Money, Banking, and International Financemachines, and equipment while consumers are unsure about long-term investments, such as
buying a house or car. Interest rate stability is related to the stability of the financial markets.
Large swings in interest rates can cause sizeable capital gains and losses in the financial
markets. Consequently, some investors earn profits while others earn losses.
Foreign-exchange market stability: The Fed tries to stabilize the U.S. dollar’s value against
the major currencies, such as the Japanese yen and European euro. A strong U.S. dollar causes
U.S products to become relatively more expensive to foreigners while foreign-made products
become cheaper to U.S. citizens. Thus, consumers buy more foreign products, raising imports
while U.S. businesses sell fewer products abroad, shrinking exports. If the U.S. dollar weakens,
then U.S. imports and exports do the opposite. U.S. products become cheaper to foreigners
while foreign-made goods become more expensive. Thus, U.S. exports rise while imports fall.
Some of these goals conflict with each other. For example, if the Fed pursues monetary
policy that expands the money supply, boosting national output and lowering the unemployment
rate. However, expansionary monetary policy can trigger inflation. Then the nominal interest
rates begin to increase because of the higher expectations of inflation, the Fisher Effect.
The European Central Bank, on the other hand, has only one policy goal – price stability.
The ECB defines price stability as an inflation rate of 2% or less. Thus, this extremely low
inflation rate causes the exchange rate of the euro to strengthen relative to other currencies,
which we discuss in Chapter 16.
Time Lags and Targets
The Fed cannot influence the monetary policy goals directly. The Fed uses its tools, open-
market operations, discount rates, and reserve requirements, to influence indirectly its policy
goals. Unfortunately, three time lags hinder monetary policy. First, the Federal Reserve or
government needs data and information before it can do anything, the information lag. For
instance, government calculates the unemployment rate monthly and estimates GDP data
quarterly. The government requires nine months to know whether the economy has entered a
recession because economists define a recession as two consecutive quarters of negative real
GDP growth. Thus, a government knows the economy is in a recession by the end of the third
quarter. Second, the Federal Reserve or government must study the data, and then they devise
and approve a policy, the administrative lag. Finally, a monetary policy does not impact the
economy immediately. It takes time when the Fed implements a policy until it shows up on the
economy, the impact lag.
Time lags can amplify the business cycle. For example, the economy entered a recession
that lasted only one year. Then the economy returned to the full-employment level.
Unfortunately, the government takes three months to collect quarterly GDP data. The GDP
needs two consecutive quarters of negative GDP growth before a recession is declared. Thus,
the Fed must wait nine months to determine whether the economy has entered a recession. If the
administrative lag is one month while the impact lag equals six months, then the Fed’s policy
takes hold after one year and four months to influence the economy, or 9 + 1 +6. If the Fed
counteracted this recession, subsequently, the Fed makes the economy more unstable. After the