesses, which can increase aggregate demand for products and services. 24. Monetary Policy During Credit Crisis. During the credit crisis, the Fed used a stimulative monetary policy. Why do you think the total amount of loans to households and businesses did not increase as much as the Fed had hoped? Are the lending institutions to blame for the relatively small increase in the total amount of loans extended to households and businesses? ANSWER: The Fed was successful at reducing interest rates. However, under very bad economic conditions, many potential business projects may not be feasible even at the lower cost of borrowing, because the potential cash flows from these projects are not sufficient to make the projects worthwhile. Also, the lending institutions were cautious when granting loans because of the high potential for default risk when lending to households or businesses during such a weak economy. Lending institutions should not extend loans unless they have confidence that the loans will be repaid. 25. Stimulative Monetary Policy During a Credit Crunch. Explain why a stimulative monetary policy might not be effective during a weak economy in which there is a credit crunch. ANSWER: A credit crunch implies that banks are very careful in their credit analysis of potential borrowers, and are restricting the amount of credit they will provide. The ability of the Fed to stimulate the economy is partially influenced by the willingness of banks to lend funds. Even if the Fed increases the level of bank funds during a weak economy, banks may be unwilling to extend credit to some potential borrowers. In a weak economy, the future cash flows of many potential borrowers are more uncertain, causing a reduction in loan applications (demand for loans) and in the number of loan applicants that meet a bank’s qualification standards. 26. Response of Firms to a Stimulative Monetary Policy In a weak economy, the Fed commonly implements a stimulative monetary policy to lower interest rates, and presumes that firms will be more willing to borrow. Even if banks are willing to lend, why might such a presumption about the willingness of firms to borrow be wrong? What are the consequences if the presumption is wrong? ANSWER: The presumption about firms borrowing may be wrong because in a weak economy, firms may be concerned that they may fail if they increase their debt. They may prefer not to borrow more funds until the economy improves. Consequently, firms will not correct the weak economy by spending more money, and the Fed’s stimulative policy may be ineffective. Fed Policy Focused on Long-term Interest Rates Why might the Fed want to focus its efforts on reducing long-term interest rates rather than short-term interest rates during a weak economy? Explain how it might use a monetary policy focused on influencing long-term interest rates. Why might such a policy also affect short-term interest rates in the same direction? ANSWER: Firms incur a cost of debt that is highly influenced by the long-term Treasury rates, not the short-term Treasury rates. If the Fed wants to encourage them to borrow more funds, it may want to focus on lowering long-term interest rates. To achieve this goal, it may need to use a stimulative policy that is focused on reducing the long-term Treasury yields. The long-term loan rates are based on the long-term Treasury rate plus a risk premium. Money flows between short-term and long-term Treasury markets, which means that it is difficult for the Fed to have one type of impact in the long-term market that is different than the short-term market. Impact of Monetary Policy on Cost of Capital Explain the effects of a stimulative monetary policy on a firm’s cost of capital. ANSWER: A stimulative monetary policy is normally intended to reduce interest rates. Since lower interest rates tend to reduce the cost of debt and the cost of equity, a stimulative monetary policy reduces the cost of capital. Effectiveness of Monetary Policy What circumstances might cause a stimulative monetary policy to be ineffective? ANSWER: The ability of the Fed to stimulate the economy is partially influenced by the willingness of depository institutions to lend funds. Even if the Fed increases the level of bank funds during a weak economy, banks may be unwilling to extend credit to some potential borrowers; the result is a credit crunch. Banks provide loans only after confirming that the borrower’s future cash flows will be adequate to make loan repayments. In a weak economy, the future cash flows of many potential borrowers are more uncertain, causing a reduction in loan applications (demand for loans) and in the number of loan applicants that meet a bank’s qualification standards. Impact of ECB Response to Greece Crisis How did the debt repayment problems in Greece affect creditors from other countries in Europe? How did the ECB’s stimulative monetary policy affect the Greek crisis? ANSWER: The debt repayment problems in Greece adversely affected creditors from many other countries in Europe. In addition, Portugal and Spain had large budget deficit problems (because of excessive government spending) and experienced their own financial crises in 2012. The weak economic conditions in these countries caused fear of a financial crisis throughout Europe. The fear discouraged corporations, investors, and creditors outside of Europe from moving funds into Europe, and also encouraged some European investors to move their money out of the euro and out of Europe. Thus, just the fear by itself reduced the amount of capital available within Europe, which resulted in lower growth and lower security prices in Europe. The European Central Bank (ECB) was forced to use a more stimulative monetary policy than desired in order to ease concerns about the Greek crisis, even though this caused other concerns about potential inflation in the eurozone. The Greek crisis illustrated how the ECB’s efforts to resolve one country’s problems could create more problems in other eurozone countries that are subject to the same monetary policy. