Take Home Part of Exam IV

What are the three principal tools of monetary policy? Explain how they can be used. What are the functions of the Federal Reserve System?
Suppose that, in attempt to prevent the economy from recession, the Fed lowers the interest rate by increasing the money supply. Illustrate graphically the effect on the money supply, interest rate, and GDP.
Other things being equal, what effect will each of the following have on the equilibrium rate of interest? (a) an increase in the supply of money; (b) an increase in the equilibrium level of national income; (c) a decrease in the supply of money; (d) a leftward shift of the asset demand for money.
Why is monetary policy more effective under a flexible exchange rate?
Do the following events cause the dollar to appreciate against the Euro or to depreciate?
Health experts discover that red wine, especially French red wine, lowers cholesterol.
France’s GDP falls.
The United States experiences a higher inflation rate than France does.

The Blame Game: Who Caused the Economic Recession?

The Wall Street Journal, January 30, 2001.

George W. Bush attempted to answer his critics on the economy in his State of the Union message on January 29. It seems rather odd that the Democrats are blaming the president for the recession. His tax cut, though proposed before the recession even began, was timely, even if misdirected. It became effective just as the recession was getting underway. In fact, the recession and deflation of the past year was not caused by investors, consumers and businesses, or President Bush, but by bad monetary policy.

The Federal Reserve, in its own words, says that it had nothing to do with what its head, Alan Greenspan, calls "a significant cyclical adjustment" that the NBER nonetheless had decreed a "recession." According to the Fed, all the villains were outside its marbled palace in Washington. First, the New Economy business leaders were deluded about potential returns and built excess capacity. Second, buyers of stocks were swept away by irrational exuberance. Third, foreign-exchange traders bid up the dollar and held inflation artificially low. Finally, U.S. trading partners messed up their own economies and that spilled over to contaminate ours. If the truth is known, policy choices made by Greenspan directly caused the current recession. Fed interest-rate increases in 1999 and 2000 pushed the real federal funds rate to its highest level in 10 years.

When the Fed pushes up the fed funds rate, overall spending slows. In the past year, nominal GDP growth (real growth plus inflation) hit a wall. During the year bracketing Y2K, nominal GDP grew at an average annual rate of 7.6 percent. During the year ending in December 2001, nominal GDP likely grew by only 1.9 percent. Greenspan's tightening squeezed the economy and accelerated on-going technology-driven deflationary pressures. Past mistakes aside, at least now the Fed is on the right track. The Fed has reduced the fed funds rate 11 times during the past year. Meanwhile, Greenspan denies his complicity, and Democrats blame the president. The evidence, nonetheless, is clear: Monetary policy really does matter.

According to the author, what caused the current economic recession?
The recession did not begin until the end of March 2001. Since the Federal Reserve already was cutting the fed funds rate in January 2001, how can it be blamed for the recession?
Why does Alan Greenspan refuse to use the term "recession" and blame other myriad forces for the economic downturn?
How would fed fund rate increases cause an economic recession?