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Using the Iowa Electronic Markets in Macroeconomics. Predicting Federal Reserve Policy Developed by: Scott Simkins - North Carolina A&T State University Vineeta Hingorani - Southern University at Baton Rouge Jonathan Ikoba - Scott Community College. - PowerPoint PPT Presentation
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FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 1
Using the Iowa Electronic Using the Iowa Electronic Markets in MacroeconomicsMarkets in Macroeconomics
Predicting Federal Reserve Policy
Developed by:Scott Simkins - North Carolina A&T State UniversityVineeta Hingorani - Southern University at Baton RougeJonathan Ikoba - Scott Community College
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 2
Economic Policy and the Economy:Economic Policy and the Economy:Policy GoalsPolicy Goals Maintain low inflation Maintain low unemployment rates Promote steady economic growth Maintain stable interest rates
How? Through monetary policy
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 3
Economic Policy and the Economy:Economic Policy and the Economy:Economic Growth with Low InflationEconomic Growth with Low Inflation By using its monetary policy tools, the
Federal Reserve strives to keep the economy growing with low inflation.
To do this, it must offset “economic shocks” that affect the economy.
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 4
Economic Policy and the Economy:Economic Policy and the Economy:Offsetting Shifts in ADOffsetting Shifts in AD
Event: increase in aggregate demand Economic response
– price level rises and real GDP rises Federal Reserve policy response:
– Raise interest rate to maintain price stability
– Result: output back to original level, price level remains stable
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 5
Economic Policy and the Economy:Economic Policy and the Economy:Offsetting Shifts in ADOffsetting Shifts in AD
1. Increase in AD
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 6
Economic Policy and the Economy:Economic Policy and the Economy:Offsetting Shifts in ADOffsetting Shifts in AD
1. Increase in AD
2. Federal Reserve Raises Interest Rates
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 7
Economic Policy and the Economy:Economic Policy and the Economy:Offsetting Shifts in ADOffsetting Shifts in AD
Event: decrease in aggregate demand Economic response
– price level falls and real GDP falls Federal Reserve policy response:
– Reduce interest rate to maintain full employment
– Result: output and price level back to original level
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 8
Economic Policy and the Economy:Economic Policy and the Economy:Offsetting Shifts in ADOffsetting Shifts in AD
1. Decrease in AD
2. Federal Reserve Lowers Interest Rates
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 9
Economic Policy and the Economy:Economic Policy and the Economy:Offsetting Shifts in SRASOffsetting Shifts in SRAS
Event: decrease in aggregate supply Economic response
– price level rises and real GDP falls Federal Reserve policy response:
– Reduce interest rate to maintain full employment
– Result: output returns to potential GDP but price level rises further
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 10
Economic Policy and the Economy:Economic Policy and the Economy:Offsetting Shifts in SRASOffsetting Shifts in SRAS
1. Decrease in SRAS
2. Federal Reserve lowers interest rate
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 11
Economic Policy and the Economy:Economic Policy and the Economy:Offsetting Shifts in SRASOffsetting Shifts in SRAS
Event: decrease in aggregate supply Economic response
– price level rises and real GDP falls Federal Reserve policy response:
– Raise interest rate to maintain price stability
– Result: price level returns to original level but output falls further
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 12
Economic Policy and the Economy:Economic Policy and the Economy:Offsetting Shifts in SRASOffsetting Shifts in SRAS
1. Decrease in SRAS
2. Federal Reserve raises interest rate
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 13
Economic Policy and the Economy:Economic Policy and the Economy:Self-regulating economy?Self-regulating economy?
Event: increase in aggregate demand Economic response
– price level rises and real GDP rises Federal Reserve policy response:
– Do nothing– Result: output returns to original level but
price level rises further
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 14
Economic Policy and the Economy:Economic Policy and the Economy:Self-Regulating Economy?Self-Regulating Economy?
1. Increase in AD
2. Federal Reserve does nothing
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 15
Economic Policy and the Economy:Economic Policy and the Economy:Self-regulating economy?Self-regulating economy?
Questions: What happens when AD falls and the
Federal Reserve responds by doing nothing?
What happens when SRAS falls and the Federal Reserve responds by doing nothing?
Summary: when should the Federal Reserve actively intervene in the economy?
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 16
Economic Policy and the Economy:Economic Policy and the Economy:The “New Economy”The “New Economy” In recent years, labor productivity has been
increasing, helping to keep inflation low and generating economic growth.
