Lisa C. Herman-Ellison Kokomo High School Kokomo, Indiana Lisa Herman-Ellison teaches Advanced Placement Economics and Advanced Placement Government at Kokomo High School in Kokomo, Indiana. She has published lesson plans for the National Council on Economic Education and the Indiana Council for Economic Education. She has won state and national awards for lesson plans in economics. This lesson evolved from one of her Web-based lessons. It can be found at http://tlc.ai.org/lessons/econperf.htm.

Objectives Students learn what economic indicators tell us about the overall economic outlook. Students learn to understand how the economic outlook prompts the Federal Reserve to take action. Students learn to use the World Wide Web to locate up-to-date data. Students learn to predict future economic performance by studying up-to-date data. Students learn to advocate a course of action for the Federal Reserve, given current and projected data. Students learn to assess the impact of the Fed policy they recommend. Time Required 2 days Materials Internet-accessible computers, one for each team of two to three students, with Adobe Acrobat software to read government documents Computer disk (for each team) containing: Handout 1--Using Data to Assess Economic Performance Handout 2--Gathering and Analyzing Current Data and Choosing a Policy Supplemental Lecture--Didn't You Say the Fed Has Three Tools?

Overview
Every six or seven weeks, the world watches as the Federal Reserve's Federal Open Market Committee (FOMC) decides its monetary policy for the coming weeks. This high school lesson plan helps students to understand this process, with a focus on the Fed's primary policy tool — open market operations.

Students will learn that this cyclical process entails many steps: collecting and interpreting data, making forecasts, outlining possible policy actions, and assessing the advantages and disadvantages of each action.

In this lesson, students will face the problem of using conflicting economic indicators to forecast the near-term course of the economy. They will be introduced to just a few of the many economic indicators that the Fed uses. They'll also have a chance to try their hand at setting monetary policy.

Students will imagine that they are members of the Federal Reserve's Open Market Committee — the committee that sets the Fed's monetary policy. Students will assess current economic data, predict future economic performance, advocate a course of action for the Fed, and assess the effects of the actions they advocate.

Students will begin to understand the difficulties faced by a central bank. They will assess the intended and unintended effects of alternative monetary policy actions and begin to understand the tradeoffs associated with adopting any particular policy.

The Internet makes such a lesson possible and meaningful, as students use current data provided by the very entities which had earlier supplied the out-of-date statistics found in textbooks.

Teaching Activity
This lesson provides a culminating activity for a macroeconomics course. Therefore, students will require knowledge of several concepts and how they can be used to estimate economic performance and predict economic trends (e.g., consumer price index, unemployment rate, real GDP, index of leading economic indicators). Further, students will need to understand how the Federal Reserve uses its most important policy tool — open market operations — to influence real GDP growth and inflation. They should also understand how open market operations can affect other aspects of the economy.

As an overview, review the following questions with the class:

How does the Fed assess where the economy has been?

How does the Fed estimate where the economy is heading right now?

How can the Fed influence the future course of the economy?

What will be the likely side effects of the Fed's policy?

Explain the procedure of this lesson. Tell students they have been chosen to be Federal Reserve Bank presidents or members of the Fed's Board of Governors. Thus, they will be serving on the Federal Open Market Committee (FOMC). In teams of two or three, they are to assess recent U.S. economic performance, predict the near-term future course of the economy, and decide what policy action to take.

Distribute a disk containing Handout 1 and Handout 2 to each team. The members of the team should work together to type their answers on the disk and turn it in by the end of the period. There may be a strong temptation on the students' part simply to cut and paste definitions; emphasize to students that they are to answer the questions in their own words. If the class is one hour or less in duration, have students complete only Handout 1 on the first day. Check the students' work for understanding, and prepare to reteach or reinforce any necessary concepts at the beginning of the second class. If the class runs 90 minutes or longer, quickly check for student understanding of Handout 1 before allowing the students to proceed to Handout 2.

The next class period can be devoted, in part, to team presentations about students' analyses and recommendations for Federal Reserve action, or it can be used as an opportunity to debrief students on the difficulties associated with economic prediction and weighing the positive and negative effects of monetary policy. The questions reviewed with students at the beginning of this lesson will likely evoke different and more insightful responses than those expressed initially.

Conclusion
Through this exercise, the complexities of the American economy and policymaking procedures become clearer to students. Students seem to take greater care in assessing current real economic data and policy consequences than they do with hypothetical data. This enthusiasm usually extends beyond the classroom as students continue to follow the latest economic reports, which can result in a better-informed electorate.

