The bottom right screen in Figure 2.1 Diverse illustrations of macroeconomics shows a decision of the Federal Open Market Committee (FOMC) to reduce a key interest rate by three-fourths of a percentage point to 2.25 percent. As we shall see in our study of monetary policy, a reduction in interest rates is a tool to increase economic activity. Lower interest rates make it cheaper for households and firms to borrow, so they spend more on goods and services. The FOMC action was taken on account of weak economic conditions in the United States, but its consequences were felt worldwide.
Other monetary authorities likewise look at the state of their economies and adjust their monetary policy. The following is part of a statement from the European Central Bank (ECB), the monetary policy authority for the European Union. It was part of a press conference held in April 2005 in which Jean-Claude Trichet, president of the ECB, and Lucas Papademos, vice president of the ECB, provided a statement about economic outlook for Europe and the stance of monetary policy.
All in all, we have not changed our assessment of risks to price stability over the medium term. So far, we have seen no significant evidence of underlying domestic inflationary pressures building up in the euro area. Accordingly, we have left the key ECB interest rates unchanged. Both nominal and real rates are at exceptionally low levels, lending ongoing support to economic activity. However, upside risks to price stability over the medium term remain and continued vigilance is therefore of the essence.
I shall now explain our assessment in more detail, turning first to the economic analysis. Recent data and survey indicators on economic activity have been mixed. In general they point to ongoing economic growth at a moderate pace over the short term, with no clear signs as yet of a strengthening in underlying dynamics.
Looking further ahead, the conditions remain in place for moderate economic growth to continue. Global growth remains solid, providing a favourable environment for euro area exports. On the domestic side, investment is expected to continue to be supported by very favourable financing conditions, improved profits and greater business efficiency. Consumption growth should develop in line with real disposable income growth. However, at the same time, persistently high oil prices in particular pose downside risks to growth. […] 1
Statements such as this are reported in the business press and widely read. Businesspeople all over the world closely follow the actions of central banks. That is, the people interested in this statement by the ECB were not only European citizens but also individuals in the United States and other countries. Likewise, when the Fed takes action, the news shows up on televisions and computer screens across the world.
The ECB quotation mentions several key economic variables: inflation, real interest rates, nominal interest rates, economic activity, investment, exports, consumption growth, and real disposable income growth. These variables are also important indicators of the state of the economy, as we can tell from the fact that they play such a prominent role in the ECB assessment.
The economists at the ECB need to know the current state of the economy when deciding on what policies to pursue. But there are compelling reasons for others to care about these variables as well. Suppose, for example, that you are an investor contemplating an investment in Spain. Your interest is in making profit from producing a good in Spain and selling it in that country and others. The profitability of the investment in Spain depends on the overall state of the Spanish economy and its neighbors in the European Union who are the target group for your sales.
For you as an investor, the ECB statement contains vital information about the state of the European economy. It also contains information on the likely conduct of monetary and fiscal policy in Europe. These factors matter for you simply because they impact the profitability of your investment. Thus you want to understand the statements from the ECB, starting with the definitions of key macroeconomic variables.
By now, you may well have a number of questions. What exactly are these monetary authorities in Europe and the United States? Where do they come from and what are their powers? How exactly do their actions have so much influence on our lives? Answering these questions is one of our tasks in this book. We devote two full chapters to the determination and the influence of monetary policy in the economy.
KEY TAKEAWAY
- Real GDP has grown on average over the past 50 years, but the growth is not always constant: sometimes the economy grows quickly and sometimes real GDP grows slowly (or not at all).
- The inflation rate measures the percent change in prices. If prices are increasing, then a unit of currency, such as a dollar, buys fewer goods and services. During a period of inflation, the monetary authority may take action to reduce the inflation rate.
- Each year, the income taxes we pay to the government reflect its choice of fiscal policy. The policy meetings of the FOMC in the United States, the ECB of the European Monetary Union, and other central banks around the world are examples of monetary policy.
Checking Your Understanding
- Which of the macroeconomic variables discussed would a fiscal authority pay attentionto?
- Do the ECB and the FOMC always make the same policy decision?
- Is a change in the tax code an example of fiscal or monetary policy?
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