How much does the Federal Reserve actually affect the economy?

How much does the Federal Reserve actually affect the economy?


Economic scholars over the years have been known to pay a great deal of attention to the underlying economic effects of monetary policies. The emphasis, in this present era has been mostly focused entirely on the consequences or implications of unanticipated changes in the policies of the Federal Reserve (Satyajit 11). What would be the effect of monetary policy shocks? To what degree would the economy be affected if the Federal Reserve Bank were to do something unexpected and it what way would the economy respond to such a circumstance? Will there be a rise in inflation rates, or will the economy witness a decline? Will there be an increase in output or will the effect be the opposite in response to change in policy?
The above stated questions bring us to critically begin to conceptualize to what degree does the Federal Reserve truly affect the economy? This literature deems to analyze this notion and proffer answers to it. This research is significant because while numerous researches have studied effects of particular policies on a stipulated sector of the economy, only very few studies have been clairvoyant about the effects of the Federal Reserve on the economy and to what level is the impact of such an effect.

The Federal Reserve and its Systematic Policy

While there has been no concrete tool for predicting the actions of the Federal Reserve at any particular point in time, firms, investors as well as financial market participants constantly pay close attention to the behaviors of the Federal Reserve. This consistent analysis and evaluation of the behavior of the Fed generally are fairly significant predictors of monetary policies as well as changes within the economy based on a behavioral shift of the path of the Federal Reserve. The Fed equally communicates its outlook on the economy on a regular basis and statements in the FOMC policy documents clearly present a relatively fair indication of currents trends and stances of the state of policies.
Given all the modes of communication as well as scrutiny, monetary surprises or shocks of any consequences are more than likely to be rare events. This notion implies that the systematic behavior of the Federal Reserve will be its primary mechanism for influencing or affecting the economy. The manner in which the Federal Reserve moves interest rate in response to economic variables such as output growth and inflation will provide us with a means of analyzing the extent to which the Federal Reserve affects the economy. Via the analysis of two different policies which basically have similar long term objectives “Price stability” we hope to ascertain the level of influence of the Federal Reserve on the economy.

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Changes in Productivity

In trying to analyze the Federal Reserve’s systematic monetary policies, this literature focuses on how changes in productivity influences or shapes economic activities and in turn how the Federal Reserve affects such an influence. Productivity levels are clear factors of how much output can be produced from a stipulated amount of capital and labor. The more that can be produced, the more productive the economy (Blinder et al.).
In trying to ascertain the importance of productivity changes on movement of economic outputs, a critical assessment on the graph below illustrates this. The graph presents changes in productivity measured as a deviation from productivity shocks (trend growths) along with output growth within America from a time period of 1948 to 2000.
As can be seen, productivity changes are quite variable, in most cases exceeding 2 %. A positive change amounting to 2% of change in productivity implies that 2% more output may be produced using the amount of capital and labour.
Another ignificant feature illustrated in the graph above is the high degree of simultaneous or co-movement between shifts in productivity and output growth. The correlation coefficient that exist betweenproductivity shocks and output growth is 0.83. this value denotes the fact that productivity shocks or changes is critical to economic growth. How, then and to what level does the Federal Reserve and its monetary policy affect the manner in which these productivity shocks influence the economy and its activities. Satyajit (1995) cleary states in one of his article that in situations when productivity is high, then output, investments and employment follow the same trend.
An analysis of another graph illustrates the behavior of four significant element or rather variables following changes or shocks to productivity. The varying behaviors of these variables is based on the realbusiness cycle model which describes the correlation of the variables and provide us with a theory as to the implications of productivity on the economy.
One significant attribute of the real business cyce model is that there are no impediments to the allocation of resources or alterations in prices. All prices are flexible and change without any cost whatsoever. Particularlly, the prices of goods depict tendencies to change with changes in marginal cost of producing a good. In similar fashion, wage rates as well as wages on rentals on capitalshow the same tendency to change when there is a change in productivity. The real business cycle model though many assume it not be be realistic, does in some way provide a necessary benchmark for theevaluation of the effects of monetary policies dished out by the Federal Reserve in a more realistic environment (Dotsey 37).
In analyzing the graph above, Taking productivity for iastance, A zero (0) value indicates that productivity is at its normal level and a value of one (1) shows that productivity has incresed by 1 % above its mormal level. The productivity shock examined in this case is one that ceases over time and is quite similar to those studied in business cycle analysis.
Due to the fact that higher productivity establishes that more output can be produced, using the same capital and labor, it doesn’t come as a shock that output should be high when there is an increase in productivity. It is equally eveident that as productivity dissipates, increase in output follows suit. One other significant thing to note from the graph is that output does rise a good deal more than productivity, but for this to occur, there must be the mplementation of other actors ofproduction such as capital and labor in an equally increasing measure. If these factors did not increase then output growth would mirror the exact trend of productivity.
Within the graph and its underlyin analysis, an essential point to note as well as understand within the context of the cascade of effects which occur due to productivity shocks is that these effects are optimal form a standpoint of every individual within the economy. The consequent rise or increase in hours worked, output, real interest rates and investments all result from firms as well as individuals taking advantage of increase in productivity. Additional opportunities have been said to created by productivity rises.