Economic Concepts Board of Governors   A government agency charged with overseeing the operations of the Federal Reserve System. The Board, consisting of seven members, sets reserve requirements and approves the setting of discount rates by Federal Reserve Banks. Consumer Price Index (CPI)  Measures the cost of a market basket of goods and services bought by the "typical" consumer. The CPI is one measure of the overall price level. Depository Institution  A class of financial corporations including commercial banks and similar institutions. Discount Rate  The interest rate charged by a Federal Reserve Bank on short-term loans to depository institutions. A depository institution borrows through the "discount window" when it needs additional funds to meet the Fed's reserve requirements. Usually, depository institutions try to borrow from other sources (e.g., the federal funds market) before turning to the discount window. Federal Reserve Bank  One of twelve institutions nationwide that, along with the Board of Governors, comprise the Federal Reserve System. Legally, Federal Reserve Banks are private corporations, owned by depository institutions that belong to the Federal Reserve System. Federal Funds Rate  The interest rate that one depository institution charges when it lends part of its reserve balances at a Federal Reserve Bank to another depository institution. In general, loans made on the federal funds market must be paid back within a single business day. Also known as the "fed funds rate." Federal Open Market Committee (FOMC)  The principal policymaking arm of the Fed System. The FOMC sets policy with respect to open market operations. The FOMC consists of the seven members of the Board of Governors and the twelve Federal Reserve Bank presidents; at any given time, five Bank presidents are voting members of the FOMC, and the other seven are nonvoting members. Gross Domestic Product (GDP)  Measures the market value of all final goods and services produced by residents in a country in one year. Inflation An increase in the general price level — the average price of all final goods and services. Leading Indicators  Statistics used to predict the course of the business cycle, e.g., when the economy will go into recession or high growth. The Index of Leading Indicators combines a number of leading indicators into a single overall indicator. Monetary Policy  The set of actions taken by the Federal Reserve System to affect the level of bank reserves which, in turn, affect the overall money supply. The object of Fed monetary policy is to encourage maximum sustainable growth and a stable overall price level. Nominal GDP  Measures a country's total production of goods and services in one year, measured in dollars. Nominal GDP growth reflects both the increase in real GDP and increases in the overall price level (i.e., inflation). This inflation distortion limits the usefulness of comparing nominal GDP data from different years. Open Market Operations  The principal tool of monetary policy. It comprises the Federal Reserve's purchase and sale of government securities in order, respectively, to increase or decrease the quantity of bank reserves. Doing so affects the money supply and the federal funds rate. Real GDP  Measures a country's total production of final goods and services in one year. Real GDP removes the inflation distortion from nominal GDP so that one can compare economic output in different years. Recession  A decline in real GDP for two or more successive quarters; recession is often characterized by high unemployment and a decline in inflation. Reserve Requirement  The percentage of deposits that a bank must hold in reserve and cannot lend. These deposits are called "bank reserves." The reserve requirement limits the growth of the money supply, but the Fed seldom adjusts reserve requirements in the course of monetary policy. Unemployment Rate  The number of unemployed people (those who are not working but who are actively seeking employment) as a percentage of the total labor force (unemployed people plus those working).

Supplemental Lecture Didn't You Say the Fed Has Three Tools? Most economics texts will explain to students that the Federal Reserve has three tools of monetary policy. Why, then, does this lesson plan focus solely on one of them — open market operations? What happened to reserve requirements and the discount rate? When the FOMC meets every few weeks, its principal order of business concerns open market operations (OMO). For several decades, OMO has been the principal tool of monetary policy. In open market operations, the Fed can either: buy Treasury securities, which puts more money in circulation and causes the federal funds rate to fall; or sell Treasury securities, which takes money out of circulation and causes the federal funds rate to rise. [NOTE: The money supply and the federal funds rate are two sides of the same coin. So, the FOMC could either aim for a federal funds rate of X% (yielding a money supply of $Y) or it could aim for a money supply of $Y (yielding a federal funds rate of X%). In practice, one method may be more practical than the other, but the two are analytically equivalent.] Reserve requirements still exist but are rarely adjusted as part of monetary policy. Simply put, the reserve requirement adjustment takes so long to filter through the economy that it's not an effective monetary tool in a fast-moving economy. Reserve requirements are set not by the FOMC, but rather by the Board of Governors. For different reasons, the discount rate is also a fairly ineffective way to alter the money supply (which is the object of monetary policy). The discount rate only affects the money supply if a lot of banks are borrowing through the discount window, and that is not the case. The discount rate is often adjusted to keep it in line with the federal funds rate, but the discount rate adjustments themselves have little direct impact on the money supply. The discount rate is set on a coordinated basis by the twelve Federal Reserve Banks, subject to the approval of the Board of Governors. Students who wish to learn more about reserve requirements and the discount rate can turn to the New York Fed's Web site: Fedpoint 45: Reserve Requirements: www.ny.frb.org/pihome/fedpoint/fed45.html Fedpoint 30: Discount Rate: www.ny.frb.org/pihome/fedpoint/fed30.html