What is the role of the Federal Reserve in an economy experiencing significant increases in productivity?
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 17
Role of the Federal Reserve:Role of the Federal Reserve:Policy Goals and ObjectivesPolicy Goals and Objectives Maintain low inflation Maintain low unemployment rates Promote steady economic growth Maintain stable interest rates
To meet its policy goals, the Federal Reserve uses changes in the federal funds rate as its primary monetary policy tool.
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 18
Role of the Federal Reserve:Role of the Federal Reserve:Policy Instrument: The Fed Funds RatePolicy Instrument: The Fed Funds Rate
The fed funds (interest) rate is determined in the federal funds market
The Federal Reserve affects the supply of reserves in the federal funds market through open market operations, changes in the discount rate, and changes in the reserve requirement.
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 19
Role of the Federal Reserve:Role of the Federal Reserve:FOMC MeetingsFOMC Meetings FOMC consists of the Board of Governors of
the Federal Res. and 5 Fed. Reserve district bank presidents
Led by Federal Reserve Chairman (Greenspan)
Meets approximately every 6 weeks Determines changes in monetary policy; in
particular, changes in the “target level” of the federal funds rate.
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 20
Role of the Federal Reserve:Role of the Federal Reserve:Effects of Federal Reserve PolicyEffects of Federal Reserve Policy Changes in the fed funds rate affect a wide
variety of interest rates in the economy. In turn, changes in interest rates affect
business and consumer spending. Aggregate spending levels affect inflation,
unemployment, and output growth. In addition, changes in interest rates also
affect stock market growth, which in turn can affect consumer and business spending.
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 21
Role of the Federal Reserve:Role of the Federal Reserve:What can Fed Policy Do?What can Fed Policy Do? Some economists argue that the Fed’s goal
should simply be to keep inflation low; that in the long run, real rather than monetary factors, will determine output and employment levels.
In reality, the Federal Reserve currently looks at a wide variety of economic data before implementing changes in monetary policy.
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 22
Predicting Federal Reserve Policy:Predicting Federal Reserve Policy:Summarizing Current Economic ConditionsSummarizing Current Economic Conditions
Federal Reserve Beige Book– Summary of economic conditions around the
country; published just prior to FOMC meetings
http://www.bog.frb.fed.us/FOMC/BeigeBook/2000/ Other Web sources
– The Dismal Scientisthttp://www.dismal.com/
– BLS Economy at a Glancehttp://stats.bls.gov/eag/eag.map.htm
– Economic Statistics Briefing Roomhttp://www.whitehouse.gov/fsbr/esbr.html
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 23
Predicting Federal Reserve Policy:Predicting Federal Reserve Policy:Recent Federal Reserve BehaviorRecent Federal Reserve Behavior Main policy objective: keep inflation low Over the past year (Aug., 1999 - August,
2000), Federal Reserve has been raising the target fed funds rate due to concerns about tight labor markets and future inflation.
Unemployment rate hit 30-year record low in early 2000, productivity is increasing, and output is rising, but inflation remains low.
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 24
Predicting Federal Reserve Policy:Predicting Federal Reserve Policy:Forecasting StrategiesForecasting Strategies When predicting future Federal Reserve
policy, you must ask:– What are the Fed’s objectives?– What is current state of the economy?– What must the Fed do to achieve its objectives,
given the current state of the economy?
Requires: constant monitoring of economic activity in the economy
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 25
Predicting Federal Reserve Policy:Predicting Federal Reserve Policy:An Example Using the IEMAn Example Using the IEM Example: November, 1999 FedPolicy market
Daily IEM contract prices are used to illustrate the relationship among economic conditions, Fed policy objectives, and IEM contract prices
Contracts in this market and their associated payoff rules are:
Contract Name Contract Description / Liquidation Value Payoff Rules
FRup1199 $1.00 if the fed-funds rate target rises; $0 otherwiseFRsame1199 $1.00 if the fed-funds rate target remains unchanged; $0 otherwiseFRdown1199 $1.00 if the fed-funds rate target falls; $0 otherwise
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 26
IEM FedPolicy Contract Prices - Nov. 1999
0.00
0.20
0.40
0.60
0.80
1.0025
-Oct
26-O
ct27
-Oct
28-O
ct29
-Oct
30-O
ct31
-Oct
1-N
ov2-
Nov
3-N
ov4-
Nov
5-N
ov6-
Nov
7-N
ov8-
Nov
9-N
ov10
-Nov
11-N
ov12
-Nov
13-N
ov14
-Nov
15-N
ov16
-Nov
Date
Co
ntr
act
Pri
ce (
$)
FRup1199
FRsame1199
FRdown1199
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 27
IEM FedPolicy Contract Prices - Nov. 1999
0.00
0.20
0.40
0.60
0.80
1.0025
-Oct
26-O
ct27
-Oct
28-O
ct29
-Oct
30-O
ct31
-Oct
1-N
ov2-
Nov
3-N
ov4-
Nov
5-N
ov6-
Nov
7-N
ov8-
Nov
9-N
ov10
-Nov
11-N
ov12
-Nov
13-N
ov14
-Nov
15-N
ov16
-Nov
Date
Co
ntr
act
Pri
ce (
$)
November 5Employment Report Released -Unemployment rate declines to 29-year low but pressure on wages remains tame.
