FREE ESSAY ON FEDERAL RESERVE AND THE ECONOMIC BUBBLE

FEDERAL RESERVE AND THE ECONOMIC BUBBLE

On Tuesday, November 16, 1999, the Federal Reserve Board will decide whether or not to
tighten monetary policy at the Federal Open Market Committee meeting. Throughout the year
the Fed has been somewhat hesitant to raise rates, which could slow the economy. While
raising the Federal Funds and Discount Rates could, in the long run, lead to higher
interest rates, many people worry that the potential for an overheated economy is high,
and there is little risk from too slow growth. Overheating in the economy, popularly
known as the economic bubble, could reverse the current decline in inflation. Therefore,
action should be taken to prevent such a thing from happening.
The purpose of monetary policy is to stabilize prices and make sure that economy is
operating at full potential (stabilize employment and production). Data proves that both
have been fulfilled. Price inflation is low at 2% and unemployment is close to 4%.
(Bureau of Economic Analysis and Bureau of Labor Statistics) This low rate of
unemployment, however, can be a problem for many businesses, because it can make finding
qualified labor difficult. So, which move can be considered the most appropriate?
I feel that the best action is to tighten monetary policy. The economy is growing at a
rate above its potential, as a result of high consumer spending, which is driven by
swelling stock prices. Households and businesses are borrowing more and saving less.
According to the Bureau of Labor Statistics, there has been a steady decline in the
unemployment and underemployment rates. The underemployed includes the unemployed,
discouraged workers, and those working part-time that desire to work full-time. This aids
in the 4% real GDP growth. While this may seem attractive, it is not desirable in an
economy that is overheating, such as ours. 
With the phenomenon of low unemployment comes high labor costs. Businesses spend large
amounts of resources in hiring, labor retention, and in the training and educating of
less qualified workers. Consequently, profit margins are falling. Earnings have fallen in
the past year, however stock prices continue to increase at record highs. This is
evidence that investors have extremely high expectations for the future earnings growth
of their investments. Investors will be disappointed if earnings continue to lag. If the
economy does not slow down, then businesses will have no choice but to raise the prices
of their goods and services, or they will run the risk of seeing their stock price drop.
The small unemployment pool suggests that we should pay particular attention to inflation
risks. The relationship between unemployment and inflation is illustrated by the Phillips
Curve, named after the economist A.W. Phillips. This relationship exists because low
employment is associated with high aggregate demand, and demand puts upward pressure on
wages and prices throughout the economy. Therefore, it is probable that if the economy
remains overheated, then inflation will rise. 
The model of the Philips Curve is also related to the Model of Aggregate Demand and
Aggregate Supply. This model shows the relationship between the price level and the
quantity of output of goods and services. The higher the aggregate demand, the greater
the output, and in turn, the lower the unemployment rate. The lower the aggregate demand,
the lower the supply, and the higher the unemployment rate. 
A decrease in the money supply, which can be accomplished by raising rates, will shift
the aggregate demand curve to the left and move the economy to a point with low inflation
and higher unemployment. This will not only keep the economy away from possible
inflation, but it will also provide companies with a larger and more qualified applicant
pool.
Raising the Federal Funds Rate (interest rate that banks charge each other) and the
Discount Rate (interest on the loans that the Fed makes to banks) will decrease the
demand by banks to borrow from the Fed. This leads to the reduction in the money supply.
If the money supply within banks is reduced, then banks will raise their interest rates,
which will discourage the non-bank public from borrowing, and encourage them to save.
This in turn will reduce consumer spending. Inflation is at a very low point, and many
economists, such as Alan Greenspan, are doubtful that it will get any lower. However,
additional rate hikes might prevent the excessive overheating that many economists fear.

The Federal Reserve Board made the decision to tighten monetary policy on November 16,
1999. The federal funds rate was raised 25 base points to 5.5%. The discount rate was
raised 25 base points from 4.75% to 5%.
Works Cited
Trapped by the Bubble" The Economist 25 Sept. 1999: 17 - 18.
Boldin, Michael. "Foreseeing Rate Hikes in the Futures Market" www.dismal.com
Boldin, Michael. "What Will the Fed Do Next?" www.dismal.com
Glassman, James K., Kevin A. Hasset Dow 36000 The Atlantic Monthly Sept 1999: 37-58.
Kohn, Donald L. Secretary of the FOMC "Minutes of the Federal Open Market Committee"
www.dismal.com/fed/minutes/fomc_minutes082499.stm
Schlesinger, Jacob M. "Fed Holds Rates Steady but Chills Market." Wall Street Journal 6
Oct. 1999, A2
Schlesinger, Jacob M. Stock Surge Could Trigger Fed Move." Wall Street Journal 8 Oct.
1999, A2.
Schlesinger, Jacob M. and Sarah Lueck "Fed Raises Rates by One-Quarter Point." Wall
Street Journal 17 Nov. 1999, A2
Testimony of Alan Greenspan; July 22, 1999;
http://woodrow.mpls.frb.fed.us/info/policy/mpo/mp9997.html
July 1999 Humphrey-Hawkins Report: Report Section 1: Monetary Policy and the Economic
Outlook http://www.bog.frb.fed.us/boarddocs/HH/1999/July/Reportsection1.htm
Economy At a Glance; Bureau of Labor Statistics; http://stats.bls.gov/eag.table.html