Handout 1 Using Data to Assess Economic Performance The first step in the process of making monetary policy is using data to assess the economy's recent performance and make a best guess about where the economy will head under current monetary policy. The Federal Reserve Bank of New York's Web site has a page (www.newyorkfed.org/aboutthefed/fedpoint/fed45.html) that gives students an idea of how the FOMC evaluates data. This site provides a dozen or so data series and explains how the FOMC might use each of these series to assess recent eco-nomic performance and predict the course of events in the near term. (Keep in mind that as of this writing, the Web site's data go only through mid-1999.) For each of the following variables, read the description and examine the chart found on the New York Fed's Web site. Explain in your own words what each of these variables can tell us about the recent performance of the economy and/or about the near-term future. Try especially to talk about the relationship between each of the 12 variables on the one hand and real GDP growth and/or inflation on the other. a) Real Gross Domestic Product (GDP) b) Consumer Price Index (CPI) c) Non-farm Payroll Employment d) Housing Starts e) Industrial Production/Capacity Utilization f) Retail Sales g) Business Sales and Inventories h) Advance Durable Goods Shipments, New Orders, and Unfilled Orders i) Lightweight Vehicle Sales j) Yield on 10-year Treasury Bond k) S&P 500 Stock Index l) M2 Based on your economic texts and background knowledge, answer the following: Which of the following economic conditions could be consistent with a recession? Real GDP growth of -2%, inflation rate of -2%, and unemployment rate of 9% Real GDP growth of 1%, inflation rate of 7%, and unemployment rate of 6% Real GDP growth of 3%, inflation rate of 4%, and unemployment rate of 5% Real GDP growth of 7%, inflation rate of 9%, and unemployment rate of 10% Which of the following is most indicative of a future period of economic growth? A decrease in the major stock indexes A decrease in new vehicle sales An increase in housing starts An increase in business inventories It's also important to know how the Fed reacts to economic data. Here's a question along that line: If the data suggest that the United States is heading toward a bout of inflation, what action is the FOMC likely to take to prevent the inflation from occurring? Buy Treasury securities on the open market (causing the federal funds rate to fall) Sell Treasury securities on the open market (causing the federal funds rate to rise) Reduce the reserve requirement Raise the discount rate Ask American companies to delay price or wage increases

Handout 2 Gathering and Analyzing Current Data and Choosing a Policy A key to making good monetary policy is to have up-to-date information. Using the World Wide Web, find recent data on as many as possible of the 12 indicators shown on the New York Fed's Web site. For each indicator found, explain what the data indicate about recent and near-term future economic growth and/or inflation. Bear in mind that the evidence in the data may be conflicting (e.g., some indicators may show potential growth, while others may indicate a potential recession; some may indicate rising inflation, while others indicate declining inflation). Now, each team should write a brief essay answering the following questions: Given these economic data, how would your team assess the U.S. economy as of the final date of the available data? Was the economy expanding, contracting, or flat? Given these economic data, would your team expect economic expansion, recession, or a stagnant economy for the next year? Explain the reasons for your prediction. Now imagine that you are the FOMC. Given your expectations about the near-term course of real GDP growth and inflation, what should the FOMC do with respect to monetary policy (specifically, open market operations)? Should the Fed buy Treasury securities, sell securities, or neither? Be sure to base your finding on the data and explain the economic advantages of the policy action that you propose. If the Federal Reserve were to accept your recommendations, predict the likely effects on real GDP, inflation, and also on a few of the following. Be sure to explain why you feel these variables will respond as you have predicted. Unemployment Domestic value of the dollar Interest rates International value of the dollar Imports Exports

Answers to Handout 1 The New York Fed's Web site describes the following associations between the indicators and economic performance. Keep in mind that these associations will not always hold and that economists disagree on the strength and reliability of some of these associations: A reduction in real GDP indicates falling aggregate demand. Two successive quarters of falling GDP constitute a recession. Falling CPI may indicate a likelihood of recession. An increase of unemployment indicates a potential recession, as firms reduce production. A reduction in new housing starts indicates a lack of consumer confidence and a potential recession. A reduction in industrial production may indicate a slowing of manufacturing activity and a possibility of layoffs. A reduction in retail sales may indicate a lack of consumer confidence and the potential for recession. A reduction in business sales or rise in inventories may indicate firms may reduce production and lay off workers. A reduction in demand for durable goods may indicate lack of consumer confidence and potential recession. A reduction in lightweight vehicle sales may indicate a lack of consumer confidence and production cutbacks. A significant increase in Treasury bond interest rates can signal increased interest rates, which could slow housing sales and construction and purchases of high-priced and durable goods. A reduction in the S&P 500 stock index indicates a lack of consumer confidence and sluggish sales. A reduction or slowing of growth of M2 can indicate a slowing of nominal GDP. Which of the following economic conditions are consistent with a recession? (a) Which of the following is more often indicative of a future period of economic growth? (c) To keep inflation from rising, the Fed will most likely: (b) Answers to Handout 2 The answers to this section will vary, depending upon the current economic data and the students' suggested actions for the Federal Reserve. Here's a sample essay: The data indicate inflationary pressure on the economy, as inflation has been climbing from 2% to 4%. Real growth has been running at over 4% — a big increase over the previous year. Booming car sales and durables purchases suggest that the economy will continue on this high growth/high inflation course. This rising inflation could become a long-term threat to the economy, so the FOMC should take action to temper the price rises. The Fed should sell securities in order to reduce the level of reserves and, therefore, the money supply. We expect interest rates to rise, and this could lead to increased unemployment.