Using the Iowa Electronic Markets in Macroeconomics

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


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


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.


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



1. Increase in AD



1. Increase in AD

2. Federal Reserve Raises Interest Rates



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



1. Decrease in AD

2. Federal Reserve Lowers Interest Rates


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



1. Decrease in SRAS

2. Federal Reserve lowers interest rate



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



1. Decrease in SRAS

2. Federal Reserve raises interest rate


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


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


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?


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?


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.


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.


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.


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.


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.


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


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.


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


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


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



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.



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.



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



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.


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.


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.

Documents

Using the Iowa Electronic Markets in Macroeconomics