Question
An article in the Economist discussed the situation facing the U.S. economy in mid-2015: "The combination of weaker-than-expected CPI inflation and some dovish comments in the minutes of the Federal Reserve's July meeting have caused the dollar ... to fall. Inflation continues to languish close to zero due to cheap oil and the effect of a strengthening dollar." By "dovish comments, the article meant that some members of the Fed's Federal Open Market Committee did not believe that the target for the federal funds rate should be raised in the coming months.a. If investors come to believe that the Fed might not be increasing interest rates, why would the value of the dollar decline?b. What does "the strengthening of the dollar" mean? Why would a strengthening of the dollar reduce the inflation rate in the United States?
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The Federal Reserve (Fed) uses interest rates as a tool to control inflation. When the Fed increases interest rates, it reduces the quantity of money in circulation, which in turn stabilizes the value of the dollar. This is because higher interest rates make Show more…
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The following report appeared in the New York Times on August 7,1989 ("Dollar's Strength a Surprise," $\mathrm{p} . \mathrm{D} 1$ ): But now the sentiment is that the economy is heading for a "soft landing," with the economy slowing significantly and inflation subsiding, but without a recession. This outlook is good for the dollar for two reasons. A soft landing is not as disruptive as a recession, so the foreign investments that support the dollar are more likely to continue. Also, a soft landing would not force the Federal Reserve to push interest rates sharply lower to stimulate growth. Falling interest rates can put downward pressure on the dollar because they make investments in dollar-denominated securities less attractive to foreigners, prompting the selling of dollars. In addition, the optimism sparked by the expectation of a soft landing can even offset some of the pressure on the dollar from lower interest rates. a. Show how you would interpret the third paragraph of this report using this chapter's model of exchange rate determination. b. What additional factors in exchange rate determination might help you explain the second paragraph?
While many economists and policymakers supported the Fed's decision to maintain the federal funds rate at a near-zero level for over six years, Charles Schwab, the founder and chairman of a discount brokerage firm that bears his name, argued that the economy was harmed by keeping interest rates low for an extended period of time: $$\begin{array}{l}{\text { U.S. households lost billions in interest }} \\ {\text { income during the Fed's near-zero interest }} \\ {\text { rate experiment.... Because they are often }}\\{\text { reliant on income from savings, seniors were }} \\ {\text { hit the hardest... Seniors make up } 13 \% \text { of the }} \\ {\text { U.S. population and spend about S1.2 trillion }} \\ {\text { annually.... This makes for a potent multiplier }} \\ {\text { effect. }}\end{array}$$ a. What type of spending was Schwab expecting would have increased if the Fed had raised interest rate earlier than it did? b. Would higher interest rates have had an effect on other types of spending? Briefly explain. c. Which of the types of spending that you discussed in answering parts (a) and (b) does the Fed appear to believe has the more "potent multiplier effect? Briefly explain.
Inflation, Unemployment, and Federal Reserve Policy
Federal Reserve Policy from the 1970 s to the Present
In congressional testimony, former Federal Reserve Chairman Ben Bernanke said: $$\begin{array}{l}{\text { Another significant factor influencing }} \\ {\text { medium-term trends in inflation is the public's }} \\ {\text { expectations of inflation. These expectations }} \\ {\text { have an important bearing on whether transi- }} \\ {\text { tory influences on prices, such as changes in }} \\ {\text { energy costs, become embedded in wage and }} \\ {\text { price decisions and so leave a lasting imprint }} \\ {\text { on the rate of inflation. }}\end{array} $$ What did Bernanke mean when he said that the public's expectations of inflation could "become embedded in wage and price decisions"? What would be the effect on the short-run Phillips curve of the public coming to expect a higher inflation rate?
The Short-Run and Long-Run Phillips Curves
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