Like many other investors, you are a “Fed watcher,” who constantly monitors any actions
taken by the Fed to revise monetary policy. You believe that three key factors affect
interest rates. Assume that the most important factor is the Fed’s monetary policy. The
second most important factor is the state of the economy, which influences the demand
for loanable funds. The third factor is the level of inflation, which also influences the
demand for loanable funds. Because monetary policy can affect interest rates, it affects
economic growth as well. By controlling monetary policy, the Fed influences the prices
of all types of securities.
The following information is available:
• Economic growth has been consistently strong over the past few years but is beginning
to slow down.
• Unemployment is as low as it has been in the past decade but has risen slightly over
the past two quarters.
• Inflation has been about 5 percent per year for the past few years.
• The dollar has been strong.
• Oil prices have been very low.
Yesterday, an event occurred that you believe will cause much higher oil prices in the
United States and a weaker U.S. economy in the near future. You plan to determine
whether the Fed will respond to the economic problems that are likely to develop.
You have reviewed previous economic slowdowns caused by a decline in the aggregate
demand for goods and services and found that each slowdown precipitated a loosemoney
policy by the Fed. Inflation was 3 percent or less in each of the previous economic
slowdowns. Interest rates generally declined in response to these policies and the
U.S. economy improved.
Assume that the Fed’s philosophy regarding monetary policy is to maintain economic
growth and low inflation. There does not appear to be any major fiscal policy forthcoming
that will have a major effect on the economy. Thus, the future economy is up to the
Fed. The Fed’s present policy is to maintain a 2 percent annual growth rate in the money
supply. You believe that the economy is headed toward a recession unless the Fed uses a
very stimulative monetary policy, such as a 10 percent annual growth rate in the money
The general consensus of economists is that the Fed will revise its monetary policy to
stimulate the economy for three reasons: (1) it recognizes the potential costs of higher
unemployment if a recession occurs, (2) it has consistently used a stimulative policy in
the past to prevent recessions, and (3) the administration has been pressuring the Fed to
use a stimulative monetary policy. Although you will consider the economists’ opinions,
you plan to make your own assessment of the Fed’s future policy. Two quarters ago,
GDP declined by 1 percent. Last quarter, GDP declined again by 1 percent. Thus, there
is clear evidence that the economy has recently slowed down.
1. Do you think that the Fed will use a stimulative monetary policy at this point? Explain
2. You maintain a large portfolio of U.S. bonds. You believe that if the Fed does not
revise its monetary policy, the U.S. economy will continue to decline. If the Fed stimulates
the economy at this point, you believe that you would be better off with stocks than
with bonds. Based on this information, do you think you should switch to stocks?
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