FRup1199
FRsame1199
FRdown1199
The price of FRsame1199 rose with the new economic information.
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 28
IEM FedPolicy Contract Prices - Nov. 1999
0.00
0.20
0.40
0.60
0.80
1.0025
-Oct
26-O
ct27
-Oct
28-O
ct29
-Oct
30-O
ct31
-Oct
1-N
ov2-
Nov
3-N
ov4-
Nov
5-N
ov6-
Nov
7-N
ov8-
Nov
9-N
ov10
-Nov
11-N
ov12
-Nov
13-N
ov14
-Nov
15-N
ov16
-Nov
Date
Co
ntr
act
Pri
ce (
$)
November 10Producer Price Index Report Released -Overall producer prices fall by 0.1% but core rate of inflation was up 0.3%, higher than expected.
FRup1199
FRsame1199
FRdown1199
Notice how the price of FRsame1199 dropped with the new economic information.
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 29
IEM FedPolicy Contract Prices - Nov. 1999
0.00
0.20
0.40
0.60
0.80
1.0025
-Oct
26-O
ct27
-Oct
28-O
ct29
-Oct
30-O
ct31
-Oct
1-N
ov2-
Nov
3-N
ov4-
Nov
5-N
ov6-
Nov
7-N
ov8-
Nov
9-N
ov10
-Nov
11-N
ov12
-Nov
13-N
ov14
-Nov
15-N
ov16
-Nov
Date
Co
ntr
act
Pri
ce (
$)
FRup1199
FRsame1199
FRdown1199
November 12Mixed economic signals makes predicting Fed policy at upcoming FOMC meeting a "tough call"
The FRsame1199 and FRup1199 contracts remained near $.50 until the FOMC announced its rate hike on Nov. 16
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 30
IEM FedPolicy Contract Prices - Nov. 1999
0.00
0.20
0.40
0.60
0.80
1.0025
-Oct
26-O
ct27
-Oct
28-O
ct29
-Oct
30-O
ct31
-Oct
1-N
ov2-
Nov
3-N
ov4-
Nov
5-N
ov6-
Nov
7-N
ov8-
Nov
9-N
ov10
-Nov
11-N
ov12
-Nov
13-N
ov14
-Nov
15-N
ov16
-Nov
Date
Co
ntr
act
Pri
ce (
$)
November 5Employment Report Released -Unemployment rate declines to 29-year low but pressure on wages remains tame.
November 10Producer Price Index Report Released -Overall producer prices fall by 0.1% but core rate of inflation was up 0.3%, higher than expected.
FRup1199
FRsame1199
FRdown1199
November 12Mixed economic signals makes predicting Fed policy at upcoming FOMC meeting a "tough call"
IEM contract prices respond as new economic information is released. The contract prices reflect the probability that the Fed will change its policy stance at the specified FOMC meeting.
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 31
Predicting Federal Reserve Policy:Predicting Federal Reserve Policy:SummarySummary The FOMC uses changes in the federal
funds target rate to promote its policy goals of low inflation, high employment, and steady economic growth.
Accurately predicting Federal Reserve policy changes requires (1) understanding Fed monetary policy objectives, and (2) keeping abreast of current economic conditions.
FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEMwww.biz.uiowa.edu/iem/assignments 32
Predicting Federal Reserve Policy:Predicting Federal Reserve Policy:Summary - continuedSummary - continued Contract prices in the IEM FedPolicy market
react quickly to new information about the state of the economy.
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