Monetary Policy And The Economy Essay - 2,043 words

... 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 sugges ...................................................................................................................................................................................................................................................................................................................................................................

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Essay Tags: term interest rates, aggregate demand, long term interest, real interest rates, demand for goods

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