Effects of Monetary Policies when Prices do not adjust instantaneously

Our previous analysis bordered on how the economic response to an increase in productivity was instantaneous. Hence, product prices adjust instantly to changes in productivity. Given such a setting, one could quite say that monetary policies are quite irrelevant. However, from what we know and from numerous studies, such an environment is unrealistic. This lack of realism establishes the notion that in a bid to understand the significance of monetary policies and the degree of effect of the Federal Reserve on the economy, a better description of the economy must be provided.
One of the major changes that will be effected within this literature will involve the alteration of the assumption of perfect flexibility in prices. Though no substantial evidence exist on whether firms adjust prices instantaneously, Blinder et al surveyed a series of firms and established that most firms do not alter product prices for up to a year (William et al.).Bils and Klenow in a detailed review on price changes of commodities and services examined and documented the price behavior of almost 350 products and showed how frequently the price of each commodity changed over time. In their findings, the depict that prices of products remain fixed for almost 6 months, though some products showed 30 to 40 % of prices did change with every quarter.
In capturing this facet of behavior, let us assume that each firm adjust its prices once in every year, with 25 % of all firms adjusting prices per quarter.
In situations where price setting is sluggish, economic behavior is dependent on the monetary policies of the Federal Reserve. Firstly, we will examine the factor of money growth. With a long tradition of monetary theory, this one policy is most notably linked with Milton Freidman. A major justification for the prescription of this policy is based on its ability to control and determine the rate of long run inflation while equally making available adequate capital on the average for the economy to function efficiently. However as a response to the persistent growth in productivity, the money growth policy appears not to be an appropriate policy. In spite of the fact that this policy permits the economy to function smoothly and in a less volatile manner than is observed in the real business cycle model, individuals within that economy are less well off. This notion of sluggishness in price setting is invariably translated into an overall sluggishness in economic activities.
If we analyze the output graph in the figure above, we notice that it increases only by half with productivity. The underlying reason for this lack in responsiveness is witnessed in the bottom left panel, depicting that employment witnessed a decline, which is a sharp contrast with what we obtained in the flexible price real business cycle model where arise in productivity caused an increase in employment. In this model however, workers lose out on the potential gains in the economy. In similar fashion, investment under this policy is comparatively less responsive and real interest rates drop.
Why does the economy behave so differently? The core reason for this is the sluggishness in price adjustments. Results based on the analysis of the policies within this literature lead to the key question whether the Federal Reserve Bank or the Central Bank can engineer shifts in the economy and to what level?
Based on our analysis, the answer to the above question is yes and to a very large degree. The Federal Reserve could affect the economy to varying degrees. If it chooses to follow an interest rate rule, via raising interest rates aggressively in a situation where prices start to rise and aggressively lowering interest if prices drop. In our model economy, the effect and the level of of the Federal Reserve within the context of this stated policy is depicted in the graph below.
In reality, the economy is affected to varying degrees by various types of shocks. For instance, changes in fiscal policy or changes in private demands, perhaps initiated or induced by large swings in equity or a response to a persistent productivity disturbance. Due to the notion that policies should be designed to respond to all forms of disturbances or shocks, the Federal Reserve’s behavior is not expected to mimic the rules of the economy but rather should be the other way round. This notion goes a long way to show that the Federal Reserve does to a very large extent affect the economy. Again to emphasize this notion, if the Federal Reserve policies are designed appropriately, then these actual polies should fair rather well in respect to any particular shock (Khan et al. 825).


The Federal Reserve with its policies especially the systematic portions of monetary policy do have a major degree of effect on the economy and all its underlying activities. This is true because it significantly influences the price setting behavior of firms and demand levels. A consistent money growth rule does to a large extent inhibit the economy’s capacity and ability to respond efficiently to changes in productivity, whereas an implementation of the interest rate rule which is focused on price level gives room for the economy to respond to productivity shocks rather effectively. This is the degree to which the Federal Reserve can affect the economy.

Works Cited

    1. Bils, Mark, and Peter J. Klenow. “Some Evidence on the Importance of Sticky Prices,” National Bureau of Economic Research Working Paper 9069, July 2002.
    2. Blinder, Alan S., Elie R. D. Canetti, David E. Lebow, and Jeremy B. Rudd. “Asking About Prices: A New Approach to Understanding Price Stickiness,” Russell Sage Foundation, New York, 1998. Retrieved from April 22, 2014.
    3. Chatterjee, Satyajit. “Productivity Growth and the American Business Cycle,” Federal Reserve Bank of Philadelphia Business Review, September/October 1995, pp. 13-22.
    4. Chatterjee, Satyajit. “From Cycles to Shocks: Progress in Business-Cycle Theory,” Federal Reserve Bank of Philadelphia Business Review, March/April 2000, pp. 1-11
    5. Dotsey, Michael. “Structure from Shocks,” Federal Reserve Bank of Richmond Economic Quarterly, 88, 2002, pp. 37-48.
    6. English, William B., William R. Nelson, and Brian P. Sack. “Interpreting the Significance of Lagged Interest Rates in Estimated Monetary Policy Rules,” Federal Reserve Board Finance and Economics Discussion Series 2002-24, 2002.
    7. Khan, Aubhik, Robert G. King and Alexander L. Wolman. “Optimal Monetary Policy,” Review of Economic Studies, October 2003, pp. 825-60.

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