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Q6 Suppose monetary policy 'eases'. How will the slope of the yield curve be affected? Explain how your answer might be influenced if the easing of credit led to a rise in expected inflation.

Recalling the previous question, if economic authorities ease monetary policy (in the sense that they increase money supply) two contrasting effects can appear. On one hand real interest rates would decrease and, given a certain level of inflation, also nominal interests would go down, thus implying a flattening of the yield curve. On the other hand, an increase in money supply would lead, given a certain level of economic activity, to an upsurge of expected inflation. To maintain the same real interest rates, also nominal rates have to increase, thus implying a steepening of the curve.

Yet, the final outcome depends on the relative strength of the two factors. In more technical words, the outcome depends on the relative position of the economy in the business cycle. If the economy is close to a peak (almost full employment of factors), the expansionary monetary policy provides the reason to expect higher inflation, higher nominal rates and a steeper yield curve.  If the economy is in a stable position, the yield curve is more likely to be unaffected.

( EXERCISES

Q1 On 7 November 1991, the financial press reported:

(a) The Federal Reserve sought to revive the US economic recovery by cutting the discount rate by 0.5 percentage points to 4.5%, the lowest in 18 years.

(b) The Fed explained that the discount rate was cut against a background of 'sluggish' expansion of the monetary and credit aggregates, and 'abating inflationary pressures'.

(c) The Fed's action was preceded by statistics indicating poor employment growth and faltering economic activity.

(d) Mr Michael Boskin, the chief White House economist, said lower interest rates would help the economy, but warned that there might be a lag of one or two quarters.

(e) The Financial Times reported that the Fed's action 'reflected growing evidence that the economic recovery has stalled' and 'followed heavy pressures from the White House which was "rattled" by polls indicating disapproval of President George Bush' handling of the economy'.

Comment on (i) the reasons advanced for the Fed's cut in the discount rate, (ii) the likely effects of this action, and (iii) the sectors likely to be most affected by it.

i) The main reason behind the Fed's decision lies in the anti-cyclical goal of economic policy. Poor employment growth, faltering economic activity and abating inflationary pressures mean that the economy is in a period of stagnation and is leading towards the bottom part of the present economic cycle. Recalling the AS / AD model represented in figure 13.1, the present position shows an important gap between actual and potential growth. The Federal Reserve uses monetary policy to stimulate investment and aggregate demand through a decrease in the official discount rate.

31/07/97

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