Chapter 5: Monetary Theory and Policy
Managing 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.
a. 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.
b. 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.
c. 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.
