PART 2 INTEGRATIVE PROBLEM Fed Watching Like many other investors, you are a Fed watcher, who constantly monitors any actions taken by the Fed to revise monetary policy. You believe that three key factors affect interest rates. Assume that the most important factor is the Feds monetary policy. The second most important factor is the state of the economy, which influences the demand for loanable funds. The third factor is the level of inflation, which also influences the demand for loanable funds. Because monetary policy can affect interest rates, it affects economic growth as well. By controlling monetary policy, the Fed influences the prices of all types of securities. The following information is available: Economic growth has been consistently strong over the past few years but is beginning to slow down. Unemployment is as low as it has been in the past decade but has risen slightly over the past two quarters. Inflation has been about 5 percent per year for the past few years. The dollar has been strong. Oil prices have been very low.

Yesterday, an event occurred that you believe will cause much higher oil prices in the United States and a weaker U.S. economy in the near future. You plan to determine whether the Fed will respond to the economic problems that are likely to develop. You have reviewed previous economic slowdowns caused by a decline in the aggregate demand for goods and services and found that each slowdown precipitated a loosemoney policy by the Fed. Inflation was 3 percent or less in each of the previous economic slowdowns. Interest rates generally declined in response to these policies and the U.S. economy improved. Assume that the Feds philosophy regarding monetary policy is to maintain economic growth and low inflation. There does not appear to be any major fiscal policy forthcoming that will have a major effect on the economy. Thus, the future economy is up to the Fed. The Feds present policy is to maintain a 2 percent annual growth rate in the money supply. You believe that the economy is headed toward a recession unless the Fed uses a very stimulative monetary policy, such as a 10 percent annual growth rate in the money supply. The general consensus of economists is that the Fed will revise its monetary policy to stimulate the economy for three reasons: (1) it recognizes the potential costs of higher unemployment if a recession occurs, (2) it has consistently used a stimulative policy in the past to prevent recessions, and (3) the administration has been pressuring the Fed to use a stimulative monetary policy. Although you will consider the economists opinions, you plan to make your own assessment of the Feds future policy. Two quarters ago, GDP declined by 1 percent. Last quarter, GDP declined again by 1 percent. Thus, there is clear evidence that the economy has recently slowed down. Questions 1. Do you think that the Fed will use a stimulative monetary policy at this point? Explain.