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Lately, the Fed’s policies are driven by gold prices and other indicators of the future rather than by recent economic data.” The Fed would like to focus on expectations of the future rather than on historical data. Gold prices are perceived to reflect expectations of future inflation. Conversely, recent historical data may not necessarily represent economic conditions in the future. b. “The Fed cannot boost money growth at this time because of the weak dollar.” The weak dollar places upward pressure on U.S. inflation. The Fed may be concerned that high money growth will add to this pressure. c. “The Fed’s fine-tuning may distort the economic picture.” Some economists believe that the Fed should not attempt to control economic conditions by adjusting the money supply, because it may make conditions worse. Managing in Financial Markets As a manager of a firm, you are concerned about a potential increase in interest rates, which would reduce the demand for your firm’s products. The Fed is scheduled to meet in one week to assess the economic conditions and set monetary policy. Economic growth has been high, but inflation has also increased from 3 percent to 5 percent (annualized) over the last four months. The level of unemployment is so low so that it cannot possibly go much lower. a. Given the situation, is the Fed likely to adjust monetary policy? If so, how? The Fed would likely use a more restrictive monetary policy in order to reduce inflation. While this could cause higher interest rates, it may be necessary to dampen inflation, even if it also slows economic growth. Given that economic growth is high and that unemployment is very low, the Fed may believe that it could afford to slow the economy down without creating any major adverse effects. b. Recently, the Fed has allowed the money supply to expand beyond its long-term target range. Does this affect your expectation of what the Fed will decide at its upcoming meeting? This gives the Fed one more reason for using a more restrictive monetary policy, because it encourages the Fed to reduce money supply growth in order to meet the existing target range. c. Suppose that the Fed has just learned that the Treasury will need to borrow a larger amount of funds than originally expected. Explain how this information may affect the degree to which the Fed changes the monetary policy. The increased borrowing by the Treasury may place upward pressure on interest rates. Therefore, the Fed may not have to restrict money supply growth as much because the Treasury’s actions will help push interest rates higher. In this case, the Fed may still decide to cut back on money supply growth but the cut may be smaller as a result of the expected actions of the Treasury. Flow of Funds Exercise Anticipating Fed Actions Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Because of its expectations of a strong U.S. economy, Carson plans to grow in the future by expanding its business and through acquisitions. It expects that it will need substantial long-term financing and plans to borrow additional funds either through loans or by issuing bonds. The company also considers issuing stock to raise funds in the next year. An economic report recently highlighted the strong growth in the economy, which has led to nearly full employment. In addition, the report estimated that the annualized inflation rate increased to 5 percent, up from 2 percent last month. The factors that caused the higher inflation (shortages of products and shortages of labor) are expected to continue. How will the Fed’s monetary policy change based on the report? The Fed will likely focus more on reducing inflation, even if this means that it must reduce economic growth. How will the likely change in the Fed’s monetary policy affect Carson’s future performance? Could it affect Carson’s plans for future expansion? Carson’s future performance will not be as strong as expected, because the Fed’s actions will likely result in higher interest rates, which will increase the cost of borrowing. In addition, the Fed’s actions will slow economic growth, which could reduce the demand for Carson’s products, and will reduce Carson’s sales. If higher interest rates occur and slow down economic growth, Carson may not expand as much as it had planned because the demand for its products could be less than what it had expected. Explain how a tight monetary policy could affect the amount of funds borrowed at financial institutions by deficit units such as Carson Company. How might it affect the credit risk of these deficit units? How might it affect the performance of financial institutions that provide credit to such deficit units as Carson Company? A tight monetary policy could reduce economic growth, and therefore reduce the aggregate demand for products and services. Firms like Carson Company would perform worse under these conditions, and some firms may not generate sufficient sales to cover their debt payments. If economic growth is stalled, the financial institutions that provide credit are adversely affected for two reasons. First, the demand for loans is reduced, so they do not generate as much business in loans. Second, a higher percentage of their loans will default as some borrowers experience financial problems. Solution to Integrative Problem for Part II Fed Watching 1. There is no perfect answer to this question, but some factors deserve to be considered. The Fed may prefer to stimulate the economy, but the dilemma involves inflationary pressure. At the present time, the economy is almost at full employment, even though the GDP has declined slightly in the last two quarters. Inflation is assumed to be 5 percent prior to the expectation of a large increase in oil prices. Therefore, the expected inflation will now exceed 5 percent. The past inflation occurred in the presence of a strong dollar. If the dollar weakens at all (which could happen if U.S. oil prices rise), there would be additional pressure on U.S. inflation. Overall, there would be much concern that stimulating the economy could cause further inflationary pressure. While the Fed does not necessarily desire a decline in GDP, it may not be as concerned about that as inflation. Thus, the Fed is not likely to use a stimulative policy yet. If economic conditions get worse, it may need to reconsider. 2. If the Fed does not stimulate the economy, the economy will decline further, which would normally reduce interest rates. It was assumed that changes in economic growth tend to have a greater impact on interest rates than the impact of inflation. Thus, the upward pressure of increased inflationary expectations on interest rates should be offset by the downward pressure caused by a slow economy. Overall, there does not seem to be any urgency to dump bonds. The future values of stocks may be dependent on whether the Fed uses a stimulative monetary policy. Following the logic of the answer to the preceding question, the Fed is not likely to use a monetary policy. Based on this logic, there is no reason to switch to stocks.Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
