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Using the Iowa Electronic Markets in Macroeconomics

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.

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Using the Iowa Electronic Markets in Macroeconomics

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  1. 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 FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEM www.biz.uiowa.edu/iem/assignments

  2. Economic Policy and the Economy:Policy 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 IEM www.biz.uiowa.edu/iem/assignments

  3. Economic Policy and the Economy:Economic 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 IEM www.biz.uiowa.edu/iem/assignments

  4. Economic Policy and the Economy:Offsetting 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 IEM www.biz.uiowa.edu/iem/assignments

  5. Economic Policy and the Economy:Offsetting Shifts in AD 1. Increase in AD FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEM www.biz.uiowa.edu/iem/assignments

  6. Economic Policy and the Economy:Offsetting 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 IEM www.biz.uiowa.edu/iem/assignments

  7. Economic Policy and the Economy:Offsetting 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 IEM www.biz.uiowa.edu/iem/assignments

  8. Economic Policy and the Economy:Offsetting 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 IEM www.biz.uiowa.edu/iem/assignments

  9. Economic Policy and the Economy:Offsetting 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 IEM www.biz.uiowa.edu/iem/assignments

  10. Economic Policy and the Economy:Offsetting 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 IEM www.biz.uiowa.edu/iem/assignments

  11. Economic Policy and the Economy:Offsetting 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 IEM www.biz.uiowa.edu/iem/assignments

  12. Economic Policy and the Economy:Offsetting 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 IEM www.biz.uiowa.edu/iem/assignments

  13. Economic Policy and the 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 IEM www.biz.uiowa.edu/iem/assignments

  14. Economic Policy and the 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 IEM www.biz.uiowa.edu/iem/assignments

  15. Economic Policy and the 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 IEM www.biz.uiowa.edu/iem/assignments

  16. Economic Policy and the 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 IEM www.biz.uiowa.edu/iem/assignments

  17. Role of the Federal Reserve:Policy 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 IEM www.biz.uiowa.edu/iem/assignments

  18. Role of the Federal Reserve:Policy 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 IEM www.biz.uiowa.edu/iem/assignments

  19. Role of the Federal Reserve:FOMC 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 IEM www.biz.uiowa.edu/iem/assignments

  20. Role of the Federal Reserve:Effects 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 IEM www.biz.uiowa.edu/iem/assignments

  21. Role of the Federal Reserve: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 IEM www.biz.uiowa.edu/iem/assignments

  22. Predicting Federal Reserve Policy:Summarizing 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 Scientist http://www.dismal.com/ • BLS Economy at a Glance http://stats.bls.gov/eag/eag.map.htm • Economic Statistics Briefing Room http://www.whitehouse.gov/fsbr/esbr.html FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEM www.biz.uiowa.edu/iem/assignments

  23. Predicting Federal Reserve Policy:Recent 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 IEM www.biz.uiowa.edu/iem/assignments

  24. Predicting Federal Reserve Policy:Forecasting 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 IEM www.biz.uiowa.edu/iem/assignments

  25. Predicting Federal Reserve Policy:An 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 NameContract Description / Liquidation Value Payoff Rules FRup1199 $1.00 if the fed-funds rate target rises; $0 otherwise FRsame1199 $1.00 if the fed-funds rate target remains unchanged; $0 otherwise FRdown1199 $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 IEM www.biz.uiowa.edu/iem/assignments

  26. FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEM www.biz.uiowa.edu/iem/assignments

  27. The price of FRsame1199 rose with the new economic information. FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEM www.biz.uiowa.edu/iem/assignments

  28. 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 IEM www.biz.uiowa.edu/iem/assignments

  29. 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 IEM www.biz.uiowa.edu/iem/assignments

  30. 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 IEM www.biz.uiowa.edu/iem/assignments

  31. Predicting Federal Reserve Policy:Summary • 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 IEM www.biz.uiowa.edu/iem/assignments

  32. Predicting Federal Reserve Policy:Summary - continued • Contract prices in the IEM FedPolicy market react quickly to new information about the state of the economy. FALL 2000 EDITION LAST EDITED ON 9/00 Predicting Federal Reserve Policy using the IEM www.biz.uiowa.edu/iem/assignments

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